Investment Banking

1.1What is GNP?

A 1.1 GNP stands for Gross National Product. This statistic measures the total money value of all the
final goods and services produced by a country’s nationals in a year. The GNP of Top 10 countries in
the year 2004 is shown in the below table:

GNP Top 10 (2004) (currency exchange rate)

Country GNP ($ mill)
1 United States $10,945,792
2 Japan $4,389,791
3 Germany $2,084,631
4 United Kingdom $1,680,300
5 France $1,523,025
6 China $1,417,301
7 Italy $1,242,978
8 Canada $756,770
9 Spain $698,208
10 Mexico $637,159

Table 1: GNP of top ten countries

GNP is calculated as:

GNP = (Gross Domestic Product (GDP) + income earned by residents from overseas investments) –
(income earned within domestic economy by overseas residents)

GDP on the other hand, is computed as:

GDP = (Consumption + government purchases + investments + exports) - imports

Q 1.2 What is Recession?

A 1.2 A Recession is usually defined as a fall of a country's real Gross Domestic Product in two or
more successive quarters of a year. A recession may also involve falling prices, which can lead to a
depression; alternatively it may involve sharply rising prices (inflation), in which case this process is
known as stagflation. Most recessions lead to falling inflation rates or what is called disinflation.
Example 1.2:

• Asian financial crisis - 1997, caused by a collapse of the Thai currency

• Early 2000s recession - 2000 to 2003 due to the collapse of the Dot Com Bubble

Q 1.3 What is Depression?

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A 1.3 Depression means 6 quarters of declining GNP.
A 1.2 The key symptoms of Depression are low production and sales and a high rate of falling
businesses and high unemployment. Some key examples of depression are:
US Long Depression 1870s – 1890s

• Great Depression in the 1930s

• Situation in Japan after “bubble burst” in the 1990s

Q 1.4 What is Business Cycle?

A 1.4 The Business Cycle is a periodically repeated sequence of fluctuations in the aggregate
economy of a nation, varying in duration, measured by the pattern of movement in real gross domestic
product (GDP) and consisting of: a) expansion, including recovery and prosperity; b) cyclical peak; c)
downturn, including recession; and d) cyclical trough. These cycles create price changes, which lead
to changes in total spending in relation to the amount of goods and services being produced. The
curve showing all the 4 phases in Business cycle is shown below.

Figure 1: Business cycle (Source:

Q 1.5 What is Inflation?

A 1.5 Inflation is an increase in the general price level of goods and services , which results in
decrease of purchasing power. It is normally associated with economic expansion and a low
unemployment figure. The Inflation rates of few countries from 1950-1994 is shown in the below
curve:
Pink = France, Green = Germany, Gray = Japan, Red = UK, Blue = US.

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Q 1.6 What is Deflation?

A 1.6 Deflation is a decline in prices, where production exceeds demand. Deflation normally occurs
during recessions and leads to a rise in unemployment. Since 1930, it has been the norm in most
developed countries for average prices to rise year after year. However, before 1930 deflation (falling
prices) was as likely as inflation .
Example 1.6 : On the eve of the First World War, prices in the UK, overall, were almost exactly the
same as they had been at the time of the great fire of London in 1666.
Did you know? Deflation is different from Disinflation.

Q 1.7 What is CPI?

A 1.7 CPI stands for Consumer Price Index. This is an indicator of the average change in prices of
goods and services. Included in the index are food, transportation, medical care, entertainment and
other items purchased by households and individuals.It is a tool used for measuring the rate of
inflation.
Table 2, given below contains the data on CPI for industrial workers:
Table No. 2
GROUP-WISE ALL-INDIA AVERAGE CONSUMER PRICE INDEX NUMBERS FOR INDUSTRIAL
WORKERS ON BASE: 1982=100 FOR THE PERIOD 1993 TO 2003
Year Calendar Year Average
Pan, Supari, Tobacco andFuel & Clothing, Bedding and
General Food Housing Misc.
Intoxicants Light Footwear
1993 252 265 334 230 222 197 246
1994 278 296 361 241 234 219 267
1995 306 331 389 254 248 247 289
1996 334 359 422 286 276 267 314
1997 358 380 467 320 293 281 346
1998 405 437 505 348 366 293 377
1999 424 444 553 370 430 303 410
2000 441 452 587 435 456 316 436

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2001 458 462 614 475 498 320 458
2002 477 474 629 524 549 331 483
2003 496 490 648 558 577 337 503
Table 2: GROUP-WISE ALL-INDIA AVERAGE CONSUMER PRICE INDEX NUMBERS FOR
INDUSTRIAL WORKERS ON BASE: 1982=100 FOR THE PERIOD 1993 TO 2003
Source: Labour Bureau Government of India

Q 1.8 What is Balance of Payments?

A 1.8 The Balance of Payments 'BOP' is an account of all transactions between one country and all
other countries--transactions that are measured in terms of receipts and payments. A receipt
represents any dollars flowing into the country or any transaction that require the exchange of foreign
currency into dollars. A payment represents dollars flowing out of the country or any transaction that
requires the conversion of dollars into some other currency. The three main components of the
Balance of Payments are:
The Current Account including Merchandise (Exports Imports), Investment income (rents, profits,
interest)
The Capital Account measuring Foreign investment in the U.S. and U.S.investment abroad, and
The Balancing Account allowing for changes in official reserve assets (SDR's, Gold, other
payments)

Example 1.8

BOP Data -- 2000 ($millions)

Category Receipts Payments Net

I. Current Account
A. Merchandise Account
848,678 -1,224,417 -375,739
(Exports/Imports)
B. Income Account
352,866 -367,658 -14,792
(Rents, Interest, Profits)
C. Transfers -54,136
Current Account Balance -444,667
II. Capital Account
A. Foreign Investment in the U.S. 1,024,218
B. U.S. Investment Abroad -580,952
C. Statistical Discrepancy 1,401
Capital Account Balance 444,667
III. Balancing Account
0
(Official Reserve Transfers)

Q 1.9 What is Prime Rate?

A 1.9 Prime rate is the rate of interest banks charge their best customers, usually well established
companies, to borrow money.
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Example 1.9

The Prime Lending Rate of HSBC bank is currently at 13% per annum*
*Source http://www.hsbc.co.in/ as on 15/12/2005
Did you know?Base rate is the British equivalent of the U.S. prime rate

Q 1.10 What is the difference between Intermediation and Disintermediation?

A 1.10 Intermediation is the process in which investors deposit funds in commercial banks and
savings and loans. These "intermediaries" in turn to invest the funds in bonds or other securities with
yields higher than the rates they are paying depositors. Where as the Disintermediation is the process
in which investors withdraw funds on deposit with banks and savings and loans, and invest directly in
securities with higher rates of return.

Q 1.11 What is Money?

A 1.11 Money is defined as:

• “Something acceptable and generally used as payment for goods and services”
• “Anything that functions as a means of payment (medium of exchange), unit of accounts and
store of value”.

Did you know? Hot money is the money that is held in one currency but is liable to switch to another
currency at a moment’s notice in search of the highest available returns , thereby causing the first
currency’s exchange rate to plummet. It is often used to describe the money invested in currency
markets by speculators.

Q 1.12 What is a Company?

A 1.12 The word company originated from the Latin word, “com panis”, which means “come together
and share bread”. Coming together of Individuals is a MUST for formation of a company. There are
different kinds of companies: Public Vs Private, Limited Vs unlimited liability. Companies can be
created as proprietorship or partnership. Historically, the first company was registered in 1602 and it
was Dutch East India Company. These merchants survived for two centuries in India.

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Session 1 : Basic Economic Concepts:

Summary

• GNP (Gross National Product), is a statistic measure of all goods and services produced in the
country in a full year
• A Recession is usually defined as a fall of a country's real Gross Domestic Product in two or
more successive quarters of a year.
• Depression means 6 quarters of declining GNP
• Inflation is a gradual rise in prices, which results in decrease of purchasing power
• Balance of payments is a summary of money flowing in and out of the country
• Prime rate is the rate of interest banks charge their best customers, usually well established
companies, to borrow money

Q 2.1 What is meant by Risk?

A 2.1. The chance of things not turning out as expected is called as Risk. Risk is directly proportional
to return and hence assets with low risk yield low returns. In financial markets, the most commonly
used measure of risk is the volatility (or standard deviation) of the price of, or more appropriately the
total returns on, an asset.
Example 2.1

Q 2.2 What are the different types of Risks involved in Economy?

A 2.2. The different type of risks which are involved in a Economy are:

• Market Risk.
• Business Risk
• Interest Rate Risk
• Purchasing Power Risk
• Liquidity Risk
• Economic Risk
• Tax Risk

Q 2.3 What is Market Risk?

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A 2.3. In this Risk the price of a security will decline despite the strength of the underlying company.
This is considered non - diversifiable because regardless of how diversified an Investor’s portfolio is a
decline in the overall market could cause prices of all positions to fall.
Did you know? Market risk is also known as systematic risk.

Q 2.4 What is Business Risk?

A 2.4. Business Risk is also called as financial risk; this is the risk that a company may experience a
decline in earnings, impairing its ability to pay dividends or interest causing the price of its securities
to decline. Business risk is diversifiable, if an investor's portfolio is well diversified, consisting of stock
in several different companies; the effect of one company's decline in earnings is minimized.
Did you know? Idiosyncratic Risk is an unsystematic risk that is uncorrelated to the overall market
risk. In other words, the risk that is firm specific and can be diversified through holding a portfolio of
stocks.

Q 2.5 What is Interest Rate Risk?

A 2.5. Interest rate risk is the effect of rising interest rates on the value of investments. When interest
rates rise, bond prices fall to bring their yields in line with the interest rate market. Because of the
effects of compounding, long term bonds are more sensitive to interest rate fluctuations than those
with shorter maturities. If interest rates fall, bond prices rise. Again, bonds with the longest maturities
are affected the most.

Q 2.6 What is Purchasing Power Risk?

A 2.6. This is the risk that the rate of increase in the value of an investment may be lower than the
prevailing inflation rate, leading to a decline in Purchasing power. Purchasing power risk has a more
serious effect on bonds because bondholders receive a fixed return based on the coupon rate. If a
company's earnings rise due to inflation, bondholders do not benefit from the increase. Bond investors
therefore suffer a loss of earnings in terms of real dollars.

Q 2.7 What is Liquidity Risk?

A.2.7 This is the risk of not being able to sell a security, or being forced to sell at an unfavourable
price due to lack of a liquid market. An illiquid, or "thin" market usually involves an over the counter
security, and is characterized by a large difference between bid and asked prices.

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Q 2.8 What is Tax Risk?

A 2.8. Tax risk is the effect of rising tax rates on the value of investments Interest on municipal
securities is tax exempt, while returns on corporate debt, as well as dividends on preferred and
common stocks are fully taxable. Municipals' investors are at risk if tax rates are lowered. Lower taxes
would increase the effective after-tax yield on corporate securities. Municipal bond prices would then
fall, to bring their equivalent yields in line with those of corporate securities. Investors in corporate
securities, particularly bonds, are at risk if taxes are raised. Higher tax rates would decrease their
effective after-tax yields. Prices of corporate securities would then fall, to bring yields in line with
those of municipals.

Q 2.9 What is Economic Risk?

A 2.9. Economic risk includes the effects of adverse international developments, changes in
government policies or legislation and changes in consumer demand.
Did you know? Systemic Risk is the risk of damage being done to the health of the financial system
as a whole. A constant concern of bank regulators is that the collapse of a single bank could bring
down the entire financial system. This is why regulators often organise a rescue when a bank gets into
financial difficulties

Q 2.10 What is the relationship between Risk and Return?

A 2.10. There are two fundamental aspects to any investment made by or on behalf of some investor,
namely risk and return. This necessitates the need of a proper understanding as to what is risk and
what is return.

• Risk

Risk is something inherent in any investment. This risk may relate to loss or delay in the repayment of
the principal capital or loss or non-payment of interest or variability of returns. While some
investments are almost risk less (like Government Securities) or bank deposits, others are more risky.

These are differences in risk as between instruments, which can be represented as a spectrum of risk,
as in Figure 1,below.

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Figure1. Risk Reward Spectrum

• Return

Return or yield essentially differs from the nature of financial instruments, maturity period, and the
creditor or debtor nature of the instrument and a host of other factors. What influences return more is
the risk. Usually, the higher the risk, higher is the return. Therefore return is the income plus capital
appreciation in the case of ownership instruments (like common stocks) and only yield is the case of
debt instruments like debentures or bonds

Q 2.11 What is the Risk/Return Trade-off?

A 2.11. Risk is defined as the chance that an investment's actual return will be different than
expected. Measured in statistics by standard deviation. It means you have the possibility of losing
some or even all of your original investment. Low levels of uncertainty (low risk) are associated with
low potential returns. High levels of uncertainty (high risk) are associated with high potential returns.
The risk/return trade-off is the balance between the desires for the lowest possible risk against the
highest possible return. On the lower end of the scale, the risk-free rate of return is represented by the
return on U.S. Government Securities because their chance of default is next to nothing. If the risk-
free rate is currently 5%, this means for virtually no risk we can earn 5% per year on our money.

Question 2.11 Conti

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Figure 2. Dynamics of Risk-Return trade off.

Q 2.12 What is the role of Tax benefits in the risk and return relationship?

A 2.12. An added dimension to this game of risk and return is taxation benefits or the absence of the
same. Say, some instruments floated by the government and semi government bodies enjoy tax
benefits and hence their return is higher. Thus in India, post office deposits, bank deposits and
government securities are exempt from tax, either in part or in full.
The other forms of tax benefits are the exemption or rebate with respect to wealth tax or capital gains.
The investments made in specified instruments of government and semi government securities, NSS,
PPF etc are fully exempt from income tax.

Q 2.12 What is the role of Tax benefits in the risk and return relationship?

A 2.12. An added dimension to this game of risk and return is taxation benefits or the absence of the
same. Say, some instruments floated by the government and semi government bodies enjoy tax
benefits and hence their return is higher. Thus in India, post office deposits, bank deposits and
government securities are exempt from tax, either in part or in full.
The other forms of tax benefits are the exemption or rebate with respect to wealth tax or capital gains.
The investments made in specified instruments of government and semi government securities, NSS,
PPF etc are fully exempt from income tax.
Session 2 : Basic Risks in a Economy :

Summary

• Risk is defined as the chance that an investment's actual return will be different than expected.
• Market Risk is the price of a security will decline despite the strength of the underlying
company.
• Business Risk the risk that a company may experience a decline in earnings, impairing its
ability to pay dividends or interest causing the price of its securities to decline.

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• Interest rate risk is the effect of rising interest rates on the value of investments.

Brief Explanation of the CPI

The Consumer Price Index (CPI) is a measure of the average change in prices over time of goods and
services purchased by households. The Bureau of Labour Statistics publishes CPIs for two population
groups: (1) the CPI for Urban Wage Earners and Clerical Workers (CPI-W), which covers households of
wage earners and clerical workers that comprise approximately 32 percent of the total population and (2)
the CPI for All Urban Consumers (CPI-U) and the Chained CPI for All Urban Consumers (C-CPI-U), which
cover approximately 87 percent of the total population and include in addition to wage earners and clerical
worker households, groups such as professional, managerial, and technical workers, the self-employed,
short-term workers, the unemployed, and retirees and others not in the labour force.

The CPIs are based on prices of food, clothing, shelter, and fuels, transportation fares, charges for
doctors' and dentists' services, drugs, and other goods and services that people buy for day-to-day living.
Prices are collected in 87 urban areas across the country from about 50,000 housing units and
approximately 23,000 retail establishments- department stores, supermarkets, hospitals, filling stations, and
other types of stores and service establishments. All taxes directly associated with the purchase and use of
items is included in the index. Prices of fuels and a few other items are obtained every month in all 87
locations. Prices of most other commodities and services are collected every month in the three largest
geographic areas and every other month in other areas.

Prices of most goods and services are obtained by personal visits or telephone calls of the Bureau's trained
representatives.

In calculating the index, price changes for the various items in each location are averaged together with
weights, which represent their importance in the spending of the appropriate population group. Local data
are then combined to obtain a U.S. city average. For the CPI-U and CPI-W separate indexes are also
published by size of city, by region of the country, for cross-classifications of regions and population-size
classes, and for 27 local areas. Area indexes do not measure differences in the level of prices among
cities; they only measure the average change in prices for each area since the base period. For the C-CPI-
U data are issued only at the national level. It is important to note that the CPI-U and CPI-W are considered
final when released, but the C-CPI-U is issued in preliminary form and subject to two annual revisions.

The index measures price change from a designed reference date. For the CPI-U and the CPI-W the
reference base is 1982-84 equals 100.0. The reference base for the C-CPI-U is December 1999 equals
100. An increase of 16.5 percent from the reference base, for example, is shown as 116.5. This change
can also be expressed in dollars as follows: the price of a base period market basket of goods and services
in the CPI has risen from $10 in 1982-84 to $11.65.

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Calculating Index Changes

Movements of the indexes from one month to another are usually expressed as percent changes rather
than changes in index points, because index point changes are affected by the level of the index in relation
to its base period while percent changes are not. The example below illustrates the computation of index
point and percent changes.

Percent changes for 3-month and 6-month periods are expressed as annual rates and are computed
according to the standard formula for compound growth rates. These data indicate what the percent
change would be if the current rate were maintained for a 12-month period.

Index Point Change

CPI 115.7

Less previous index 111.2

Equals index point change 4.5

Percent Change

Index point difference 4.5

Divided by the previous index 111.2

Equals 0.040

Results multiplied by one hundred 0.040 x 100

Equals percent change 4.0

Regions Defined:

The states in the four regions shown in Tables 3 and 6 are listed below.

The Northeast--Connecticut, Maine, Massachusetts, New Hampshire, New York, New Jersey,
Pennsylvania, Rhode Island, and Vermont.

The Midwest--Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, North Dakota,
Ohio, South Dakota, and Wisconsin.

The South--Alabama, Arkansas, Delaware, Florida, Georgia, Kentucky, Louisiana, Maryland, Mississippi,
North Carolina, Oklahoma, South Carolina, Tennessee, Texas, Virginia, West Virginia, and the District of
Columbia.

The West--Alaska, Arizona, California, Colorado, Hawaii, Idaho, Montana, Nevada, New Mexico, Oregon,
Utah, Washington, and Wyoming.

A Note on Seasonally Adjusted and Unadjusted Data:

Because different groups use price data for different purposes, the Bureau of Labour Statistics publishes
seasonally adjusted as well as unadjusted changes each month.

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For analysing general price trends in the economy, seasonally adjusted changes are usually preferred since
they eliminate the effect of changes that normally occur at the same time and in about the same magnitude
every year--such as price movements resulting from changing climatic conditions, production cycles, model
changeovers, holidays, and sales.

The unadjusted data are of primary interest to consumers concerned about the prices they actually pay.
Unadjusted data also are used extensively for escalation purposes. Many collective bargaining contract
agreements and pension plans, for example, tie compensation changes to the Consumer Price Index
unadjusted for seasonal variation.

The X-12-ARIMA Seasonal Adjustment Method derives seasonal factors used in computing the seasonally
adjusted indexes. Seasonally adjusted indexes and seasonal factors are computed annually. Each year,
the last 5 years of seasonally adjusted data are revised. Data from January 2000 through December 2004
were replaced in January 2005. Exceptions to the usual revision schedule were: the updated seasonal data
at the end of 1977 replaced data from 1967 through 1977; and, in January 2002, dependently

Seasonally adjusted series were revised for January 1987-December 2001 as a result of a change in the
aggregation weights for dependently adjusted series. For further information, please see "Aggregation of
Dependently Adjusted Seasonally Adjusted Series," in the October 2001 issue of the CPI Detailed Report.

Combining the seasonal movement of 73 selected components derives the seasonal movement of all items
and 54 other aggregations. Each year the seasonal status of every series is re-evaluated based upon
certain statistical criteria. If any of the 73 components change their seasonal adjustment status from
seasonally adjusted to not seasonally adjust, not seasonally adjusted data will be used for the last 5 years,
but the seasonally adjusted indexes will be used before that period. Note: 43 of the 73 components are
seasonally adjusted for 2005.

Seasonally adjusted data, including the all items index levels, are subject to revision for up to five years
after their original release. For this reason, BLS advises against the use of these data in escalation
agreements.

Effective with the calculation of the seasonal factors for 1990, the Bureau of Labour Statistics has used an
enhanced seasonal adjustment procedure called Intervention Analysis Seasonal Adjustment for some CPI
series. Intervention Analysis Seasonal Adjustment allows for better estimates of seasonally adjusted data.
Extreme values and/or sharp movements, which might distort the seasonal pattern, are estimated and
removed from the data prior to calculation of seasonal factors. Beginning with the calculation of seasonal
factors for 1996, X-12-ARIMA software was used for Intervention Analysis Seasonal Adjustment.

For the fuel oil, utility (piped) gas, motor fuels, and educational books and supplies indexes, this procedure
was used to offset the effects that extreme price volatility would otherwise have had on the estimates of
seasonally adjusted data for those series. For the Non-alcoholic beverages index, the procedure was used
to offset the effects of labour and supply problems for coffee. The procedure was used to account for
unusual butter fat supply reductions, changes in milk supply, and large swings in soybean oil inventories
affecting the Fats and oils series. For Dairy products, it mitigated the effects of significant changes in milk,
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butter and cheese production levels. For Fresh vegetable series, the method was used to account for the
effects of hurricane-related disruptions. For Electricity, it was used to offset an increase in demand due to
warmer than expected weather, increased rates to conserve supplies, and declining natural gas inventories.
For new vehicle series, the procedure was used to offset the effects of a model changeover combined with
financing incentives.

Source: The CPI home page on the Internet at http://www.bls.gov/cpi/

Glossary of Economic Terms

Scarcity- The condition of not being able to have all the goods and services that we want.
Choice- What someone must make when faced with two or more alternative uses for a resource, also
called an economic choice.
Goods-Objects that can be held or touched that can satisfy people’s wants.
Services- Activities that can satisfy people’s wants.
Opportunity Cost -The next best alternative that must be given up when a choice is made. Not all
alternatives, just the next best choice.
Resources- All natural, human and human-made aids to the production of goods and services. Also called
productive resources.
Natural Resources- "Gifts of nature" that are present without human intervention (also called land).
Human Resources-The quantity and quality of human effort directed toward producing goods and services
(also called labour).
Capital Resources-Goods made by people and used to produce other goods and services (also called
intermediate goods).
Barter-The direct trading of goods and services between people without the use of money
Interdependence- Dependence on others for goods and services; occurs as a result of specialization.
Money- A medium of exchange, a good that can be used to buy other goods and services.
Production/Producers- People who use resources to make goods and services, also called workers.
Consumers-People, whose wants are satisfied by using goods and services.
Specialization- The situation in which people produce a narrower range of goods and services than they
consume.
Division of Labour -The process whereby workers perform only a single task or very few steps of a major
production task, as when working on an assembly line.
Productivity - The ratio of output (goods and services) produced per unit of input (productive resources)
over a period of time.
Markets-Any setting where buyers and sellers exchange goods, services, resources, and currencies.
Price- The value of a good or service stated in money terms.
Public Goods - Goods and services that are provides by the government. They often too expensive or not
practical to be obtained by individuals.

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Economic Systems -The way a society organizes the production, consumption, and distribution of goods
and services.
Market Economy -An economic system where private households and businesses exchange most goods
and services through private transactions. Buyers and sellers making exchanges in private markets
determine prices.
Circular flow - A model of an economy showing the interactions between households and business firms
as they exchange goods and services and resources in markets.
Trade/Exchange - Trading goods and services with people for other goods and services or for money.
When people exchange voluntarily, they expect to be better off as a result.
Factors of Production - Resources used by businesses to produce goods and services.
Investment in Capital Resources - Business purchases of new plant and equipment.
Investment in Human Resources - Activities that increase the skills and knowledge of workers.
Trade-offs - Giving up one thing to get some of another.
Demand - A schedule of how much consumers are willing and able to buy at all possible prices during
some time period.
Supply - A schedule of how much producers are willing and able to produce and sell at all possible prices
during some time period.
Equilibrium Price - The market clearing price at which the quantity demanded by buyers equals the
quantity supplied by sellers.
Competition - Techniques used by businesses to gain more customers and to earn higher profits.
Costs of Production - All resources used in producing goods and services, for which owners receive
payment.
Profit - The difference between the total revenue and total cost of a business; entrepreneurial income.
Entrepreneurship -The human resource that assumes the risk of organizing other productive resources to
produce goods and services.
Incentives- Factors that motivate and influence the behaviour of households and businesses. Prices,
profits, and losses act as incentives for participants to take action in a market economy.
Taxes- Required payments of money made to governments by households and business firms.
Income Taxes - Taxes paid by households and business firms on the income they receive.
Property Taxes - Taxes paid by households and businesses on land and buildings.
Sales Taxes - Taxes paid on the goods and services people buy.
Unemployment - The situation in which people are willing and able to work at current wages but do not
have jobs.
Shortages- The situation resulting when the quantity demanded exceeds the quantity supplied of a good,
service, or resource.
Surpluses -The situation resulting when the quantity supplied exceeds the quantity demanded of a good,
service, or resource, usually because the price is for some reason above the equilibrium price in the market.

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BUSINESS ECONOMICS-I
LESSON 1:
INTRODUCTION TO BUSINESS ECONOMICS
As the title suggests, the purpose of this lesson is to help you
understand what economics is about and what you can hope to
learn by undertaking a study of economics. Since you will learn
what economics is about as you progress through the course,
you might wonder if this lesson is really important. The degree
of success that you will experience in your study of economics
will be determined, to a large extent, by your motivation and
your intent to learn. People generally learn more when their
study is being carried out with a particular intent. In the first
half of this lesson you will read about various economic
problems and ideas. You will probably find at least some of the
problems and ideas to be interesting. You may then study
economics with an intent to acquire knowledge and reasoning
abilities that will help you to understand these ideas and solve
these problems.
1.1 What is economics ?
One of the earliest and most famous definitions of economics
was that of Thomas Carlyle, who in the early 19th century
termed it the “dismal science.” What Carlyle had noticed was the
anti-utopian implications of economics. Many utopians, people
who believe that a society of abundance without conflict is
possible, believe that good results come from good motives
and good motives lead to good results. Economists have
always disputed this, and it was the forceful statement of this
disagreement by early economists such as Thomas Malthus and
David Ricardo that Carlyle reacted to.
Another early definition, one which is perhaps more useful, is
that of English economist W. Stanley Jevons who, in the late
19th century, wrote that economics was “the mechanics of
utility and self interest.” One can think of economics as the
social science that explores the results of people acting on the
basis of self-interest. There is more to man than self-interest,

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and the other social sciences—such as psychology, sociology,
anthropology, and political science—attempt to tell us about
those other dimensions of man. As you read further into these
pages, you will see that the assumption of self-interest, that a
person tries to do the best for himself with what he has,
underlies virtually all of economic theory.
At the turn of the century, Alfred Marshall’s Principles of
Economics was the most influential textbook in economics.
Marshall defined economics as “a study of mankind in the
ordinary business of life; it examines that part of individual
and social action which is most closely connected
with the attainment and with the use of the material
requisites of wellbeing. Thus it is on one side a study of
wealth; and on the other, and more important side, a part
of the study of man.”
Many other books of the period included in their definitions
something about the “study of exchange and production.”
Definitions of this sort emphasize that the topics with which
economics is most closely identified concern those processes
involved in meeting man’s material needs. Economists today
do not use these definitions because the boundaries of
economics have expanded since Marshall. Economists do more
than study exchange and production, though exchange remains
at the heart of economics.
Most contemporary definitions of economics involve the
notions of choice and scarcity. Perhaps the earliest of these is by
Lionell Robbins in 1935: “Economics is a science which
studies human behavior as a relationship between ends and
scarce means which have alternative uses.” Virtually all
textbooks have definitions that are derived from this definition.
Though the exact wording differs from author to author, the
standard definition is something like this: “Economics is the
social science which examines how people choose to use
limited or scarce resources in attempting to satisfy their
unlimited wants.”
In other words “Economics is the science of choice — the
science that explains the choices that we make and how those
choices change as we cope with scarcity.”
By now you must have got an idea that scarcity is central in

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these definitions. Now let’s examine scarcity.
1.2 Scarcity and Choice
Scarcity means that people want more than is available. Scarcity
limits us both as individuals and as a society. As individuals,
limited income (and time and ability) keep us from doing and
having all that we might like. As a society, limited resources
(such as manpower, machinery, and natural resources) fix a
maximum on the amount of goods and services that can be
produced.
Scarcity requires choice. People must choose which of their
desires they will satisfy and which they will leave unsatisfied.
When we, either as individuals or as a society, choose more of
something, scarcity forces us to take less of something else.
Economics is sometimes called the study of scarcity because
economic activity would not exist if scarcity did not force people
to make choices.
When there is scarcity and choice, there are costs. The cost of
any choice is the option or options that a person gives up. For
example, if you gave up the option of playing a computer game
to read this text, the cost of reading this text is the enjoyment
you would have received playing the game. Most of economics
is based on the simple idea that people make choices by
comparing the benefits of option A with the benefits of
option B (and all other options that are available) and choosing
the one with the highest benefit. Alternatively, one can view the
cost of choosing option A as the sacrifice involved in rejecting
option B, and then say that one chooses option A when the
benefits of A outweigh the costs of choosing A (which are the
benefits one loses when one rejects option B).

Q 3.1 What is a financial system?

A 3.1 The firms and institutions that together make it possible for money to make the world go round
constitute the financial system. This includes financial markets, securities exchanges, banks , pension
funds, mutual funds, insurers, national regulators, such as the Securities and Exchange Commission
(SEC) in the United States, central banks , governments and multinational institutions, such as the
IMF and W orld Bank . The basic functions of the financial system include mobilization of savings and
promotion of investments. An effective financial system facilitates flow of funds from less productive to

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more productive activities by capitalizing on the difference in the rate of return. The financial system
provides the required intermediation between investors and the major borrowers.

Did you know?

Hawala is an ancient system of moving money based on trust . In hawala, no money moves physically
between locations; nowadays it is transferred by means of a telephone call or fax between dealers in
different countries. No legal contracts are involved, and recipients are given only a code number or
simple token, such as a low-value banknote torn in half, to prove that money is due. Over time,
transactions in opposite directions cancel each other out, so physical movement is minimised. Trust is
the only capital that the dealers have. With it, the users of hawala have a worldwide money-
transmission service that is cheap, fast and free of bureaucracy

Q 3.2 Define Liquidity:

A 3.2 Liquidity is defined as cash and in general “nearness to cash”. Simply put, the ease with which
an asset or an investment can be converted into ‘cash’. Money and monetary assets are traded in the
financial system and hence the other important activities of the financial system include provision of
liquidity and trading in liquidity.

Example: A currency like sterling pound has greater liquidity than a life insurance policy.

Q 3.3What is a financial market?

A 3.3 A financial market consists of investors or buyers, sellers, dealers and brokers and does not
refer to any physical location in particular. The participants in the market are linked by formal trading
rules and communication networks which are used for originating and trading financial securities.
Financial markets trade in money and their price is the rate of return the buyer expects the financial
asset to yield. The value of financial assets change with the investors' earning expectations or interest
rates. While the Investors look for the highest return for a given level of risk (by purchasing the
securities for the lowest price), the users of funds endeavour to borrow at the lowest rate possible.

Q 3.4Who are the key participants in the Financial System?

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A 3.4. Financial system consists of variety of institutions, markets and instruments. The key
participants in the financial system are:

• Financial Institutions.
• Suppliers of funds
• Financial Markets
• Fund Demanders.

Session 3 : Introduction to Financial Markets:

Question 3.4 Conti

They are related as shown below:

Q 3.5What are Important Functions Of Financial Markets?

A 3.5. The following are the important functions

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• Facilitate Price Discoveries .

The price of financial assets is established by the regular and continuous interaction among the
plentiful buyers and sellers who throng the financial markets. Well-organized financial markets ensure
accurate pricing of the assets. To know the true value of a financial asset it is advisable to simply look
at its price in the financial market.

• Provide Liquidity To Financial Assets .

Financial markets provide a sophisticated medium to the Investors to sell their financial assets as and
when required. In the absence of such a medium, the motivation of investors to hold financial assets
dwindles. Added to this, the negotiable and transferable feature of the securities make it possible for
companies to raise long-term funds from investors with short-term and medium-term horizons. The
company is assured of long-term availability of funds heedless of who owns the securities.

• R educe The Cost Of Transacting.

Search costs and Information costs are the two major costs associated with transacting of financial
assets. Search costs comprise those explicit costs such as the expenses incurred on advertising
when one wants to buy or sell an asset and implicit costs such as the effort and time put in to locate a
customer. Information costs refer to those costs incurred in evaluating the investment merits of
financial assets.

Q 3.6How are Financial Markets classified?

A 3.6. Financial markets are classified based on the following parameters:

• Financial Claim: Debt market & Equity market

The debt market is the financial market for fixed claims (debt instruments) and the equity market is the
financial market for residual claims (equity instruments).
The two main products issued by capital markets specialists are shares and bonds. Shares are also
known as equities. Investors buy them and 'share' in the profits of the company through dividends, if
there are any.
Unlike equities, bonds are a form of debt. Like equities, a company sells bonds to investors, in order
to raise money. However, at some point in future, the company promises to pay the bondholders their
money back. As well as companies, governments also borrow money on the debt markets.

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• Maturity Of Claim: Money market & Capital market

Money market is referred to as the market for short-term financial claims and Capital market is
referred to the market for long-term financial claims.
Generally the cut-off between short-term and long-term financial claims has been one year. The
money market is the market for short-term debt instruments as short-term financial claims are mostly
debt claims. The capital market is the market for long-term debt instruments and equity instruments.

• Type Of Issue: Primary market & Secondary market

The primary market is one in which public issue of new securities is made through a prospectus in a
retail market. It does not have a physical location. The investors in the retail market are reached by
direct mailing.
The secondary market or stock exchange where existing securities are traded, is an auction market
and may have a physical location such as the rotunda of the Bombay Stock Exchange, the trading
floor of Delhi stock exchange where members of the exchange meet to trade securities directly.

• Timing Of Delivery: Cash market & Futures market

A cash or spot market is one where the delivery occurs immediately and a forward or futures market is
one where the' delivery occurs at a pre-determined time in future

Question 3.6 Conti

Fig 2: Classification of financial markets

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Q 3.7How did the Capital markets evolve?

A 3.7. The capital market has its beginnings in medieval Europe before the Industrial revolution. The
Landowners and municipal bodies issued debt securities while small business houses issued equities.
The structure of the market and the investment options were quite primitive. In the Post-Industrial Era,
the growth of the corporate form of organizations with limited liability provided a wide spread of
shareholding wherein shares were freely transferable and tradable. This paved way for the growth of
capital markets. The evolution was further helped by the transformation of family run businesses in to
publicly held corporations.

Question 3.8

Q 3.8How did the Indian Capital Market evolve?

A 3.8. The Indian capital market is one of the oldest markets in Asia having founded nearly 200 years
ago. The first deals in shares and securities happened in Bombay in the 1830’s. The Bombay Stock
Exchange, BSE, was established in 1875 as “The Native Share and Stock Brokers Association”.
Before its formation, the native brokers assembled in the famous Dalal Street in South Bombay to
transact in shares and securities. The BSE was formed as a voluntary non-profit association of
brokers primarily to protect their interests in the business of trading securities. Currently, the BSE is
engaged in the process of converting itself to a demutualised corporate entity. Though in the initial
years, the Indian capital market was focused on Bombay and Gujarat, it later on spread to almost all
the major trading centres in the country and stock exchanges were formed in these places.

Q 3.9Describe the post-independence and post-liberalisation scenario of the capital markets:

A 3.9. In the post-independence the presence of Capital Issues (Control) Act, 1947 controlled each
and every fresh capital issue. Every public offer required the central government’s approval and the
pricing of shares was restricted. Due to these restrictions, most of the Indian companies depended on
the development financial institutions like ICICI, IDBI etc for their capital requirements. After the
liberalization in 1991, the Capital Issues (Control) Act was repealed and a new regulatory authority
called the Securities and Exchange Board of India was established under the Securities and
Exchange Board of India Act 1992. The capital market has undergone a sea change after the
formation of SEBI. The rapid growth of the Capital market can be attributed to the increase in capital
mobilization from investors and also due to the decline of development banking activities of the
financial institutions. The following table illustrates the rapidity at which the capital market has grown
after the liberalization

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Q 3.10Name the Capital Market Constituents:

A 3.10. Capital markets divisions are the factory floors of investment banks. While most factories turn
out widgets and other physical goods, capital markets bankers produce financial products, such as
equities and bonds, for companies that want to raise money. There are five basic constituents of a
Capital market. They are:

• Issuers of Securities: These are basically companies incorporated under the Companies Act,
1956, either privately owned or owned by the government. The Government can also raise
finance from the capital market using the long-term debt route.
• Investors: These can be either wholesale investors like institutional investors such as mutual
funds etc or retail investors.
• Intermediaries: These provide help in mobilizing resources from the investors and provide
other support services. The intermediaries consist of brokers; merchant bankers, market
makers, underwriters, custodians, depository participants, registrars and share transfer
agents.
• Instruments: These are floated in the market to raise capital both in debt and equity. Equity
instruments include equity shares, preference shares, convertibles such as fully or partly
convertible debentures and warrants. Debt instruments include non-convertible debentures
and bonds. Shares do not carry any assured return whereas debt instruments carry fixed
interest.
• Infrastructure: This is an essential requirement for the efficient functioning of the capital
market. It includes stock exchanges, the depositories, the regulators and the necessary
statutory framework.

Summary
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• Trading in money and monetary assets constitute the activity in the financial markets and are
referred to as the financial system
• A financial market consists of investors or buyers, sellers, dealers and brokers and does not
refer to any physical location in particular.
• The Three important functions of financial markets are to facilitate Price discoveries, provide
liquidity t o financial assets and r educe the cost of transacting
• Financial markets provide a sophisticated medium to the Investors to sell their financial assets
as and when required
• The Indian capital market is one of the oldest markets in Asia having founded nearly 200
years ago
• Money market is referred to as the market for short-term financial claims and Capital market is
referred to the market for long-term financial claims

Q1) Liquidity is defined as

answer id Cash and “nearness to cash”

answer id Investments

answer id Fixed assets

answer id Money market instruments

Please check one answ er

Q 4.1 What is an international financial market?

A 4.1 In the International financial market, funds are raised from lenders or investors in a country by
borrowers or issuers from another country. Transactions are conducted in currencies other than the
domestic currencies of respective countries. This market is generally outside the purview of any single
country and consists of the global bond and equity markets and a huge derivatives market. It enables
the flow of excesses in certain economies to the deficit and more needy economies. While the
international financial market had its development in Europe around the fifties, the creation of the
“euro” market in the fifties and sixties gave it a firm establishment

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Q 4.2 What is a Euro market?

A 4.2 The Euro Market is a market in which financial instruments – both short and long terms – that
are denominated in a variety of currencies other than the domestic currency of the host currency are
transacted.

Q 4.3 What are the different segments of the International Financial Market?

A 4.3 The three segments of the International Financial Market are

1. Debt market
2. Equity market
3. Derivatives market

Q 4.4 Describe the bond market in detail:

A 4.4 The debt market consists of a bond market that is very vibrant and much sought after by foreign
issuers. The international bond market consists of the following sub-segments:

1. Domestic Bond market

2. Foreign bond market
3. Euro bond market

Domestic Bonds:

• Issued by domestic companies in a particular country mainly to domestic investors

• Participation of overseas investors depending on local regulations
• Denominated in the currency of the country of issuance
• Usually fixed-interest instruments with tenor ranging from 1-30 years
• Issued either through a public offer or through private placements

Foreign bonds:

• Issued within the domestic capital market by a foreign issuer for domestic investors
• Participation of overseas investors is not allowed
• Denominated in the currency of the host country
• Requires to be permitted by local regulations of the host country

Euro Bonds:
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• Issued and sold in a jurisdiction outside the country of denomination
• Are issued in a different currency
• Not entirely regulated by the local laws of that country
• Primary issues are governed by government and central bank guidelines of the various
countries in which the bonds are issued
• Secondary market trades are self regulated by International Securities Market Association

Q 4.5 What is a Depository Receipt mechanism?

A 4.5 A Depository receipt (DR) is a security that represents ownership in a foreign security. The
mechanism of ‘depository receipts’ for shares underlying them has been in existence since 1927 in
the capital market of USA and was designed originally to aid US investors to trade in securities that
were not listed on the US exchanges. DRs are eligible to be traded on all US stock exchanges as well
as many other European stock exchanges. American Depository Receipts (ADRs) were issued in the
US for the benefit of the investors in the US. The Securities and Exchange Commission (SEC)
regulates the issue of ADRs. Private placement of the ADRs need not be registered under the SEC
whereas the public issue must be registered. Global Depository Receipts (GDRs) are issued to the
investors across the globe. In the US, if the GDRs have to be issued through the public route they
need to be ADRs that comply with the US securities law. The following diagram illustrates the
schematic representation of Depository Receipts

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Question 4.5 Conti

The depository receipt mechanism is an indirect way of inviting the foreign investors by issuing the
shares in a foreign jurisdiction with a surrogate listing mechanism. This is made possible by issue of
intermediary securities called depository receipts (DRs) that actually represent the underlying shares
against which they have been issued. The extent of representation would depend on the terms of the
issue like how many shares are represented by each DR.
Did you know? Samsung Co. ltd., the South Korean major made the first GDR issue in December
1990.

Q 4.6 What is a global depository?

A 4.6 A Company in one jurisdiction can issue depository receipts in other jurisdictions where such
issues are permitted. DRs are issued with the support of an agency that acts as a global depository.
The functions of a global depository are:

• To administer the DRs for the individual investors

• Handling transfer of DRs arising out of secondary market trades
• Dividend distribution

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• Recovery of withholding tax
• Conversion of the DRs into shares etc.,

The DRs are listed and then traded on the exchanges where they are listed. The Issuing Company
issues the requisite shares underlying the DRs in its domestic jurisdiction to a domestic custodian
against receipt of cash from the investors for the DRs. These shares represent the issued capital of
the company. The underlying shares are not allowed to be traded in the domestic market because the
DRs representing

The depository mechanism creates two distinct pools of securities

• One being the issued shares

• The other being the DRs representing those shares.

Did you know?ADRs are American Depository Receipts. They are Certificates issued by a U.S.
depository bank, representing foreign shares held by the bank, usually by a branch or correspondent
in the country of issue. One ADR may represent a portion of a foreign share, one share or a bundle of
shares of a foreign corporation. ADRs are subject to the same currency, political, and economic risks
as

Question 4.7

Q 4.7 What is the relationship between depository receipts and the shares underlying them?

A 4.7 The following figure depicts the relationship between the two.

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Q 4.8 Why should there be a complicated issue of DRs instead of issuing shares directly to
investors?

A 4.8 The following are the answers to the above question:

1. Under current regulations, Indian companies are not supposed to make an issue of its shares
abroad to the foreign public and list these shares directly on global exchanges.
2. To invest in depository receipts, foreign investors need not register with SEBI whereas to
invest in shares, they have to register with SEBI.
3. A capital gain through investment in shares in India by foreign investors is subject to taxes
whereas there is no tax for capital gains made on DRs.
4. Settlement of transactions in DRs happens through international settlement systems, which
are more convenient for the foreign investors whereas settlement in shares have to be cleared
in domestic clearinghouses in India.
5. Lastly, compliance with Foreign Exchange Management Act and RBI approvals is not required
for sale of depository receipts by foreign investors.
6. Shares are listed only on the domestic stock exchanges and not on international stock
exchanges.

Q 4.9 What do you mean by Fungibility of Depository Receipts?

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A 4.9 Fungibility refers to the convertibility of depository receipts in to the shares underlying them.
This provides for a two-way exit route to the foreign investors. They can exit either through the sale of
DRs in the overseas market or through the sale of shares in the domestic market. Fungibility makes
the prospects for the investor better since the price differential between the depository and the
underlying shares can be exploited to make arbitrage gains. The ADRs became fungible in US market
in 1990. The Indian government had initially prescribed two year lock-in-period for GDRs to become
fungible. This restriction is now removed.
Did you know the meaning of “Fungible”? You can't tell them apart. Something is fungible when
any one single specimen is indistinguishable from any other. Somebody who is owed $1 does not care
which particular dollar he gets. Anything that people want to use as MONEY must be fungible,
whether it is GOLD bars, beads or shells.

Q 4.10 What does Two-way Fungibility of Depository Receipts mean?

A 4.10 Two-way Fungibility of DRs implies that DRs and the shares underlying them are convertible
both ways but within their respective jurisdictions. This means that an overseas investor may convert
DRs in to shares but they can be traded only in the domestic market. Similarly, a domestic investor
may convert shares into tradable DRs but they can be traded in markets wherein the DRs are listed.
The reverse Fungibility process is being governed by RBI guidelines.

Q 4.11 What are Foreign Currency Convertible Bonds?

A 4.11 A company can issue bonds that are convertible in to depository receipts at a later date. These
are known as Foreign Currency Convertible Bonds or FCCBs in India. When such bonds are issued in
the euro market they are known as euro convertibles.

Question 4.12

Q 4.12 Describe Indian Depository Receipts (IDRs):

A 4.12 Under the IDR mechanism, foreign companies incorporated outside India may take an issue of
IDRs in the Indian Capital market to raise funds. A domestic depository in India issues these IDRs
against shares of the issuing company, which are held by an overseas custodian bank. The IDR
mechanism is exactly the inverse of ADR/GDR mechanism. The IDRs would be listed and traded in
India like any other domestic shares issued by Indian companies. The issue of IDRs is subject to the
guidelines issued by the Indian Government.

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Q 4.13 What is a Derivative?

A 4.13 A Derivative can be defined as a financial instrument whose value is derived from the values of
the underlying traded assets. For example, a stock option is a derivative whose value is dependent on
the price of a stock. Derivatives can be made of any variable (not necessarily financial assets) like
price of sugar to the amount of snow falling at a certain location. With the developments happening in
the derivatives market, there is now active trading in credit derivatives, electricity derivatives, weather
derivatives and insurance derivatives. Also, extensions of the existing products like interest rate,
foreign exchange and equity derivative products have been created.

Question 4.14

Q 4.14 What are the types of derivatives?

A 4.14 Derivatives are either Financial Derivatives or Commodity Derivatives.

Financial Derivatives - Financial Derivative Contracts are interest futures, currency futures, futures
and options on stock indices, options on stocks, etc.
Commodities Derivatives - These contracts are futures and options on standard contracts of various
commodities transacted in wholesale. For example: Tea, oilseeds, metals and other products like
energy, bandwidth etc.
The main types of derivatives are:

• Forwards
• Futures
• Option markets

Forward Contracts:

• They are simplest form of derivatives

• They are basically agreements to buy or sell an asset at a certain future time for a certain
price.
• They are traded in the over-the-counter market usually between two financial institutions or
between a financial institution and its clients
• Forward Contracts on foreign exchange are very popular
• They can be used to hedge foreign currency risk
• Both the parties to a contract have a binding commitment in the contract

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• One of the parties to the contract assumes a long position and agrees to buy the underlying
asset on a certain specified future date for a certain specified price
• The other party assumes a short position and agrees to sell the asset on the same date for the
same price

Futures Contracts:

• They are basically agreements between two parties to buy or sell an asset at a certain time in
the future for a certain price.
• They are traded on exchanges unlike forward contracts
• They carry certain standardised features as per exchange specifications
• They carry a guarantee given by the exchange to both the parties that the contract will be
honoured
• The underlying assets are a very wide range of commodities and financial assets

Options:

• The right to buy or sell an asset is referred to as an Option

• Options are traded both on exchanges and in the over-the-counter market
• There are two basic types of options namely “call option” and “put option”
• Call option gives the holder the right to buy the underlying assets by a certain date for a
certain price
• Put option gives the holder the right to sell the underlying asset by a certain date for a certain
price
• The price in the contract is known as the “exercise price” or the “strike price”
• The date in the contract is known as the “expiration date” or “maturity”
• The holder of an option does not have to exercise his right whereas in forwards and futures,
the holder is obligated to buy or sell the underlying asset
• There is a cost to acquiring an option whereas it costs nothing to enter into forwards and
futures.

Q 4.15 What is a Derivatives Exchange?

A 4.15 A derivatives exchange is a market where standardized contracts, which have been defined by
the exchange, are traded. Derivatives exchanges have been in existence for a long time. The Chicago

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Board of Trade, 1848 and the Chicago Mercantile Exchange, 1919 are considered to be pioneer
derivatives exchanges. The underlying assets include foreign currencies and futures contracts as well
as stocks and stock indices.

Summary

• The Euro Market is a market in which financial instruments – both short and long terms that
are denominated in a variety of currencies other than the domestic currency of the host
currency are transacted.
• The debt market consists of a bond market that is very vibrant and much sought after by
foreign issuers
• A Depository receipt (DR) is a security that represents ownership in a foreign security
• The depository receipt mechanism is an indirect way of inviting the foreign investors by
issuing the shares in a foreign jurisdiction with a surrogate listing mechanism
• Fungibility refers to the convertibility of depository receipts in to the shares underlying them
• Under the Indian Depository Receipts (IDR) mechanism, foreign companies incorporated
outside India may take an issue of IDRs in the Indian Capital market to raise funds
• A Derivative can be defined as a financial instrument whose value is derived from the values
of the underlying traded assets
• A derivatives exchange is a market where standardized contracts, which have been defined by
the exchange, are traded

2 11.104
© Copy Right: Rai University
BUSINESS ECONOMICS-I
LESSON 1:
INTRODUCTION TO BUSINESS ECONOMICS
As the title suggests, the purpose of this lesson is to help you
understand what economics is about and what you can hope to
learn by undertaking a study of economics. Since you will learn
what economics is about as you progress through the course,
you might wonder if this lesson is really important. The degree
of success that you will experience in your study of economics
will be determined, to a large extent, by your motivation and
your intent to learn. People generally learn more when their
study is being carried out with a particular intent. In the first
half of this lesson you will read about various economic

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problems and ideas. You will probably find at least some of the
problems and ideas to be interesting. You may then study
economics with an intent to acquire knowledge and reasoning
abilities that will help you to understand these ideas and solve
these problems.
1.1 What is economics ?
One of the earliest and most famous definitions of economics
was that of Thomas Carlyle, who in the early 19th century
termed it the “dismal science.” What Carlyle had noticed was the
anti-utopian implications of economics. Many utopians, people
who believe that a society of abundance without conflict is
possible, believe that good results come from good motives
and good motives lead to good results. Economists have
always disputed this, and it was the forceful statement of this
disagreement by early economists such as Thomas Malthus and
David Ricardo that Carlyle reacted to.
Another early definition, one which is perhaps more useful, is
that of English economist W. Stanley Jevons who, in the late
19th century, wrote that economics was “the mechanics of
utility and self interest.” One can think of economics as the
social science that explores the results of people acting on the
basis of self-interest. There is more to man than self-interest,
and the other social sciences—such as psychology, sociology,
anthropology, and political science—attempt to tell us about
those other dimensions of man. As you read further into these
pages, you will see that the assumption of self-interest, that a
person tries to do the best for himself with what he has,
underlies virtually all of economic theory.
At the turn of the century, Alfred Marshall’s Principles of
Economics was the most influential textbook in economics.
Marshall defined economics as “a study of mankind in the
ordinary business of life; it examines that part of individual
and social action which is most closely connected
with the attainment and with the use of the material
requisites of wellbeing. Thus it is on one side a study of
wealth; and on the other, and more important side, a part
of the study of man.”
Many other books of the period included in their definitions
something about the “study of exchange and production.”

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Definitions of this sort emphasize that the topics with which
economics is most closely identified concern those processes
involved in meeting man’s material needs. Economists today
do not use these definitions because the boundaries of
economics have expanded since Marshall. Economists do more
than study exchange and production, though exchange remains
at the heart of economics.
Most contemporary definitions of economics involve the
notions of choice and scarcity. Perhaps the earliest of these is by
Lionell Robbins in 1935: “Economics is a science which
studies human behavior as a relationship between ends and
scarce means which have alternative uses.” Virtually all
textbooks have definitions that are derived from this definition.
Though the exact wording differs from author to author, the
standard definition is something like this: “Economics is the
social science which examines how people choose to use
limited or scarce resources in attempting to satisfy their
unlimited wants.”
In other words “Economics is the science of choice — the
science that explains the choices that we make and how those
choices change as we cope with scarcity.”
By now you must have got an idea that scarcity is central in
these definitions. Now let’s examine scarcity.
1.2 Scarcity and Choice
Scarcity means that people want more than is available. Scarcity
limits us both as individuals and as a society. As individuals,
limited income (and time and ability) keep us from doing and
having all that we might like. As a society, limited resources
(such as manpower, machinery, and natural resources) fix a
maximum on the amount of goods and services that can be
produced.
Scarcity requires choice. People must choose which of their
desires they will satisfy and which they will leave unsatisfied.
When we, either as individuals or as a society, choose more of
something, scarcity forces us to take less of something else.
Economics is sometimes called the study of scarcity because
economic activity would not exist if scarcity did not force people
to make choices.
When there is scarcity and choice, there are costs. The cost of

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any choice is the option or options that a person gives up. For
example, if you gave up the option of playing a computer game
to read this text, the cost of reading this text is the enjoyment
you would have received playing the game. Most of economics
is based on the simple idea that people make choices by
comparing the benefits of option A with the benefits of
option B (and all other options that are available) and choosing
the one with the highest benefit. Alternatively, one can view the
cost of choosing option A as the sacrifice involved in rejecting
option B, and then say that one chooses option A when the
benefits of A outweigh the costs of choosing A (which are the
benefits one loses when one rejects option B).

EU Moves Towards Integrating Capital Markets

18 Oct 2005

The high cost of cross-border trading in securities is driving debate on reform of Europe's capital
markets and the creation of a pan-European capital market in order to cut costs. Although the
benefits of an integrated market are agreed, there is less consensus and lack of momentum on the
method of integration.

Last month, Charlie McCreevy, the EU's internal market commissioner, warned Europe's financial
services industry that it was not moving fast enough in cutting the costs of cross-border trading in
securities. According to McCreevy, cross-border clearing and settlement costs can be up to six times
more than those of domestic settlements. He argues that the introduction of consolidated structures
in the EU, such as a single pan-European central counterparty, and therefore the creation of a pan-
European capital market, could help cut the high costs of cross-border trading.

The significance of this subject is exemplified by focus on the securities markets at SIBOS this year
(5-9 September), an annual international banking conference and exhibition. The expense of cross-
border security settlement was described by Andrew Crockett, president of JPMorgan Chase, as a
"major issue for the capital markets" at a conference session on the Giovannini Group's report, which
identified 15 barriers to efficient European clearing and settlement. The session focused on issues

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and challenges surrounding ongoing reform and harmonisation of Europe's capital markets. Crockett
described how the securities industry still has a variety of issues to resolve including the relationship
between European and global initiatives, and how to ensure consistency between them; whether to
favour a consolidated competitive market structure; and how individual firms can be rewarded for
making the investments necessary to achieve change.

The EU Commission originally launched a consultation on objectives and actions to deliver efficient
cross-border clearing and settlement in May 2002 and a second communication in April 2004 taking
into account recommendations from the Giovannini Group's report. Although some respondents
support the Commission's proposals to consider a directive on securities clearing and settlement,
including many EU regulators, banks and exchanges, opinion is divided. In his article, Clearing and
Settlement: Is Regulation Needed?, Ian Dalton explains how Euroclear, for instance, remains
unconvinced that a directive focused on the activities of settlement systems will reduce cross-border
settlement costs. He agrees with the European Parliament's report that a rigorous regulatory impact
assessment is needed before any legislation is proposed.

Aside from the question of whether to legislate, there is also lack of consensus on what to harmonise
across Europe's capital markets. As mentioned, Internal Market Commissioner McCreevy claims the
creation of consolidated structures in the EU will help cut the costs of cross-border trading in
securities. In contrast, at a recent roundtable on cross-border clearing and settlement hosted by
Rhyme Systems, Charles Pugh, senior relationship manager at Euroclear, said the focus should be
on "harmonisation of laws rather than infrastructure".

Euroclear believes the way forward for more efficient European clearing and settlement is through
the harmonisation of market practices, and where necessary, laws, regulations and fiscal processes.
The settlement group is currently working on two programmes: harmonisation of market practices
across the Euroclear group markets; and consolidation of technology platforms and the interface
used by clients to interact with Euroclear.

One of the main obstacles in creating a pan-European capital market is the national dynamics of the
clearing and settlement systems across Europe. Mark Wellham, product manager at Rhyme
Systems, explains: "If you look at custody and settlement, post-trade operations in France, for
example, will comprise a different set of market practices than elsewhere and, for instance, the UK
has stamp duty while other countries will have no such practice, or different versions of the same
thing."

At the SIBOS conference session, Alberto Giovannini, CEO of Unifortune and chairman of the
Giovannini Group, pointed out that though there was universal agreement on the challenges of
creating an integrated capital market, momentum was a critical issue because participants were

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currently taking "a limited role". This is mainly due to the different interests of market participants and
European member states.

Bob Wigley, managing director and chairman EMEA at Merrill Lynch, a panelist at the conference
session, said, "Progress towards the objective of pan-European infrastructure on clearing and
settlement, and to achieving the substantial benefits it would bring has, in common with so many
other well intentioned European initiatives, sadly been derailed by the pursuit of vested and
perceived national interests." He highlighted obstacles such as existing clearing and settlement
structures that are not owned by organisations whose objectives are to achieve, over time, the lowest
overall cost of trading and post-trading services combined with the greatest responsiveness to users'
and consumers' needs. "There are examples of domestic legislation and local infrastructure rules
that are designed more with the protection of perceived national or local business interests in mind
rather than the needs or interests of consumers," he added.

Be it through harmonisation of laws and/or consolidation of platforms, there is consensus that an

integrated European capital market will help reduce the costs of cross-border trading and also
improve efficiencies within the European clearing and settlement infrastructure. Indeed, Trevor
Pitman, group managing director at Fitch Ratings, comments: "Anyone in favour of free trade,
liberalised markets and initiatives to cut the costs of trading would be in favour of an integrated
capital market." He believes that an integrated European capital market would be beneficial to
corporate borrowers and, in turn, beneficial to the industry's rating agencies.

Rhyme System's Wellham agrees: "For players that deal largely in cross-border trades and in high
volumes, cross-border charges will be reduced significantly through an integrated capital market. In
cross-border trade, companies may have different systems for different markets but potentially [with
an integrated European capital market] those companies could ultimately need only one where all
their European trades are processed."

Both Euroclear and Merril Lynch advocate industry participation in moving forward development of
efficient pan-European clearing and settlement. Wigley argues that education and information
dissemination is critical to "dispelling myths, counteracting protectionist strategies and creating
greater awareness among the investment community that harmonisation will generate substantial
benefits". In his article, Euroclear's Dalton stresses the fact that the clearing settlement industry has
a "moral obligation to contribute to the Commission's education".

The European Commission is now deciding whether legislation, or other intervention, is necessary
on European clearing and settlement. The next six months will be interesting and crucial for the
securities industry as debate and consultation continues.

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Securities Market Infrastructure Trends in India

Debopama Sen, Citigroup - 03 Oct 2005 - Originally published in Global Custody Review

Continuous improvements in infrastructure and increased sophistication of available products are

inevitable consequences of the rapid development of the Indian capital markets. Debopama Sen,
Securities Country Manager India, Citigroup Global Transaction Services, summarises the major
changes that are anticipated by the market in the coming months, and assesses their likely
implications for foreign investors.

It is a well-established truth that the Indian capital markets have taken significant strides in the last
decade. The reforms undertaken by the Government over the last decade have not only refined and
modernised the market infrastructure, but increased the attractiveness of the Indian capital markets
to global investors. The fiscal year 2004-05 saw net investments from Foreign Institutional Investors
(FIIs) reaching $10bn, with total net FII investment standing at $35.9bn as of March 31, 2005.

Making India "a benchmark for the globe" is the mission statement of the Securities and Exchange
Board of India (SEBI). The continuing inflow of foreign investment, the seamless implementation of
T+2 settlement, and the rapid growth of the derivatives market are testaments to the fundamental
resilience and structural strength of the securities market.

Continuous improvements in infrastructure and increased sophistication of available products are

inevitable consequences of the rapid development of the Indian capital markets. We summarise
below the major changes that are anticipated by the market in the coming months, and assess their
likely implications for foreign investors.

1. Enhancing the corporate bond market infrastructure

SEBI had identified the need to build further transparency in India's corporate bond markets in its
Strategic Action Plan for 2004-05. In his 2005-06 Union Budget speech, the Finance Minister of India
announced that a committee of experts would look into the changes that are required to make the
corporate bond market as vibrant as the equity capital markets. The Committee will look into legal,
regulatory, tax and market design issues. The corporate debt market today in India is an over-the-
counter market with bilateral settlement taking place directly between counterparties due to the
absence of a central clearing house. It can be expected that the infrastructural measures
recommended by the Committee would aim to build the same transparency and risk containment
measures that exist in the equity markets today.

2. Extending STP to the derivatives and debt markets

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Straight through Processing (STP) was successfully introduced in the equity capital markets in 2002-
03. In 2004, SEBI mandated STP for all institutional transactions executed through the stock
exchanges, which has ensured STP for the equity capital markets. However, the process flow for
debt and derivatives trading and settlement continues to be manual and paper-based.

The equity exchange traded derivatives segment in India has seen explosive growth since the
commencement of trading on the exchanges in 2000 with average daily traded value being in excess
of $3bn currently. In April 2005, the FII share of open interest in the futures and options segment
reached an all time high of 42 per cent, an indication of the significant interest shown by FIIs in the
segment. It is likely that the existing infrastructure for ensuring STP in the equity markets will be
suitably enhanced so that it may operate in the derivatives and debt markets.

3. SMILE taskforce recommendations

In April 2004, SEBI established the Securities Market Infrastructure Leveraging Expert (SMILE)
taskforce to carry out a thorough "health check" of the securities market. In August 2004, SMILE
published a report entitled "Infrastructure and Process Flows for the Primary Market" recommending
increased automation in the entire process flow from confirmation to allotment to refunds. In January
2005, the taskforce published "Infrastructure and Process Flows for Enhancing Distribution Reach in
the Mutual Fund Industry." The SMILE taskforce's recommendations are under review for
implementation.

The SMILE taskforce's recommendations for the primary market related to automating the primary
market process in its entirety - from confirmation to allotment and refunds - with the aim of reducing
manual entry and avoidance of duplicate records. The taskforce's suggestions to the mutual fund
industry was to evaluate enhancing their reach by leveraging the existing depository infrastructure as
an alternative to the existing collections centre model.

4. Structural changes to payment and settlement infrastructure

India's payment and settlement system currently involves a variety of payment instruments - both
paperbased and electronic. Settlement is characterised by the presence of multiple clearing houses
(about 1050) handled by various legal entities. The clearing houses are voluntary bodies set up by
the participating banks and post offices and they function in an autonomous manner. Due to the
multiplicity of operators, local practices vary from place to place, which may lead to a lack of
coordination among organisations resulting in inconsistency of operations. This also limits the scope
of implementing innovations in the systems.

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In its vision document titled "Payment Systems - Vision 2005-08", the Reserve Bank of India (RBI)
has envisaged the Indian Retail Clearing function being entrusted to a separate single legal entity
while the RBI remains the settlement institution for all clearing systems.

The single entity having uniformity in structure, operations and procedures will facilitate
standardisation and efficiency in the processing of smaller value payments. Citigroup India is a
member of the National Payments Council constituted by the RBI.

Real Time Gross Settlement (RTGS) is expected to revolutionise the payments infrastructure in the
country. The expansion of RTGS has been hampered by the relatively low penetration of technology
in public sector banks. A reduction in operational costs will hasten the adoption of RTGS for
securities settlements and reduce usage of paper-based instruments in the country.

The Development of India's Market Infrastructure: Significant Milestones

Since the establishment of the Securities and Exchange Board of India (SEBI) as the
securities markets regulator in 1988, much progress has been made in the modernisation of
India's market infrastructure. The developments, which are expected in the coming months,
are the latest of a large number of initiatives, which have been adopted so far. Significant
milestones so far include the:

• Replacement of open outcry trading with screen trading at the major stock
exchanges.

• Shortening of the settlement cycle from 30/14 days to a rolling T+2 settlement
cycle.

• Introduction of dematerialisation.

• Launch of derivatives trading.

• Implementation of risk management measures.

• Establishment of the Clearing Corporation of India Limited (CCIL) as the

clearing house for Government Securities and Forex.

• Introduction of the Market Participants and Investor (MAPIN) database.

• Launch of the Indonext Trading Platform on the BSE for Small and Medium
Sized Enterprises.

• Introduction of Real Time Gross Settlement (RTGS).

• Implementation of mandatory Straight Through Processing (STP) for

institutional equity trades.

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5. Further progress towards adoption of a T+1 rolling settlement cycle

SEBI has envisaged a T+1 rolling settlement cycle for equity trades. This is likely to become more
practical as RTGS becomes more widespread. Other key considerations include the presence of a
banking sector infrastructure able to support T+1, automation of broker back-offices in line with T+1
and the complications arising due to foreign investors and global custodians having operations and
dealing rooms in multiple time zones. It remains to be seen whether the challenges of working with
investors in multiple time zones hinders the introduction of a T+1 settlement cycle.

6. Maturity of the derivative markets

The rapid growth of the derivatives market in India has been remarkable. The basket of derivatives is
expected to be expanded based on various instruments available internationally. Index futures and
options may be extended to other indices and stocks while stock futures and options could be
extended to active securities. In April 2005, the National Stock Exchange (NSE) announced the
phased introduction of futures and options contracts for 70 additional individual securities as against
55-odd existing securities till then.

It is possible that new derivatives, based on the exchange rate, gold or international instruments will
be introduced in the future. Foreign Institutional Investors (FIIs) until now have had to deposit cash
for collateral to satisfy margin requirements for derivatives trading. In the coming months, SEBI and
the exchanges are expected to publish guidelines that will enable FIIs to post securities as collateral.
At this stage, however, it seems unlikely that physical - as opposed to cash - settlement of derivative
contracts will be possible before the second half of 2006.

7. Implementation of securities lending and borrowing

The absence of a widespread program of securities lending and borrowing has been a limiting factor
to the introduction of the physical settlement of derivatives contracts. However, securities lending
and borrowing is expected to be introduced to handle settlement shortages by 1 June 2005. The
program may be extended to a wider base after a period of one year.

Summary

The Indian securities markets remain unique by virtue of its multiple exchanges and depositories.
The next three years would be crucial in the continuing development of the Indian capital markets as
they will give direction and pace to the infrastructural and product reforms that are transforming the
face of the securities market. The reforms in the corporate debt market could herald in the era of
anonymous order driven trading and a clearing house model of settlement - as distinct from the
existing OTC trading and bilateral settlement that is in vogue today. The widespread adoption of
RTGS may build the necessary infrastructure for an efficient payments system. The adoption of
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automation in the primary market would address the existing gap between the secondary and the
primary markets.

Prices and Yields

1.1. CONFOUNDING COMPOUNDING
Bond managers have it easy - a whole lifetime of employment rests upon the
understanding and manipulation of a single, simple equation. And here it is;
FV = PV(1+r)n eq. 1
Contained in this equation is the ability to work out the Future Value (FV) of an
investment whose Present Value (PV) is known and invested at a rate (r) for
number of investment periods (n). It also proffers the ability to earn mindboggling
bonuses, if you know how to use it. How we use this equation is
important so it's worth going through the examples, just for the avoidance of
doubt.
1.2. EXAMPLE OF INTEREST OVER ONE YEAR
Due an excessively generous bonus system, I currently have £50,000 in a bank
account which is less than generously offering 7.5% per annum for the next
year. What will the value of my investment be in 1 year's time?
PV = £50,000 r = 7.5% = 0.075 n = 1
FV = 50,000 x (1 + 0.075)1
FV = 53,750
So, for my £50,000 I will have £53,750 at the end of one year. I will receive
£3,750 of interest, which is nice.
At the end of one year I will receive the £3,750 but what do I do then? Well, I
could indulge my love of Italian suits and continue my deep desire to propel the
UK trade deficit to new heights or being the sensible person that I am I could
place it on deposit again and receive another year's interest plus interest on the
interest that I have already earned. This is the essence of compound interest -
getting paid for something you've already received.
1.3. EXAMPLE OF COMPOUND INTEREST
You have received £3,750 of interest and you are forgoing your love of Italian
suits to place on your money deposit for another year at 7.5%. What is value of
the extra interest?
PV = £3,750 r = 7.5% = 0.075 n = 1
FV = 3,750 x (1 + 0.075)1
FV = 4,031.25
Stewart Cowley, Newton Investment Management

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Did you know – Financial Markets

Arbitrage

Arbitrage is the activity of exploiting imbalances between two or more markets. Foreign money exchangers
operate their entire businesses on this principle. They find tourists who need the convenience of a quick
cash exchange. Tourists exchange cash for less than the market rate and then the money exchanger
converts those foreign funds into the local currency at a higher rate. The difference between the two rates is
the spread or profit.

There are plenty of other instances where one can engage in the practice arbitrage. In some cases, one
market does not know about or have access to the other market. Alternatively, arbitrageurs can take
advantage of varying liquidities between markets.

The term 'arbitrage' is usually reserved for money and other investments as opposed to imbalances in the
price of goods. The presence of arbitrageurs typically causes the prices in different markets to converge:
the prices in the more expensive market will tend to decline and the opposite will ensue for the cheaper
market. The efficiency of the market refers to the speed at which the disparate prices converge.

Engaging in arbitrage can be lucrative, but it does not come without risk. Perhaps the biggest risk is the
potential for rapid fluctuations in market prices. For example, the spread between two markets can fluctuate
during the time required for the transactions themselves. In cases where prices fluctuate rapidly, would-be
arbitrageurs can actually lose money.

Insider Trading

'Insider trading' can refer to two separate financial transactions--one being perfectly legal and the other
being subject to massive civil fines and possible prison time. The legal form of insider trading involves the
sale of securities or stocks by officers of a company or stockholders who own more than 10% of the
company.

Any stockholder is free to buy or sell their shares based on public information about the company's current
or future financial outlook. A company president can sell off his shares if news of an impending bankruptcy
filing is announced in the Wall Street Journal, for example. The company president is considered an insider,
obviously, but his decision to sell his stock was based on information any other stockholder could have
discovered.

The illegal form of insider trading involves information NOT readily available to the rest of the stockholders.
Whenever an individual becomes a major stockholder or a senior officer in a company, he or she must

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agree to keep certain events absolutely secret, even if these events could spell financial disaster for
stockholders. The Security and Exchange Commission (SEC) watches for signs of insider trading whenever
companies experience huge losses or gains.

If, for example, a vice-president of a drug company learned that the Food and Drug Administration would
not be approving his company's newest drug treatment for diabetes, he could not legally sell off his own
shares or advise his friends and family to sell off their holdings. The decision to sell off stocks in a company
that is about to receive devastating news would be based on privileged information. The vice-president of
that company and anyone he told about the FDA decision could be charged with insider trading.

Insider trading is not a new white-collar crime; the use of privileged information for financial gain has been
around since the inception of stock trading. Most stockholders are free to make buying or selling decisions
based on anything from a strong hunch to the latest pop culture trends. However, executives and major
stockholders have an obligation to avoid the use of insider trading even if it means personal financial
losses. Without stiff penalties for insider trading, corporate executives everywhere could unfairly profit from
their personal knowledge. Regular stockholders without access to this information would not be able to sell
off their stock in a failing company or reap the benefits of a company poised for success.

LIBOR

LIBOR, the London Interbank Offered Rate, is the most active interest rate market in the world. It is
determined by rates that banks participating in the London money market offer each other for short-term
deposits. LIBOR is used in determining the price of many other financial derivatives, including interest rate
futures, swaps and Eurodollars. Due to London's importance as a global financial center, LIBOR applies not
only to the Pound Sterling, but also to major currencies such as the US Dollar, Swiss Franc, Japanese Yen
and Canadian Dollar.

LIBOR is determined every morning at 11:00am London time. A department of the British Bankers
Association averages the inter-bank interest rates being offered by its membership. LIBOR is calculated for
periods as short as overnight and as long as one year. While the rates banks offer each other vary
continuously throughout the day, LIBOR is fixed for the 24 hour period. Generally, the difference between
the instantaneous rate and LIBOR is very small, especially for short durations.

The most important financial derivatives related to LIBOR are Eurodollar futures. Traded at the Chicago
Mercantile Exchange (CME), Eurodollars are US dollars deposited at banks outside the United States,
primarily in Europe. By holding the deposits outside the country, US depositors are not subject to Federal
Reserve margin requirements, allowing higher leverage of the funds. The interest rate paid on Eurodollars

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is largely determined by LIBOR, and Eurodollar futures provide a way of betting on or hedging against
future interest rate changes.

Interest rate swaps are another significant financial derivative dependent on LIBOR. In an interest rate
swap, two parties exchange sets of interest payments on a given amount of capital. Generally, one party
will have a fixed interest payment, while the other will have a variable rate. The variable rate payment
stream is often defined in terms of LIBOR. Interest rate swaps, and by extension LIBOR, are extremely
important in providing a liquid secondary market for residential mortgages, which in turn allows lower
interest rates on US mortgages.

While LIBOR does have implications for transactions conducted in Euros, the advent of the Euro has
brought with it the creation of the Euribor. Conceptually similar to the LIBOR, the Euribor benchmark is
defined and maintained by the European Banking Federation

Short selling

In finance, short selling is selling something that one does not (yet) own. Most investors "go long" on an
investment, hoping that price will rise. Short sellers borrow a security and sell it, hoping that it will
decrease in value so that they can buy it back at a lower price and keep the difference. For example,
assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow (say)
100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of
XYZ shares later falls to $5 per share, the short seller would then buy 100 shares back for $500, return
the shares to their original owner, and make a $500 profit. In a given year about 2% of stocks on the New
York Stock Exchange are sold short.

History

Short selling has been a target of ire since at least the 17th century when England banned it outright.
Short sellers are widely regarded with suspicion because, to many people, they are profiting from the
misfortune of others. However, less than 5% of all shorts are done by public investors and traders,
whereas at least 95% of short sales are done by broker-dealers and market makers who do not even
always have to own shares to sell them (i.e. Naked Short Selling).

The term "short" was in use from at least the mid-19th century. It is commonly understood that "short" is
used because the short seller is in a deficit position with his brokerage house.

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Short sellers were blamed (probably erroneously) for the Wall Street Crash of 1929. Regulations
governing short selling were implemented in 1929 and in 1940. Political fallout from the 1929 crash led
Congress to enact a law banning short sellers from selling shares during a sharp downturn. President
Hoover condemned short sellers and even J. Edgar Hoover said he would investigate short sellers for
their role in prolonging the Depression. Legislation introduced in 1940 banned mutual funds from short
selling (this law was lifted in 1997).

When Wall Street "downgrades" a stock, one may reasonably assume that interested parties have
already established a short position in (i.e. sold short) the stock being downgraded, as invariably the stock
drops or even plummets when the "downgrade" hits the wire. Therefore, public investors are typically too
late to short by the time the "downgrade" is heard on the news.

Mechanism

Short selling consists of the following:

· You borrow shares.

· You sell them and the proceeds are credited to your account at the brokerage firm.
· You must "close" the position by buying back the shares (called covering) - If the price drops, you
make a profit. Otherwise you make a loss.
· You finally return them to the lender.

Concept

Short selling is the opposite of "going long". The short seller takes a fundamentally negative, or "bearish"
stance, anticipating that the price of the shorted stock will fall (not rise as in long buying), and it will be
possible to buy at a lower price whatever was sold, thereby making a profit ("selling high and buying low,"
to reverse the adage). The act of buying back the shares, which were sold short, is called 'covering the
short'. Day traders and hedge funds will often use short selling to allow them to profit on trading in stocks
that they believe are overvalued, just as traditional long investors attempt to profit on stocks, which are
undervalued by buying those stocks.

The short seller owes his broker and must repay the shortage when he covers his position. Technically,
the broker usually in turn has borrowed the shares from some other investor who is holding his shares
long; the broker itself seldom actually purchases the shares to loan to the short seller.

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Example: Borrowing 100 shares from someone, selling them immediately at $1.00 - when the stock
drops, you buy them back for $0.50 and give the 100 shares back to the original owner keeping the profit.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is
able to make delivery of the shorted securities. This is referred to as a "locate", and it is a legal
requirement that U.S. regulated broker-dealers not permit their customers to short securities without first
obtaining a locate. Brokers have a variety of means to borrow stocks in order to facilitate locates and
make good delivery of the shorted security. The vast majority of stocks borrowed by U.S. brokers come
from loans made by the leading custody banks and fund management companies (see list below).
Sometimes, brokers are able to borrow stocks from their customers who own "long" positions. In these
cases, if the customer has fully paid for the long position, the broker cannot borrow the security without
the express permission of the customer, and the broker must provide the customer with collateral and pay
a fee to the customer. In cases where the customer has not fully paid for the long position (meaning, the
customer borrowed money from the broker in order to finance the purchase of the security), the broker will
not need to inform the customer that the long position is being used to effect delivery of another client's
short sale.

Also read “Ban on short-selling” by B.Venkatesh in Business Line’s Investment World on April
29,2001.

THE Securities and Exchange Board of India (SEBI) recently banned short selling.

What is short selling and why did SEBI ban such trading?

Suppose you hold a view that, say, Infosys, is overvalued at the current price and may fall sometime
soon. If you want to bet on your hunch, you can sell the stock now and buy it back at a lower price at a
later date. This process of selling the stock without holding it is called short selling.

Short selling is important for the overall functioning of the market. This is because such trading enables
investors to take a bearish or a bullish view on the market; you buy the stock if you are bullish, or short-
sell the stock if you hold a bearish view.

Short selling can, however, destabilise the market if not properly regulated. The bears, for instance, can
deliberately push a stock down by short selling. Of course, bulls can likewise push up stocks. But, given
investor psychology, pushing prices down is not as well tolerated as pushing prices up.

That is one reason why even developed markets regulate short selling. At the New York Stock Exchange,
for instance, you can short-sell only on a zero-plus tick. If, for instance, the immediately preceding trades

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in Infosys are Rs 3,710, Rs 3,700 and Rs 3,700, the zero-plus tick rule means that you can short-sell only
at Rs 3,700 and not at a lower price. This ensures that bears do not push prices down sharply by short
selling.

Now, why did SEBI ban short selling? Recall that the market was falling sharply in the last few weeks.
Short selling typically precipitates the fall in such a trending market. Suppose Infosys is falling by, say, Rs
200 every day, traders will be tempted to profit from the trend by short-selling the stock, which will only
push its price further down. Since falling equity values is bad news for investors and the economy, SEBI
thought it fit to ban short selling.

Q 6.1 What are Investment banks?

A 6.1 Investment banks are essentially financial intermediaries, who primarily help businesses and
governments with raising capital, corporate mergers and acquisitions, and securities trade. In USA
such banks are the most important participants in the direct market by bringing financial claims for
sale. They help interested parties in raising capital, whether debt or equity in the primary market to
finance capital expenditure.

Once the securities are sold, investment bankers make secondary markets for the securities as
brokers and dealers. In 1990, there were 2500 investment banking firms in USA doing underwriting
business. About 100 firms are so large that they dominate the industry. In recent years some
investment banking firms have diversified or merged with other financial institutions to become full
service financial firms.

Q 6.2 What is the difference between Investment Banks & Commercial Banks?

A 6.2 Investment banks have often been thought to be as Commercial banks, and rightly so. However,
both the terms have different connotations in United States. Early investment banks in USA differed
from commercial banks, which accepted deposits and made commercial loans. Commercial banks
were chartered exclusively to issue notes and make short-term business loans. On the other hand,
early investment banks were partnerships and were not subject to regulations that apply to
corporations. Investment banks were referred to as private banks and engaged in any business they
liked and could locate their offices anywhere. While investment banks could not issue notes, they
could accept deposits as well as underwrite and trade in securities.

As put forth earlier, the distinction between commercial banks and investment banks is unique and is
confined to the United States, where it is by legislation that they are separated. In countries where

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there is no legislated separation, banks provide investment-banking services as part of their normal
range of banking activities. Coming back to countries where investment banking and commercial
banking are combined. Such countries have what is known as universal banking system. Say for
example, European Countries have universal banking system, which accepts deposits, make loans,
underwrites securities, engage in brokerage activities and offer financial services.

Q 6.3 How is the scenario for Investment Banking in India?

A 6.3 In India commercial banks are restricted from buying and selling securities beyond five percent
of their net incremental deposits of the previous year. They can subscribe to securities in the primary
market and trade in shares and debentures in the secondary market. Further, acceptance of deposits
is limited to commercial banks. Non-bank financial intermediaries accept deposits for fixed term are
restricted to financing leasing/hire purchase, investment and loan activities and housing finance. They
cannot act as issue managers or merchant banks. Only merchant bankers registered with the
Securities and Exchange Board of India (SEBI) can undertake issue management and underwriting,
arrange mergers and offer portfolio services. Merchant banking in India is non-fund based except
underwriting. The following figure (figure 1), serves as an effective tool of rightly distinguishing
between the above two banks.

Q 6.4 What is Universal Banking?

A 6.4 It refers to the combination of commercial banking and investment banking including securities
business. It envisages multiple business activities and can take number of forms ranging from the true
universal bank represented by the German Model with few restrictions to the UK model providing a
broad range of financial activities through separate affiliates of the bank and the US model with a
holding company structure through separately capitalized subsidiaries.

Q 6.5 What are the Principal Functions Of Investment Banks?

A 6.5 Global investment banks typically have several business units, each looking after one of the
functions of investment banks. For example, Corporate Finance, concerned with advising on the
finances of corporations, including mergers, acquisitions and divestitures; Research, concerned with
investigating, valuing, and making recommendations to clients - both individual investors and larger
entities such as hedge funds and mutual funds regarding shares and corporate and
government bonds); and Sales and Trading, concerned with buying and selling shares both on behalf
of the bank's clients and also for the bank itself. For Investment banks management of the bank's own
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capital, or Proprietary Trading, is often one of the biggest sources of profit. For example, the banks
may arbitrage stock on a large scale if they see a suitable profit opportunity or they may structure their
books so that they profit from a fall in bond price or yields. In short the functions of Investment banks
include:

1. Raising Capital
2. Brokerage Services
3. Proprietary trading
4. Research Activities
5. Sales and Trading

Q 6.6 Explain the “Raising Capital” function:

A 6.6 Corporate Finance is a traditional aspect of Investment banks, which involves helping
customers raise funds in the Capital Market and advising on mergers and acquisitions. Generally the
highest profit margins come from advising on mergers and acquisitions. Investment Bankers have had
a palpable effect on the history of American business, as they often proactively meet with executives
to encourage deals or expansion.

Question 6.7

Q 6.7Explain the “Brokerage Services” Function:

A 6.7 Brokerage Services, typically involves trading and order executions on behalf of the investors.
This in turn also provides liquidity to the market. These brokerages assist in the purchase and sale of
stocks, bonds, and mutual funds.

Q 6.8Explain the “Proprietary Trading” Function:

A 6.8 Under Investment banking proprietary trading is what is generally used to describe a situation
when a bank trades in stocks, bonds, options, commodities, or other items with its own money as
opposed to its customer’s money, with a view to make a profit for itself. Though Investment Banks are
usually defined as businesses, which assist other business in raising money in the capital markets (by
selling stocks or bonds), they are not shy of making profit for itself by engaging in trading activities.

Question 6.9

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Q 6.9Explain the “Research Activities” Function:
A 6.9 Research, is usually referred to as a division which reviews companies and writes reports about
their prospects, often with "buy" or "sell" ratings. Although in theory this activity would make the most
sense at a stock brokerage where the advice could be given to the brokerage's customers, research
has historically been performed by Investment Banks (JM Morgan Stanley, Goldman Sachs etc). The
primary reason for this is because the Investment Bank must take responsibility for the quality of the
company that they are underwriting Vis a Vis the prices involved to the investor.

Q 6.10 Explain the “Sales and Trading” Function:

A 6.10 Often referred to as the most profitable area of an investment bank, it is usually responsible for
a much larger amount of revenue than the other divisions. In the process of market making,
investment banks will buy and sell stocks and bonds with the goal of making an incremental amount of
money on each trade. Sales is the term for the investment banks sales force, whose primary job is to
call on institutional investors to buy the stocks and bonds, underwritten by the firm. Another activity of
the sales force is to call institutional investors to sell stocks, bonds, commodities, or other things the
firm might have on its books.

Q 6.11 What does the Business Portfolio of Investment Banks constitute?

A 6.11CORE BUSINESS PORTFOLIO

1.NON-FUND BASED

Merchant Banking Services for

• Management of Public offers of equity and debt instruments

• Open offers under the Takeover Code
• Buy back offers
• De-listing offers

Advisory and Transaction service in

• Project Financing
• Syndicated Loans

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 Structured Finance

 Venture Capital

 Private Equity

 Preferential Issues

 Private Placements of equity and debt

 Business advisory and structuring

 Financial restructuring

 Corporate Reorganisations such as mergers and de-mergers, hive-offs, asset sales, sell-off and
exits, strategic sale of equity.

 Acquisitions and takeovers

 Government disinvestments and privatisation

 Asset Recovery agency services (presently in take off stage)

2. FUND BASED

• Underwriting
• Market Making
• Bought Out deals
• Investments in primary market

• Investment banks are essentially financial intermediaries, who primarily help businesses and
governments with raising capital, corporate mergers and acquisitions, and securities trade.
• Early investment banks in USA differed from commercial banks, which accepted deposits and
made commercial loans.
• Distinction between commercial banks and investment banks is unique and is confined to the
United States, where it is by legislation that they are separated.
• Countries where investment banking and commercial banking are combined have universal
banking system.
• Universal Banking refers to the combination of commercial banking and investment banking
including securities business

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• Sales and Trading is often referred to as the most profitable area of an investment bank, it is
usually responsible for a much larger amount of revenue than the other divisions

Q 7.1 How did Investment banking evolve in India?

A 7.1 For more than three decades, the investment banking activity was mainly confined to merchant
banking services. The foreign banks were the forerunners of merchant banking in India. The erstwhile
Grindlays Bank began its merchant banking operations in 1967 after obtaining the required license
from RBI. Soon after Citibank followed through. Both the banks focussed on syndication of loans and
raising of equity apart from other advisory services. In 1972, the Banking Commission report asserted
the need for merchant banking activities in India and recommended a separate structure for merchant
banks totally different from commercial banks’ structure. The merchant banks were meant to manage
investments and provide advisory services. The SBI set up its merchant banking division in 1972 and
the other banks followed suit. ICICI was the first financial institution to set up its merchant banking
division in 1973.

Q 7.2 How did the formation of SEBI boost the Development of Investment banking in India?

A 7.2 The advent of SEBI in 1988 was a major boost to the merchant banking activities in India and
the activities were further propelled by the subsequent introduction of free pricing of primary market
equity issues in 1992. Post-1992, there was lot of fluctuations in the issue market affecting the
merchant banking industry. SEBI started regulating the merchant banking activities in 1992 and a
majority of the merchant bankers were registered with it. The number of merchant bankers registered
with SEBI began to dwindle after the mid nineties due to the inactivity in the primary market. Many of
the merchant bankers were into issue management or associated activity such as underwriting or
advisory. Many merchant bankers succumbed to the downturn in the primary market because of the
over-dependence on issue management activity in the initial years. Also not all the merchant bankers
were able to transform themselves into full-fledged investment banks. Currently bigger industry
players who are in investment banking are dominating the industry.

Q 7.3 What were the major constraints in Indian Investment banking industry?

A 7.3 The major constraints were:

• The Indian investment banks depended on issue management to a greater extent and so
some of them had to perish due to the primary market downturn in the 90’s.

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• The bigger industry players were the only ones to survive because of a general lack of
institutional financing in a big way to fund capital market activity, which would have otherwise
paved way for other smaller players.
• The lack of depth in the secondary market, especially in the corporate debt market could not
supplement the primary market for any major development.

Q 7.4 What are the Characteristics of Indian Investment Banking Industry?

A 7.4 Till the 1980s, the Indian financial services industry was characterised by debt services in the
form of term lending by financial institutions and working capital financing by banks and non-banking
financial companies. Capital markets was still an unorganised industry and was mostly restricted to
stock broking activity. In the early nineties, when the capital markets opened up, merchant banking
and asset management services flourished. Many banks, NBFCs and financial institutions entered the
merchant banking, underwriting and advisory services driven by the boom in the primary market.

Over the subsequent years, the merchant banking industry had faced a huge downturn due to
recession in the capital markets. Also, the capital markets and investment banking activities came
under lot of regulatory developments that required separate registration, licensing and capital
controls. This proved to be an impediment for the growth of the investment banking industry.

Q 7.5 What is the Structure of Indian Investment Banking Industry?

A 7.5 The Indian investment banking industry has a heterogeneous structure for the following
reasons:

• The regulations do not permit all investment banking functions to be performed by a single
entity for two reasons:

1. To prevent excessive exposure to business risk

2. To prescribe and monitor capital adequacy and risk mitigation mechanisms.

• The commercial banks are prohibited from getting exposed to stock market investments and
lending against stocks beyond certain specified limits under the provisions of RBI and Banking
Regulation Act.
• Merchant banking activities can be carried out only after obtaining a merchant-banking license
from SEBI.
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• Merchant bankers other than banks and financial institutions are not authorised to carry out
any business other than merchant banking.
• The Equity research activity has to be carried out independent of the merchant banking
activity to avoid conflict of interest.
• Stock broking business has to be separated into a different company

Question 7.6

Q 7.6 Explain in brief the regulatory framework for Investment banking:

A 7.6 An overview of the regulatory framework is furnished below:

• All investment banks incorporated under the Companies Act, 1956 are governed by the
provisions of that Act.
• Those investment banks that are incorporated under a separate statute are regulated by their
respective statute. Ex: SBI, IDBI.
• Universal banks that function as investment banks are regulated by RBI under the RBI Act,
1934.
• All Non-banking Finance Companies that function as investment banks are regulated by RBI
under RBI Act, 1934.
• SEBI governs the functional aspects of Investment banking under the Securities and
Exchange Board of India Act, 1992.
• Those investment banks that carry foreign direct investment either through joint ventures or as
fully owned subsidiaries are governed by Foreign Exchange Management Act, 1999 with
respect to foreign investment.

Q 7.7 Who are the major Players in the Indian Industry?

A 7.7 Several big investment banks have set many group entities in which the core and non-core
business segments are distributed. SBI, IDBI, ICICI, IL&FS, Kotak Mahindra, Citibank and others offer
almost all of the investment banking activities permitted in the country. The long-term financial
institutions like ICICI and IDBI have converted themselves into full service commercial banks (called
as Universal banks). The Indian investment banks have not gone global so far though some banks do
have a presence in the overseas. The middle level constitutes of some niche players and a few
subsidiaries of the public sector banks. Certain banks like Canara bank and Punjab National bank
have had successful merchant banking activities while some other subsidiaries have either closed
their operations or sold off their business due to a couple of securities scam in the industry.

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There are also merchant banks structures as NBFCs such as Alpic Finance, Rabo India Finance ltd
and so on. Some of the pure advisory firms that operate in the Indian market are Lazard Capital, Ernst
& Young, KPMG, and Price Water Coopers etc.

Q 7.8 What are the Core Services of Indian Investment banks?

A 7.8 They are

• Merchant Banking, Underwriting and Book Running

• Mergers and Acquisition Advisory
• Corporate Advisory

Q 7.9 What are the Support services and Businesses of Indian Investment banks?

A 7.9 They are

• Secondary Market Activities

• Asset Management Services
• Wealth Management Services (Private Banking)
• Institutional Investing

Q 7.10 How does the Future of Investment banking in India look like?

A 7.10 The scope for investment banking in India is very big, as much of it has not been exploited so
far. This proves to be a significant point for a bright future for the Indian investment banks. A lot of
pure merchant banks and advisory firms have an opportunity to convert themselves in to full service
investment banks. With this, their markets are bound to broaden and their service deliveries poised to
be more efficient. The technological and market developments influencing the capital market will also
provide an additional impetus to the growth of the investment banks.

Summary

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• The erstwhile Grindlays Bank began its merchant banking operations in 1967 after obtaining
the required license from RBI
• The advent of SEBI in 1988 was a major boost to the merchant banking activities in India and
the activities were further propelled by the subsequent introduction of free pricing of primary
market equity issues in 1992
• Till the 1980s, the Indian financial services industry was characterised by debt services in the
form of term lending by financial institutions and working capital financing by banks and non-
banking financial companies
• The Indian investment banking industry has a heterogeneous structure
• The commercial banks are prohibited from getting exposed to stock market investments and
lending against stocks beyond certain specified limits under the provisions of RBI and Banking
Regulation Act
• The Indian investment banks have not gone global so far though some banks do have a
presence in the overseas

Question 5.1

Q 5.1 Which are the Acts that govern the Indian Statutory Framework for Capital markets?

A 5.1 The Indian capital market is regulated under the following broad statutory framework:

• The companies Act, 1956

• The Securities Contracts (Regulation) Act, 1956 (SCRA)
• The Securities and Exchange Board of India Act, 1992 (SEBI Act)
• The Depositories Act, 1996
• Foreign Exchange Management Act, 1999 (certain provisions) (FEMA)
• The Income tax Act, 1961 (capital market securities) (IT Act)

The securities business is also affected by the provisions of the stamp law (both Central & State level
laws) and relevant provisions of the Benami Transactions (Prohibition) Act 1988.

Q 5.2 Name the Regulatory Authorities of the Capital Markets in India and how do they control
the capital market?

A 5.2 The following are the regulatory authorities for the capital market in India:
1. The Department of Company Affairs (DCA)
2. The Department of Economic Affairs (DEA)
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3. The Securities and Exchange board of India (SEBI)
4. The Central Listing Authority (CLA)
5. The Reserve Bank of India (RBI)
6. The Stock Exchanges
The Department of Company Affairs (DCA):
The Department of Company Affairs (DCA) is the main regulator for compliance under the Companies
Act for prescribing rules and regulations for all capital market transactions to be made by companies.
Some of the focus areas are with respect to incorporation of companies, annual reporting, registration
of charges, allotment and refunds, holding of shareholder meetings etc.

The Department of Economic Affairs (DEA):

There are two divisions under the DEA. They are Capital market division and the Stock exchange
division. The SEBI Act, the SCRA and the Depositories Act were all administered by DEA. The DEA is
responsible for the formulation of suitable policies for the development of the capital market in
consultation with SEBI, RBI and other agencies. It also deals with all the organizational matters
related to SEBI, including the appointment of the chairman and members of the SEBI board.

The SEBI:

The SEBI is the primary regulator of the working of the capital market in terms of the following:

• New issues
• Listing agreements with stock exchanges
• Trading mechanisms
• Investor protection
• Corporate disclosure by listed companies etc.,

and has regional offices in metros. The functions and powers of SEBI are prescribed under sections
11 and 11A of the SEBI Act. The following are some of the areas that are regulated by SEBI:

1. The business in stock exchanges and any other securities market

2. Registering and monitoring of the intermediaries like stock brokers etc., who may be associated
with the securities markets in any manner

3. Registering and regulating the work of depositories, participants, custodians of securities, foreign
institutional investors, credit rating agencies etc.

4. Prohibiting fraudulent and unfair trade practices relating to securities markets

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5. Promoting investor’ education and training of intermediaries

6. Prohibiting insider trading in securities

7. Regulating substantial acquisition of shares and take-over of companies

Wide powers have been conferred on SEBI and it is the most important agency regulating the capital
market in India. Its powers encompass the primary and secondary markets, the equity, debt and
derivative segments and corporate disclosures and trading mechanisms of stock exchanges.

The CLA:

It is a body constituted by SEBI for vetting of offers documents for public offerings in the primary
market and for other related activities. The following are the functions of the CLA:

• Receiving and processing of applications for letter precedent to listing from applicants
• Making recommendations to SEBI on issues pertaining to the protection of investors in
securities
• Undertaking of any other activity delegated by SEBI.

The RBI:
The Reserve Bank of India exerts an indirect influence on the Capital markets since it is more of a
money market regulator. Some of the areas in which it exercises control are:

• Regulating the exposure of banks, FIs and other financial intermediaries in capital market
instruments mostly related to equity & debt.
• Fixing the norms for regulating the flow of funds from the banking system to the securities
market

• Regulating the capital flows in the money market to regulate the liquidity in the financial
system. RBI sucks out the excess liquidity in the system by the mechanism of repurchase
options or Repos.
• Carrying out the borrowing programmes of the Indian Government in the long-term debt
market and the money market.
• Determination of bank rate, the benchmark for other interest rates in the economy including
the rates at which capital market and money market instruments are traded.
• Regulating the flow of foreign funds in to the securities market.
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The Stock Exchange:
The Stock market is a market body that wields some influence on the companies that are listed on it
by virtue of the “Listing agreement” between itself and the company.

Stock markets can exert only contractual influence and not any legal influence on the companies. The
following are the areas that are monitored by the Stock markets:

• Promotes discipline and adherence to corporate governance by listed companies

• Protects the interests of the investors
• Initiates action against defaulters as provided in the listing agreement
• In extreme cases enforces compulsory de-listing of companies
• Developing a fair and transparent trading mechanism
• Enforcing payments from market participants without any defaulters and bankruptcies

Q 5.3 What does Clearing Corporation do ?

A 5.3 Clearing Corporation is an agency, which keeps track of buy and sell trades done by the
members. For example: National Securities Clearing Corporation Limited (NSCCL), Clearing
Corporation of India Ltd. (CCIL), etc.
The clearing corporation calculates obligations for the member, for a given trading period. It can
impose and collect margins on behalf of the exchange on outstanding positions of the members. The
agency ensures settlement of the trades done on the stock exchange. Clearing Corporation acts as a
clearing and settlement body for one or more stock exchanges like NSCCL in USA.
Did you know? Clearing is the process of matching, guaranteeing and registering transactions and
Automated clearinghouse - ACH is an electronic clearing and settlement system for exchanging
electronic transactions among participating depository institutions; such electronic transactions are
substitutes for paper checks and are typically used to make recurring payments such as payroll or
loan payments. The Federal Reserve Banks operate an automated clearinghouse, as do some
private-sector firms

Q 5.4 Who are the Capital Market Intermediaries?

A 5.4 The following are the capital market intermediaries:

1. Stock brokers and Sub-brokers

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2. Depositories and Participants

3. Custodians

4. Share Transfer Agents

5. Debenture Trustees

6. Credit Rating Agencies

7. Portfolio Managers

Question 5.5

Q 5.5 Who is a Stock Broker?

A 5.5 Brokers are members of the stock exchange and trade on the stock exchange on behalf of the
investors. Actual investors cannot directly trade on the stock exchange. Thus, the brokers establish a
primary link between the securities market and the investors. The broker carries out trading activity for
a brokerage fee. Even Corporate members can be brokers provided they meet the requirements of
Securities Contracts (Regulation) Rules and SEBI. The books of stockbrokers are subject to audit by
the stock exchange and inspection by SEBI.

Q 5.6 Who are Sub-brokers?

A 5.6 Sub-brokers aid the brokers for the purpose of marketing securities or soliciting broking
business. They function under the brokers and are not members of any stock exchange. The sub-
brokers have to compulsorily register with SEBI. All brokers have to maintain records of sub-brokers
working under them.

Q 5.7 What is De-materialization?

A 5.7 The method of converting physical securities into electronic form is known as dematerialization.
For several decades the Indian market was trading in through the physical form. The physical form of
securities led to lot of delays in trading and settlement and also there were lot of risks associated with
it like loss in transit, damage to the security etc. So the conversion of physical form of securities into

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electronic form and dealing with them through electronic transfers has eliminated several risks and
delays.

Q 5.8 What is Re-materialization?

A 5.8 The conversion of the electronic form of shares back in to its physical form is known as re-
materialization.

Q 5.9 Who is a Depository?

A 5.9 A Depository is a central agency that maintains electronic records of securities, without which
de-materialization is not possible. In the depository system, the holding and trading of the securities is
in scrip-less form (without physical certifications). Also unlike in the physical system, the securities in
the depository system become fungible, i.e. the securities do not have individual existence through
distinctive numbers. In the physical system, shares are grouped under share certificates with
distinctive numbers for individual identification. Depositories Act, 1996, governs depository system in
India. The two depository institutions functioning currently in India are:
1. National Securities Depository Limited (NSDL)
2. Central Depository Services Limited (CDSL)
Depository Participant (DP) acts on behalf of the Depository as an agent and becomes the interface
between the investor and the Depository. Each DP is provided with a unique identification number by
the depository and each investor who opens a demat account with a particular DP is also provided a
unique investor number.

Q 5.10 What is the Difference between Bank and Depository?

A 5.10 Bank holds funds in the account and transfer funds between accounts without handling cash.
Bank safeguards the money. Depository on other hand holds securities in accounts and transfers
securities between accounts without handling physical securities. Depository safeguards securities.

Q 5.11 What is the role of a Custodian?

A 5.11 A Custodian is a person or entity that deals with safekeeping of securities of a client and
providing the following services:

• Maintaining accounts of securities of a client

• Collecting the benefits or rights accruing to the client in respect of securities
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• Keeping the client informed of the actions taken or to be taken by the issuer of securities,
having a bearing on the benefits or rights accruing to the client
• Maintaining and reconciling records of the services referred to above.

Q 5.12 Who is a Share Transfer Agent?

A 5.12 The shares of a listed company are traded on a daily basis on the stock exchange, which
entails frequent updating of records of shareholders and the register of members. Share Transfer
Agents (STAs) are service providers who handle the process of maintaining ledger records of all the
shareholders of a company and the day-to-day transactions of the shares of the company. SEBI
regulates the STAs and make it necessary for them to register with it and impose minimum capital
adequacy requirements etc.

Q 5.13 What does a Debenture Trustee do?

A 5.13 The Debenture Trustees are appointed to address the interests of the debenture holders and
safeguard their rights. The assets that are required to be secured for the debentures are secured in
favour of the trust. The debenture holders are made the beneficiaries of the trust, which is
administered by the Debenture Trustee. The structure is framed through a debenture trust deed or a
trusteeship agreement, which provides for terms and conditions that govern the following:

• Issue of the debentures

• Creation of security
• Enforcement thereof in case of default
• Other provisions intended to protect the interests of debenture holders.

Q 5.14 What role do Credit Rating Agencies have in the Capital Market?

A 5.14 Credit Rating is an assessment done on the issuer to find out the expected capacity and
inclination of the issuer to service his obligations based on qualitative and quantitative factors. This is
being carried out by independent third party agencies on security issues by an issuer and conveyed to
the investors. The Credit rating is an assessment of the issue-specific default risk associated with an
instrument to be subscribed by investors. The US based Standard & Poor and Moody’s are the largest
credit rating agencies. Credit rating is a recent development in India and was formally flagged off with
the setting up of the Credit Rating Information Services of India Ltd (CRISIL) in 1988. The other two

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agencies are Credit Rating Agency of India Ltd (ICRA Ltd.) and Credit Analysis and Research Ltd
(CARE Ltd.). Credit Rating is regulated by SEBI under the SEBI (Credit Rating Agencies) Regulations
1999.

Q 5.15 What services do Portfolio Managers provide?

A 5.15 A Portfolio is defined as the total holdings of assets (generally securities), which includes
shares, bonds, debentures or any other marketable securities. A Portfolio Manager is one who
advises, directs, undertakes on behalf of a client, the management or administration of a portfolio of
securities on a contract or arrangement basis. A portfolio manager provides the following services:

• Conducts in-depth research into the performances of companies with an investment angle
• Manages the investment of the clients’ funds in high income generating shares
• Monitors the portfolio and tracks corporate and market developments
• Manages to deal with lodging of physical securities if any
• Provides tax management services on investments.

Portfolio managers are regulated by SEBI under the SEBI (Portfolio Manager) Rules 1993 and the
SEBI (Portfolio Managers) Regulations 1993. Also it is mandatory for all portfolio managers to register
themselves with SEBI.

Summary

• The Indian capital market is regulated by six acts under a broad statutory framework
• The Department of Company Affairs (DCA) is the main regulator for compliance under the
Companies Act for prescribing rules and regulations for all capital market transactions to be
made by companies
• There are two divisions under the DEA. They are Capital market division and the Stock
exchange division.
• The SEBI is the primary regulator of the working of the capital market
• The CLA is a body constituted by SEBI for vetting of offers documents for public offerings in
the primary market and for other related activities
• Brokers are members of the stock exchange and trade on the stock exchange on behalf of the
investors
• A Depository is a central agency that maintains electronic records of securities, without which
de-materialization is not possible

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• Credit Rating is an assessment done on the issuer to find out the expected capacity and
inclination of the issuer to service his obligations based on qualitative and quantitative factors.

EU Moves Towards Integrating Capital Markets

18 Oct 2005

The high cost of cross-border trading in securities is driving debate on reform of Europe's capital
markets and the creation of a pan-European capital market in order to cut costs. Although the
benefits of an integrated market are agreed, there is less consensus and lack of momentum on the
method of integration.

Last month, Charlie McCreevy, the EU's internal market commissioner, warned Europe's financial
services industry that it was not moving fast enough in cutting the costs of cross-border trading in
securities. According to McCreevy, cross-border clearing and settlement costs can be up to six times
more than those of domestic settlements. He argues that the introduction of consolidated structures
in the EU, such as a single pan-European central counterparty, and therefore the creation of a pan-
European capital market, could help cut the high costs of cross-border trading.

The significance of this subject is exemplified by focus on the securities markets at SIBOS this year
(5-9 September), an annual international banking conference and exhibition. The expense of cross-
border security settlement was described by Andrew Crockett, president of JPMorgan Chase, as a
"major issue for the capital markets" at a conference session on the Giovannini Group's report, which
identified 15 barriers to efficient European clearing and settlement. The session focused on issues
and challenges surrounding ongoing reform and harmonisation of Europe's capital markets. Crockett
described how the securities industry still has a variety of issues to resolve including the relationship
between European and global initiatives, and how to ensure consistency between them; whether to
favour a consolidated competitive market structure; and how individual firms can be rewarded for
making the investments necessary to achieve change.

The EU Commission originally launched a consultation on objectives and actions to deliver efficient
cross-border clearing and settlement in May 2002 and a second communication in April 2004 taking
into account recommendations from the Giovannini Group's report. Although some respondents
support the Commission's proposals to consider a directive on securities clearing and settlement,

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including many EU regulators, banks and exchanges, opinion is divided. In his article, Clearing and
Settlement: Is Regulation Needed?, Ian Dalton explains how Euroclear, for instance, remains
unconvinced that a directive focused on the activities of settlement systems will reduce cross-border
settlement costs. He agrees with the European Parliament's report that a rigorous regulatory impact
assessment is needed before any legislation is proposed.

Aside from the question of whether to legislate, there is also lack of consensus on what to harmonise
across Europe's capital markets. As mentioned, Internal Market Commissioner McCreevy claims the
creation of consolidated structures in the EU will help cut the costs of cross-border trading in
securities. In contrast, at a recent roundtable on cross-border clearing and settlement hosted by
Rhyme Systems, Charles Pugh, senior relationship manager at Euroclear, said the focus should be
on "harmonisation of laws rather than infrastructure".

Euroclear believes the way forward for more efficient European clearing and settlement is through
the harmonisation of market practices, and where necessary, laws, regulations and fiscal processes.
The settlement group is currently working on two programmes: harmonisation of market practices
across the Euroclear group markets; and consolidation of technology platforms and the interface
used by clients to interact with Euroclear.

One of the main obstacles in creating a pan-European capital market is the national dynamics of the
clearing and settlement systems across Europe. Mark Wellham, product manager at Rhyme
Systems, explains: "If you look at custody and settlement, post-trade operations in France, for
example, will comprise a different set of market practices than elsewhere and, for instance, the UK
has stamp duty while other countries will have no such practice, or different versions of the same
thing."

At the SIBOS conference session, Alberto Giovannini, CEO of Unifortune and chairman of the
Giovannini Group, pointed out that though there was universal agreement on the challenges of
creating an integrated capital market, momentum was a critical issue because participants were
currently taking "a limited role". This is mainly due to the different interests of market participants and
European member states.

Bob Wigley, managing director and chairman EMEA at Merrill Lynch, a panelist at the conference
session, said, "Progress towards the objective of pan-European infrastructure on clearing and
settlement, and to achieving the substantial benefits it would bring has, in common with so many
other well intentioned European initiatives, sadly been derailed by the pursuit of vested and
perceived national interests." He highlighted obstacles such as existing clearing and settlement
structures that are not owned by organisations whose objectives are to achieve, over time, the lowest
overall cost of trading and post-trading services combined with the greatest responsiveness to users'
and consumers' needs. "There are examples of domestic legislation and local infrastructure rules

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that are designed more with the protection of perceived national or local business interests in mind
rather than the needs or interests of consumers," he added.

Be it through harmonisation of laws and/or consolidation of platforms, there is consensus that an

integrated European capital market will help reduce the costs of cross-border trading and also
improve efficiencies within the European clearing and settlement infrastructure. Indeed, Trevor
Pitman, group managing director at Fitch Ratings, comments: "Anyone in favour of free trade,
liberalised markets and initiatives to cut the costs of trading would be in favour of an integrated
capital market." He believes that an integrated European capital market would be beneficial to
corporate borrowers and, in turn, beneficial to the industry's rating agencies.

Rhyme System's Wellham agrees: "For players that deal largely in cross-border trades and in high
volumes, cross-border charges will be reduced significantly through an integrated capital market. In
cross-border trade, companies may have different systems for different markets but potentially [with
an integrated European capital market] those companies could ultimately need only one where all
their European trades are processed."

Both Euroclear and Merril Lynch advocate industry participation in moving forward development of
efficient pan-European clearing and settlement. Wigley argues that education and information
dissemination is critical to "dispelling myths, counteracting protectionist strategies and creating
greater awareness among the investment community that harmonisation will generate substantial
benefits". In his article, Euroclear's Dalton stresses the fact that the clearing settlement industry has
a "moral obligation to contribute to the Commission's education".

The European Commission is now deciding whether legislation, or other intervention, is necessary
on European clearing and settlement. The next six months will be interesting and crucial for the
securities industry as debate and consultation continues.

Business Ethics and Compliance

in the Sarbanes-Oxley Era
A Survey by Deloitte and Corporate Board Member Magazine
Chapter 5
INVESTMENT BANKING AND SECURITIES ISSUANCE
JAY R. RITTER°
University of Florida, Gainesville
Contents
Abstract 254
Keywords 254
1. Introduction 255

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1.1. Overview 255
1.2. A brief history of investment banking and securities regulation 257
1.3. The information conveyed by investment and financing activities 259
2. Seasoned equity offerings (SEOs) 261
2.1. Announcement effects 261
2.2. Evidence on long-run performance 263
2.3. Reasons for underperformance 269
3. Short-run and long-run reactions to corporate financing activities 272
4. Initial public offerings (IPOs) 277
4.1. Overview 277
4.2. Short-run underpricing of IPOs 279
4.3. Alternative mechanisms for pricing and allocating securities 279
4.4. Explanations of underpricing 284
4.4.1. Dynamic information acquisition 284
4.4.2. Prospect theory 284
4.4.3. Corruption 286
4.4.4. The winner’s curse 286
4.4.5. Informational cascades 287
4.4.6. Lawsuit avoidance 288
4.4.7. Signalling 288
4.4.8. The IPO as a marketing event 288
4.4.9. Summary of explanations of new issues underpricing 289
° This draft has benefited from comments from seminar participants at Emory University, the University
of California at Davis, Korea University, Chung-Ang University (Korea), the Hong Kong University of
Science and Technology, and City University of Hong Kong, and from Alon Brav, Hsuan-Chi Chen,
Raghu Rau, Ren´e Stulz, Anand Vijh, Kent Womack, and Li-Anne Woo. The comments of Tim Loughran
are particularly appreciated, as is research assistance from Donghang Zhang.
Handbook of the Economics of Finance, Edited by G.M. Constantinides, M. Harris and R. Stulz
© 2003 Elsevier Science B.V. All rights reserved

Q 6.1 What are Investment banks?

A 6.1 Investment banks are essentially financial intermediaries, who primarily help businesses and
governments with raising capital, corporate mergers and acquisitions, and securities trade. In USA
such banks are the most important participants in the direct market by bringing financial claims for
sale. They help interested parties in raising capital, whether debt or equity in the primary market to
finance capital expenditure.

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Once the securities are sold, investment bankers make secondary markets for the securities as
brokers and dealers. In 1990, there were 2500 investment banking firms in USA doing underwriting
business. About 100 firms are so large that they dominate the industry. In recent years some
investment banking firms have diversified or merged with other financial institutions to become full
service financial firms.

Question 6.2

Q 6.2 What is the difference between Investment Banks & Commercial Banks?
A 6.2 Investment banks have often been thought to be as Commercial banks, and rightly so. However,
both the terms have different connotations in United States. Early investment banks in USA differed
from commercial banks, which accepted deposits and made commercial loans. Commercial banks
were chartered exclusively to issue notes and make short-term business loans. On the other hand,
early investment banks were partnerships and were not subject to regulations that apply to
corporations. Investment banks were referred to as private banks and engaged in any business they
liked and could locate their offices anywhere. While investment banks could not issue notes, they
could accept deposits as well as underwrite and trade in securities.
As put forth earlier, the distinction between commercial banks and investment banks is unique and is
confined to the United States, where it is by legislation that they are separated. In countries where
there is no legislated separation, banks provide investment-banking services as part of their normal
range of banking activities. Coming back to countries where investment banking and commercial
banking are combined. Such countries have what is known as universal banking system. Say for
example, European Countries have universal banking system, which accepts deposits, make loans,
underwrites securities, engage in brokerage activities and offer financial services.

Q 6.3 How is the scenario for Investment Banking in India?

A 6.3 In India commercial banks are restricted from buying and selling securities beyond five percent
of their net incremental deposits of the previous year. They can subscribe to securities in the primary
market and trade in shares and debentures in the secondary market. Further, acceptance of deposits
is limited to commercial banks. Non-bank financial intermediaries accept deposits for fixed term are
restricted to financing leasing/hire purchase, investment and loan activities and housing finance. They
cannot act as issue managers or merchant banks. Only merchant bankers registered with the
Securities and Exchange Board of India (SEBI) can undertake issue management and underwriting,
arrange mergers and offer portfolio services. Merchant banking in India is non-fund based except
underwriting. The following figure (figure 1), serves as an effective tool of rightly distinguishing
between the above two banks.

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Question 6.4

Q 6.4 What is Universal Banking?

A 6.4 It refers to the combination of commercial banking and investment banking including securities
business. It envisages multiple business activities and can take number of forms ranging from the true
universal bank represented by the German Model with few restrictions to the UK model providing a
broad range of financial activities through separate affiliates of the bank and the US model with a
holding company structure through separately capitalized subsidiaries.

Q 6.5 What are the Principal Functions Of Investment Banks?

A 6.5 Global investment banks typically have several business units, each looking after one of the
functions of investment banks. For example, Corporate Finance, concerned with advising on the
finances of corporations, including mergers, acquisitions and divestitures; Research, concerned with
investigating, valuing, and making recommendations to clients - both individual investors and larger
entities such as hedge funds and mutual funds regarding shares and corporate and
government bonds); and Sales and Trading, concerned with buying and selling shares both on behalf
of the bank's clients and also for the bank itself. For Investment banks management of the bank's own
capital, or Proprietary Trading, is often one of the biggest sources of profit. For example, the banks
may arbitrage stock on a large scale if they see a suitable profit opportunity or they may structure their
books so that they profit from a fall in bond price or yields. In short the functions of Investment banks
include:

1. Raising Capital
2. Brokerage Services
3. Proprietary trading
4. Research Activities
5. Sales and Trading

Q 6.6 Explain the “Raising Capital” function:

A 6.6 Corporate Finance is a traditional aspect of Investment banks, which involves helping
customers raise funds in the Capital Market and advising on mergers and acquisitions. Generally the
highest profit margins come from advising on mergers and acquisitions. Investment Bankers have had

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a palpable effect on the history of American business, as they often proactively meet with executives
to encourage deals or expansion.

Q 6.7Explain the “Brokerage Services” Function:

A 6.7 Brokerage Services, typically involves trading and order executions on behalf of the investors.
This in turn also provides liquidity to the market. These brokerages assist in the purchase and sale of
stocks, bonds, and mutual funds.

Q 6.8Explain the “Proprietary Trading” Function:

A 6.8 Under Investment banking proprietary trading is what is generally used to describe a situation
when a bank trades in stocks, bonds, options, commodities, or other items with its own money as
opposed to its customer’s money, with a view to make a profit for itself. Though Investment Banks are
usually defined as businesses, which assist other business in raising money in the capital markets (by
selling stocks or bonds), they are not shy of making profit for itself by engaging in trading activities.

Question 6.9

Q 6.9Explain the “Research Activities” Function:

A 6.9 Research, is usually referred to as a division which reviews companies and writes reports about
their prospects, often with "buy" or "sell" ratings. Although in theory this activity would make the most
sense at a stock brokerage where the advice could be given to the brokerage's customers, research
has historically been performed by Investment Banks (JM Morgan Stanley, Goldman Sachs etc). The
primary reason for this is because the Investment Bank must take responsibility for the quality of the
company that they are underwriting Vis a Vis the prices involved to the investor.

Question 6.10

Q 6.10 Explain the “Sales and Trading” Function:

A 6.10 Often referred to as the most profitable area of an investment bank, it is usually responsible for
a much larger amount of revenue than the other divisions. In the process of market making,
investment banks will buy and sell stocks and bonds with the goal of making an incremental amount of
money on each trade. Sales is the term for the investment banks sales force, whose primary job is to
call on institutional investors to buy the stocks and bonds, underwritten by the firm. Another activity of

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the sales force is to call institutional investors to sell stocks, bonds, commodities, or other things the
firm might have on its books.

Q 6.11 What does the Business Portfolio of Investment Banks constitute?

A 6.11CORE BUSINESS PORTFOLIO

1.NON-FUND BASED

Merchant Banking Services for

• Management of Public offers of equity and debt instruments

• Open offers under the Takeover Code
• Buy back offers
• De-listing offers

Advisory and Transaction service in

• Project Financing
• Syndicated Loans

 Structured Finance

 Venture Capital

 Private Equity

 Preferential Issues

 Private Placements of equity and debt

 Business advisory and structuring

 Financial restructuring

 Corporate Reorganisations such as mergers and de-mergers, hive-offs, asset sales, sell-off and
exits, strategic sale of equity.

 Acquisitions and takeovers

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 Government disinvestments and privatisation

 Asset Recovery agency services (presently in take off stage)

2. FUND BASED

• Underwriting
• Market Making
• Bought Out deals
• Investments in primary market

12 What does the support activity portfolio of Investment banks constitute?

A 6.12 SUPPORT ACTIVITY PORTFOLIO

1. NON-FUND BASED

Secondary Market services

• Stock Broking
• Derivative products
• Portfolio management

Support services

• Sales and distribution

• Equity Research & Investment advisory
• Corporate research and information services

• Investment banks are essentially financial intermediaries, who primarily help businesses and
governments with raising capital, corporate mergers and acquisitions, and securities trade.
• Early investment banks in USA differed from commercial banks, which accepted deposits and
made commercial loans.
• Distinction between commercial banks and investment banks is unique and is confined to the
United States, where it is by legislation that they are separated.
• Countries where investment banking and commercial banking are combined have universal
banking system.
• Universal Banking refers to the combination of commercial banking and investment banking
including securities business

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• Sales and Trading is often referred to as the most profitable area of an investment bank, it is
usually responsible for a much larger amount of revenue than the other divisions

Question 9.1

Q 9.1How did the securities market evolve?

A 9.1 In March, 1792, twenty-four of New York City's leading merchants met secretly at Corre's Hotel
to discuss ways to bring order to the securities business and to wrest it from their competitors, the
auctioneers. Two months later, on May 17, 1792, these merchants signed a document named the
Buttonwood Agreement, named after their traditional meeting place, a buttonwood tree. The
agreement called for the signers to trade securities only among themselves, to set trading fees, and
not to participate in other auctions of securities. These twenty-four men had founded what was to
become the New York Stock Exchange.

Q 9.2 What are Securities?

A 9.2 In simplest terms, a Security represents the evidence of a property right. i.e., it represents the
claim on an asset and also any future cash flows that can arise from that asset. Investing in capital
markets can be done through various financial instruments. These instruments are called securities.
Securities are the source of funding to the corporate and non-corporate bodies by the method of
borrowing or lending. According to the securities contracts regulation act (1956), securities include
Shares, Scrips, Stocks, bonds, debenture stock or any other marketable securities. There are four
broad categories of securities: bonds, common stocks, preferred stocks and derived securities.

Q 9.3 Describe the Securities Market:

A 9.3 The market where securities are dealt with is called a securities market. It is mechanism for
bringing together buyers and sellers of a particular type of security or a financial asset. Prices for
financial assets will be set by these buyers and sellers, which in turn will finally influence the
allocation of resources throughout the economy. Knowledge of securities market is essential if one
has to know how securities are priced in these markets.

Did you know? Arbitrage is the simultaneous buying and selling of a security at two different prices
in two different markets, resulting in profits without risk. Perfectly efficient markets present no
arbitrage opportunities. Perfectly efficient markets seldom exist, but arbitrage opportunities are often
precluded because of transactions costs

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Q 9.4 What are the different types of Securities?

A 9.4 Securities (or investment opportunities) are broadly categorized into the following

• Bonds

Bonds have a fixed maturity that is the date when the firm has to pay all the liabilities it owes to the
bondholder. Bondholders have a fixed claim on the income of the firm i.e. a fixed interest every year
irrespective of the firms’ earnings. This also goes on to say that that the bondholders are entitled to a
fixed interest payment each year (or semi-annual period), regardless of what the income of the firm
may be during that period. Bondholders also have the right to receive their interest payment before
any dividends are declared to the equity shareholders. Besides, bondholders have what is termed a
fixed claim on the assets of the firm. This means that when the bonds mature, or in the event of the
liquidation of the firm, the bondholders are entitled to receive a stated amount (the principal), and this
claim has priority over any of the claims of the equity owners. Finally, the claims of bondholders are
legally binding. If the company defaults on either interest or principal payments, it can be forced into
bankruptcy.

Did you know?A bond issued by a foreign institution is known as a bulldog in the UK, a Yankee in the
USA, a samurai bond in Japan, and so on.

• Common Stocks

Common stocks lie on the other end of the securities spectrum. Common stocks, or equity shares, are
said to be perpetual. That is, there is no maturity for common stocks since the equity shares exist as
long as the corporation exists. In addition to that, holders of common stock have what is termed a
residual claim against the income and assets of the firm. That is, holders of common stock have the
last claim to the firm’s income, or the assets of the firm in the event of liquidation. The other facet to
this that the equity owners can claim everything that remains after all other claims have been met.
Thus, the potential for gain is greater for holders of common stock than for bondholders whose gain is
fixed. On the other hand, as is evident, the risk is correspondingly greater for the equity owners since
they have the last claim to the firm’s income and assets. Lastly there is no legal requirement to pay
dividends. Rather, dividends are paid at the discretion of the company.

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• Preferred Stocks

With characteristics of both the common stock and bonds, these stocks are also called hybrid security
since its characteristics lies somewhere between those of common stocks and bonds. It’s similar to
the bonds, in a way that it enjoys claims on the assets of the firm in the event of liquidation, and also
to do with fixed income. On the other hand, like common stock, preferred stock is a perpetual liability
of the firm. Also, like common stock, the decision to pay preferred stock dividends is at the discretion
of the board of directors, whereas interest payments are mandatory. Finally, preferred stock dividends
are treated as common stocks dividends for tax purposes. Finally from the viewpoint of the firm,
preferred dividends, like common dividends, are not a tax-deductible expense, whereas interest
payments on bonds are a deductible expense.

• Derived Securities

Derived Securities are nothing but such financial assets as warrants, options, convertible bonds, and
futures. They are classified as derived from the value of another security. For example, the value of a
call option is derived from the value of a common stock against which the call option is written,
whereas the value of a commodity future is derived from the value of a commodity that must be
delivered in the future.

Q 9.5 What is the relationship between Risk and Return?

A 9.5 There are two fundamental aspects to any investment made by or on behalf of some investor,
namely risk and return.

• Risk

Risk is something inherent in any investment. This risk may relate to loss or delay in the repayment of
the principal capital or loss or non-payment of interest or variability of returns. While some
investments are almost risk less (like Government Securities) or bank deposits, others are more risky.

• Return

Return or yield essentially differs from the nature of financial instruments, maturity period, and the
creditor or debtor nature of the instrument and a host of other factors. What influences return more is
the risk. Usually, the higher the risk, higher is the return. Therefore return is the income plus capital
appreciation in the case of ownership instruments (like common stocks) and only yield is the case of
debt instruments like debentures or bonds.

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Q 9.6 Elucidate the Characteristics Of Securities Market:

A 9.6 The characteristics are:

• Securities markets are information sensitive

Information, be it positive or negative has a great effect on the final prices of the stocks listed. The
prices of stocks are determined by the intermingling of the demand for and supply of stocks. Thus, it
so happens that any favourable news increases the demand for the particular stock, thus raising
prices and vice versa.

• Asymmetric information abounds

With the flow of information from all sides, there is bound to be many such situations where this
information contradicts each other. In other words, a securities market is one place, which is by
default prone to rumours, speculations and asymmetric information. Some of this information does
wonders to the company, while some may significantly bring down prices of individual stocks.

Q 9.7 What are the Types of Securities Market?

A 9.7 There are two types of securities market namely,

• Primary Market
• econdary Market

Q 9.8What is a Primary Market?

A 9.8 The primary market consists of the new issues market in which new securities are sold by

• Public limited companies

• Government and semi government bodies
• Public sector undertakings.

Funds can also be raised by mutual funds and FIs. All the above are eligible to be listed on
recognised stock exchanges for trading. For the purpose of trading, the securities are to be
transferable and marketable.

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New issues and further issues are made for

• New project of a new company

• Expansion and diversification of an existing company
• Cost overruns of projects
• Working capital purposes of the issuer company.

Q 9.9Is there any time limit to public issues?

A 9.9 There are separate time limits for public offer and rights offer

1)Public offer

• Should be advertised in papers, 10 to 15 days in advance

• Opening, Closing and earliest closing dates should be specified
• A minimum of 3 and a maximum of 10 days to be kept open for subscription.

2)Rights offer

• Offer should be kept open for a minimum of 30 days and a maximum of 60 days
• Specific dates for closing of renunciations, split forms are to be specified.

Did you know?Rights issue or Rights offer is selling new shares to existing shareholders to raise
capital.

Q 9.10 What is a Secondary Market?

A 9.10 The secondary market is nothing but, what we commonly refer to as the stock exchange, which
is again a place where securities are traded. The Government, semi-Government bodies, Public
Sector undertakings and companies for borrowing funds and raising resources essentially issue these
securities. Securities as previously defined include any monetary claims and include stock, shares,
debentures, bonds etc. If these securities are marketable as in the case of Government Stock, they
are transferable by endorsement and are like movable property. They are tradable on the on the stock
exchange. So is the case with the shares of Companies.

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Under the Securities Contract Regulation Act of 1956, securities’ trading is regulated by the Central
Government and such trading can take place only in Stock Exchanges recognized by the government
under this Act. There are at present 23 stock exchanges in India. Of these the major ones are in
Mumbai, Kolkata, Delhi, Chennai, Hyderabad, Bangalore etc. The above act has laid the ground rules
as to the methods of trading in approved contracts through registered members. As per the rules
trading is permitted in the normal trading is permitted in the normal trading hours (10 a.m. to 4 p.m.).
T

Question 9.10 Conti

The contracts approved for trading are as follows:

• Spot delivery deals are for delivery of shares on the same day or the next day as the payment
is made.
• Hand delivery deals for delivering shares within a period of 7 to 14 days from the date of the
contract.
• Delivery through a clearing for delivering shares within a period of 2 months from the date of
contract, which is now reduced to 15 days.
• Special delivery deals for delivering of shares for specific longer periods as may be approved
by the Governing Board of the Stock Exchange

SUMMARY

• Security represents the evidence of a property right. i.e. it represents the claim on an asset
and also any future cash flows that can arise from that asset.
• The market where securities are dealt with is called a securities market.
• Investor has to make proper analysis before investment, which involves both risk and return
• Securities are broadly categorized into Bonds, Common Stocks, Preferred Stocks and Derived
Instruments.
• A prudent investor should strike a right balance between risk and return.
• Primary and secondary markets form the two components of securities market.
• SEBI is the supervisory and regulatory authority for the stock and capital markets.

Question 10.1

Q 10.1 What are Money Markets?

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A 10.1 Money markets are best known as places where short-term funds are lent and borrowed. In
other words money markets are markets for short-term financial assets, which are near substitutes for
money. The instruments are dealt within the money market are liquid and can be turned over quickly
at low transaction cost and without loss. It comprises individuals, institutions and the government.
These agencies create demand for money and also ensure supply of money for a short-term period.
The demand for money emanates from merchants, traders, brokers, manufacturers, speculators and
even government institutions. The suppliers include commercial banks, insurance companies, non-
banking financial concerns and the Central Bank of the country. Hence, it is not inappropriate to say
that the money market represents the country’s pool of short-term investible funds to meet the short-
term requirements of the economy.

Question 10.2

Q 10.2 Quote some definitions of money markets:

A 10.2 According to the McGraw Hill Dictionary of Modern Economics, “Money market is the term
designed to include the financial institutions which handle the purchase, sale, and transfers of the
short term credit instruments. The money market includes the entire machinery for the channelizing of
the short-term funds. Concerned primarily with small business needs for working capital, individual’s
borrowing and government short term obligations, it differs from the long-term or capital market which
devotes its attention to dealings in bonds, corporate stocks and mortgage credit”.
The Reserve Bank of India defines it as, “the centre for dealings, mainly of short term character, in
money assets; it meets the short term requirements of borrowers and provides liquidity or cash to the
lenders. It is the place where short term surplus investible funds at the disposal of financial and other
institutions and individuals are bid by borrowers’ agents comprising institutions and individuals and
also the government itself”.

Q 10.3 What are the Objectives behind the existence of money markets?

A 10.3 Well-developed money markets serve the following objectives:

• Equilibrium Mechanism

Money markets provide an equilibrium mechanism for ironing out short-term surplus and deficits.

• Focal Point

It acts as a focal point for central bank intervention for influencing liquidity in the economy.
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• Users Access

It provides access to users of short-term money to meet their requirements at a reasonable price.

Q 10.4 What are the General Characteristics of money markets?

A 10.4 The characteristics are:

• Short-term funds are borrowed and lent

• No fixed place for conduct of operations, the transactions being conducted even over the
phone and therefore there is an essential need for the presence of well-developed
communications system.
• Dealings may be conducted with or without the help of brokers
• The short-term financial assets that are dealt in are close substitutes for money, financial
assets being converted into money with ease, speed, without loss and with minimum
transaction cost.

Question 10.5

Q 10.5 What are the essential requirements for a well-developed money market?

A 10.5 The following are the other essential requirements for a well-developed money market.

• A large volume of international trade facilitating the emergence of a system of bills of

exchange.
• Rapid and massive industrial development resulting in the development of stock exchanges
in the country.
• Political stability.
• Freedom of investment on equal basis for all individuals regardless of their residence, etc.

If we go by the above-mentioned requirements, then the money markets at London and New York will
be considered highly developed markets.

Q 10.6 What are the different Segments/Sub-Markets in a Money market?

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A 10.6 A money market comprises of a variety of segments that specialize in a certain type of activity.
Following are the different type of such segments:

1. Call Money Market

2. Collateral Loan Market

3. Bill Market

4. Acceptance Market

5. Discount Market

Q 10.7 What is a Call Money Market?

A 10.7 A market for call funds is called “Call Money Market”. It deals in money market at call and short
notice. This is an important segment of the money market. This market deals with extremely short
loans. Funds are available for being borrowed and lent for extremely short periods ranging from a day,
overnight or up to a maximum of 7 days. Funds are demanded by brokers and dealers on stock
exchanges and are advanced by commercial banks without any collateral securities. Needless to say
the money invested by banks in the call money market provides high liquidity, but comes at a price of
low profitability.

Did You Know? The size of the market for these funds in India is between Rs. 60,000 million to Rs
70,000 million, of which public sector banks account for 80% of borrowings and foreign banks/private
sector banks account for the balance 20%. Non-banking financial institutions like IDBI, LIC, GIC etc
participate only as lenders in this market. 80% of the requirement of call money funds is met by the
non-bank participants and 20% from the banking system.

Q 10.8 What is a Collateral Loan Market?

A 10.8 A market for collateral loans is known as “Collateral Loan Market”. Collateral funds refer to the
money made available against the securities such as stock, bonds, etc. This is a specialized sector of
the money market. Loans are granted against the backing of securities. The collateral is returned to
the borrower after the repayment of the loan. In the event of non-repayment of the loan, the collateral
becomes the property of the lender. The collateral loans are given for a short period lasting for a few

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months. The borrowers in the collateral market are mostly brokers and dealers in stocks and shares.
Collateral loans are mostly advanced by the commercial banks to private parties in the stock market.

Question 10.9

Q 10.9 What is a Bill Market?

A 10.9 Bill Markets are specialized segments of the money market that deals with the purchase and
sale of various types of commercial bills. Commercial Bills in turn are divided into two types of bills,
which are Bills of Exchange and Treasury Bills.

• An unconditional order in writing signed by the seller, requiring the buyer to whom it is
addressed, to pay on demand or at a fixed time in the future, a definite sum of money to the
order of seller or to the bearer is known as the Bill of exchange.
• Treasury bill is a short-term government security having a maturity period ranging from a few
days to few months. The instrument, sold by the central bank on behalf of the government
does not guarantee any fixed rate of interest to the holder. They are generally sold by auction
to the highest bidder. Being government papers, the treasury bills enthuse the confidence of
greater number of investors.

Q 10.10What is anAcceptance Market?

A 10.10 A market that deals with bankers’ acceptance is known as “Acceptance Market”. A banker’s
acceptance constitutes the draft issued by a bank (drawn by a business on a bank) and
accepting/undertaking to make payment of the money specified on the draft on demand. The bank has
to make payment either to the order of a specified party or to the bearer, the sum specified on the
draft on demand. Banker’s acceptance arises out of commercial transactions both within the country
as well as abroad.

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Q 10.11What is a Discount Market?

A 10.11 The market where bankers’ acceptances are discounted is known as “Discount Market”.
Since the bankers’ acceptance bears the signature of the bank, it can be easily discounted with less
charge. This offers the advantage of temporary funds to traders. The bankers’ acceptance is different
from a cheque as the formal is payable at a specified future date while the latter is payable on
demand.

Q 10.12 What are the similarities between Money Markets & Capital Markets?

A 10.12 The similarities are

• Transfer of resources:

Transfer of resources takes place from surplus units to deficit units both in money market and capital
market.

• Commercial banks:

Commercial banks provide both short-term and long-term finance and therefore an active part in the
money market as well as capital market.

• Liquidity adjustments:

Non-banking financial institutions and special financial institutions approach money and capital
markets to a limited degree in order to adjust their liquidity positions. Besides, financial institutions
operate on both sides of the market, borrowing and lending in both money and capital markets.

As lenders and borrowers of funds have access to both capital and money market, there is a
substantial flow of funds between capital and money markets.

• Preference for investors:

Preference is available for most of the suppliers of funds to operate in both the markets, as investors
simultaneously invest in various investment avenues such as savings bank, units, fixed deposits,
national saving certificate schemes, life insurance, government and industrial securities, real estates,
bullion etc.

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• Interest rates:

There is an interdependency of short and long-term rates of interest. This is because, rise in interest
rate in money market influences long-term interest rates also.

Q 10.13Bring out the differences between capital market and money market.

A 10.13 The following table brings out the differences between the two:

S.no Subject Capital market Money market

1 Term of finance Provides long-term funds Provides short-term funds
2 Nature of capital Capital used for fixed and workingCapital usually used for working
capital needs capital needs
3 Main function Mobilization and effectiveLending and borrowing to facilitate
utilization through lending liquidity adjustments
5 Link Acts as a link between investorActs as a link between depositor
and entrepreneurs and borrower
6 Underwriting It is a primary function Not a primary function
7 Institutions Investment houses and mortgageCommercial banks and discount
banks houses
8 Development Provided to central and stateProvided to government by
assistance governments, public and localdiscounting treasury bills, etc.
bodies, etc.
9 Negotiation Funds are lent after a prolongedDealings can take place with out
negotiation between the lendingany personal contact and
financial institutions and thenegotiations are not formal.
borrowing corporate entity.
10 Market place Dealings are conducted throughDealings are conducted through
the mechanism of stockthe over-the-phone market.
exchanges
11 Claims Bonds and shares Financial claims, assets and
securities
12 Risk High credit and market risk Low credit and market risk
S.no Subject Capital market Money market
13 Price fluctuations High Not much
14 Liquidity Low High
15 Price discovery Price discovery mechanism exists No price discovery mechanism
16 Regulator Besides central bank, specialCentral bank
regulatory authority like SEBI,

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etc.
18 Dominant Non banking financial companiesCommercial banks
institutions and special financial institutions

Continue

Summary

SUMMARY

• Money markets are best known as places where short-term funds are lent and borrowed
• Money markets specialise in instruments that are liquid and can be turned over quickly at low
transaction cost and without loss.
• Well-developed money markets serve objectives like equilibrium mechanism, focal point and
Users Access.
• The various segments/sub-markets of money markets are call money market, collateral loan
market, bill market, acceptance market and discount market.
• Treasury bill is a short-term government security having a maturity period ranging from a few
days to few months
• The money market represents the country’s pool of short-term investible funds to meet the
short-term requirements of the economy.

Did you know – Financial Markets

Arbitrage

Arbitrage is the activity of exploiting imbalances between two or more markets. Foreign money exchangers
operate their entire businesses on this principle. They find tourists who need the convenience of a quick
cash exchange. Tourists exchange cash for less than the market rate and then the money exchanger
converts those foreign funds into the local currency at a higher rate. The difference between the two rates
is the spread or profit.

There are plenty of other instances where one can engage in the practice arbitrage. In some cases, one
market does not know about or have access to the other market. Alternatively, arbitrageurs can take
advantage of varying liquidities between markets.

The term 'arbitrage' is usually reserved for money and other investments as opposed to imbalances in the
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price of goods. The presence of arbitrageurs typically causes the prices in different markets to converge:
the prices in the more expensive market will tend to decline and the opposite will ensue for the cheaper
market. The efficiency of the market refers to the speed at which the disparate prices converge.

Engaging in arbitrage can be lucrative, but it does not come without risk. Perhaps the biggest risk is the
potential for rapid fluctuations in market prices. For example, the spread between two markets can fluctuate
during the time required for the transactions themselves. In cases where prices fluctuate rapidly, would-be
arbitrageurs can actually lose money.

Insider Trading

'Insider trading' can refer to two separate financial transactions--one being perfectly legal and the other
being subject to massive civil fines and possible prison time. The legal form of insider trading involves the
sale of securities or stocks by officers of a company or stockholders who own more than 10% of the
company.

Any stockholder is free to buy or sell their shares based on public information about the company's current
or future financial outlook. A company president can sell off his shares if news of an impending bankruptcy
filing is announced in the Wall Street Journal, for example. The company president is considered an
insider, obviously, but his decision to sell his stock was based on information any other stockholder could
have discovered.

The illegal form of insider trading involves information NOT readily available to the rest of the stockholders.
Whenever an individual becomes a major stockholder or a senior officer in a company, he or she must
agree to keep certain events absolutely secret, even if these events could spell financial disaster for
stockholders. The Security and Exchange Commission (SEC) watches for signs of insider trading whenever
companies experience huge losses or gains.

If, for example, a vice-president of a drug company learned that the Food and Drug Administration would
not be approving his company's newest drug treatment for diabetes, he could not legally sell off his own
shares or advise his friends and family to sell off their holdings. The decision to sell off stocks in a company
that is about to receive devastating news would be based on privileged information. The vice-president of
that company and anyone he told about the FDA decision could be charged with insider trading.

Insider trading is not a new white-collar crime; the use of privileged information for financial gain has been
around since the inception of stock trading. Most stockholders are free to make buying or selling decisions
based on anything from a strong hunch to the latest pop culture trends. However, executives and major
stockholders have an obligation to avoid the use of insider trading even if it means personal financial
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losses. Without stiff penalties for insider trading, corporate executives everywhere could unfairly profit from
their personal knowledge. Regular stockholders without access to this information would not be able to sell
off their stock in a failing company or reap the benefits of a company poised for success.

LIBOR

LIBOR, the London Interbank Offered Rate, is the most active interest rate market in the world. It is
determined by rates that banks participating in the London money market offer each other for short-term
deposits. LIBOR is used in determining the price of many other financial derivatives, including interest rate
futures, swaps and Eurodollars. Due to London's importance as a global financial center, LIBOR applies not
only to the Pound Sterling, but also to major currencies such as the US Dollar, Swiss Franc, Japanese Yen
and Canadian Dollar.

LIBOR is determined every morning at 11:00am London time. A department of the British Bankers
Association averages the inter-bank interest rates being offered by its membership. LIBOR is calculated for
periods as short as overnight and as long as one year. While the rates banks offer each other vary
continuously throughout the day, LIBOR is fixed for the 24 hour period. Generally, the difference between
the instantaneous rate and LIBOR is very small, especially for short durations.

The most important financial derivatives related to LIBOR are Eurodollar futures. Traded at the Chicago
Mercantile Exchange (CME), Eurodollars are US dollars deposited at banks outside the United States,
primarily in Europe. By holding the deposits outside the country, US depositors are not subject to Federal
Reserve margin requirements, allowing higher leverage of the funds. The interest rate paid on Eurodollars
is largely determined by LIBOR, and Eurodollar futures provide a way of betting on or hedging against
future interest rate changes.

Interest rate swaps are another significant financial derivative dependent on LIBOR. In an interest rate
swap, two parties exchange sets of interest payments on a given amount of capital. Generally, one party
will have a fixed interest payment, while the other will have a variable rate. The variable rate payment
stream is often defined in terms of LIBOR. Interest rate swaps, and by extension LIBOR, are extremely
important in providing a liquid secondary market for residential mortgages, which in turn allows lower
interest rates on US mortgages.

While LIBOR does have implications for transactions conducted in Euros, the advent of the Euro has
brought with it the creation of the Euribor. Conceptually similar to the LIBOR, the Euribor benchmark is
defined and maintained by the European Banking Federation

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Short selling

In finance, short selling is selling something that one does not (yet) own. Most investors "go long" on an
investment, hoping that price will rise. Short sellers borrow a security and sell it, hoping that it will
decrease in value so that they can buy it back at a lower price and keep the difference. For example,
assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow (say)
100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of
XYZ shares later falls to $5 per share, the short seller would then buy 100 shares back for $500, return
the shares to their original owner, and make a $500 profit. In a given year about 2% of stocks on the New
York Stock Exchange are sold short.

History

Short selling has been a target of ire since at least the 17th century when England banned it outright.
Short sellers are widely regarded with suspicion because, to many people, they are profiting from the
misfortune of others. However, less than 5% of all shorts are done by public investors and traders,
whereas at least 95% of short sales are done by broker-dealers and market makers who do not even
always have to own shares to sell them (i.e. Naked Short Selling).

The term "short" was in use from at least the mid-19th century. It is commonly understood that "short" is
used because the short seller is in a deficit position with his brokerage house.

Short sellers were blamed (probably erroneously) for the Wall Street Crash of 1929. Regulations
governing short selling were implemented in 1929 and in 1940. Political fallout from the 1929 crash led
Congress to enact a law banning short sellers from selling shares during a sharp downturn. President
Hoover condemned short sellers and even J. Edgar Hoover said he would investigate short sellers for
their role in prolonging the Depression. Legislation introduced in 1940 banned mutual funds from short
selling (this law was lifted in 1997).

When Wall Street "downgrades" a stock, one may reasonably assume that interested parties have
already established a short position in (i.e. sold short) the stock being downgraded, as invariably the
stock drops or even plummets when the "downgrade" hits the wire. Therefore, public investors are
typically too late to short by the time the "downgrade" is heard on the news.

Mechanism

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Short selling consists of the following:

· You borrow shares.

· You sell them and the proceeds are credited to your account at the brokerage firm.
· You must "close" the position by buying back the shares (called covering) - If the price drops, you
make a profit. Otherwise you make a loss.
· You finally return them to the lender.

Concept

Short selling is the opposite of "going long". The short seller takes a fundamentally negative, or "bearish"
stance, anticipating that the price of the shorted stock will fall (not rise as in long buying), and it will be
possible to buy at a lower price whatever was sold, thereby making a profit ("selling high and buying low,"
to reverse the adage). The act of buying back the shares, which were sold short, is called 'covering the
short'. Day traders and hedge funds will often use short selling to allow them to profit on trading in stocks
that they believe are overvalued, just as traditional long investors attempt to profit on stocks, which are
undervalued by buying those stocks.

The short seller owes his broker and must repay the shortage when he covers his position. Technically,
the broker usually in turn has borrowed the shares from some other investor who is holding his shares
long; the broker itself seldom actually purchases the shares to loan to the short seller.

Example: Borrowing 100 shares from someone, selling them immediately at $1.00 - when the stock
drops, you buy them back for $0.50 and give the 100 shares back to the original owner keeping the profit.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is
able to make delivery of the shorted securities. This is referred to as a "locate", and it is a legal
requirement that U.S. regulated broker-dealers not permit their customers to short securities without first
obtaining a locate. Brokers have a variety of means to borrow stocks in order to facilitate locates and
make good delivery of the shorted security. The vast majority of stocks borrowed by U.S. brokers come
from loans made by the leading custody banks and fund management companies (see list below).
Sometimes, brokers are able to borrow stocks from their customers who own "long" positions. In these
cases, if the customer has fully paid for the long position, the broker cannot borrow the security without
the express permission of the customer, and the broker must provide the customer with collateral and
pay a fee to the customer. In cases where the customer has not fully paid for the long position (meaning,
the customer borrowed money from the broker in order to finance the purchase of the security), the

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broker will not need to inform the customer that the long position is being used to effect delivery of
another client's short sale.

Also read “Ban on short-selling” by B.Venkatesh in Business Line’s Investment World on April
29,2001.

THE Securities and Exchange Board of India (SEBI) recently banned short selling.

What is short selling and why did SEBI ban such trading?

Suppose you hold a view that, say, Infosys, is overvalued at the current price and may fall sometime
soon. If you want to bet on your hunch, you can sell the stock now and buy it back at a lower price at a
later date. This process of selling the stock without holding it is called short selling.

Short selling is important for the overall functioning of the market. This is because such trading enables
investors to take a bearish or a bullish view on the market; you buy the stock if you are bullish, or short-
sell the stock if you hold a bearish view.

Short selling can, however, destabilise the market if not properly regulated. The bears, for instance, can
deliberately push a stock down by short selling. Of course, bulls can likewise push up stocks. But, given
investor psychology, pushing prices down is not as well tolerated as pushing prices up.

That is one reason why even developed markets regulate short selling. At the New York Stock Exchange,
for instance, you can short-sell only on a zero-plus tick. If, for instance, the immediately preceding trades
in Infosys are Rs 3,710, Rs 3,700 and Rs 3,700, the zero-plus tick rule means that you can short-sell only
at Rs 3,700 and not at a lower price. This ensures that bears do not push prices down sharply by short
selling.

Now, why did SEBI ban short selling? Recall that the market was falling sharply in the last few weeks.
Short selling typically precipitates the fall in such a trending market. Suppose Infosys is falling by, say, Rs
200 every day, traders will be tempted to profit from the trend by short-selling the stock, which will only
push its price further down. Since falling equity values is bad news for investors and the economy, SEBI
thought it fit to ban short selling.

Q 12.1. What do you mean by the term “Equity”?

A 12.1. Equity simply means “Ownership”. Unlike other types of financing, equity represents the
owners’ investment in the firm. Equity holders are also called the owners of residue. That means
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these securities provide claim on residue - after payment of all obligations on the income and assets
of the firm.

Did you know?Stock is a nother term for shares . What are called ordinary shares in the UK is
known as common stock in the United States. It is also another word for inventories of goods held by
a firm to meet future demand.

Q 12.2. Discuss the classification of equities.

A 12.2. Equity is a term whose meaning depends more on the context. In general, one can think
equity as ownership in any asset after all debts associated with that are paid off. In general there are
2 forms of equities:

• Preferred stock
• Common stock

Besides them, the other classifications of equities are

• Warrants
• Depository Receipts
• Exchange traded funds
• Closed end funds

Did you know? Market Capitalisation is the market value of a company’s shares : the quoted share
price multiplied by the total number of shares that the company has issued.

Q 12.3. What are the advantages of issuing stocks?

A 12.3. The advantages are

• Company can raise more capital than it can borrow

• Need not have to make periodic interest payment to the creditors
• Need not have to make principal payments

Did you know? Ankle biter is the name of a stock issued with a market capitalization of less than
$500 million.

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Q 12.4. What are the disadvantages of issuing stocks?

A 12.4. The disadvantages are

• Principal owners have to share their ownership with other shareholders

• Shareholders will have a say in the policies that effect the companies operations.
• Investors’ interest must be given primary consideration in improving short-term earnings rather
than pursuing strategies that show less immediate promise

Did you know? Big uglies is the nickname for Unpopular stocks.

Q 12.5. State some of the benefits for investors from stock ownership.

A 12.5. In addition to the ownership in the company, they may be entitled to get a share in the profits
of the company. There is also a possibility that the company will grow and simultaneously the share
price. Owning stock gives the opportunity to earn money on money. Equity stock holders may get
dividends and bonuses depending on the performance of the company.

Did you know? Bo Derek stock is the nickname for High quality stock.

Question 12.6

Q 12.6. Distinguish between Common stocks & Preferred stocks.

A 12.6. The differences are shown in the following table.
Common Stock Preferred Stock
Dividends Dividends vary depending onDividend is fixed
the company’s share
performance
Voting rights Right to vote at shareholderNo right to vote
meetings
Claims on company assets Low priority High Priority
Market risk High Low
Did you know? Cats and dogs refer to the speculative stocks with short histories of sales, earnings,
and dividend payments

Q 12.7. Discuss briefly about Common stocks.

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A 12.7. Common stock is the most important form of equity. An owner of common stock is part owner
of the enterprise and is entitled to vote on important matters like selection of directors. They benefit
most from the improvement in the firms’ business prospects. Common stock holders have a claim on
the firm’s income and assets only after all creditors and preferred stock holders receive payment.

Few firms have more than one class of common stock, in which case the stock of one class may be
entitled to greater voting rights or to larger dividends than the stock of another class. Common stock
dividends may be paid in cash, stock or property. Cash dividend is the most common payment method
seen.

Did you know? Orphan stock is a stock that is ignored by research analysts and as a result may be
trading at low price earnings ratios.

Q 12.8. State some of the types of common stock dividends.

A 12.8. Common stock pays dividends in three forms: cash, stock and property.

Cash dividends

Cash dividends are those that are paid out in the form of cash. They are treated as investment income
and are taxable in the year they are paid.

Stock dividends

Stock dividends are dividends paid out in the form of additional shares in the corporation, or shares of
a subsidiary corporation. They are generally issued in proportion of shares already owned. For
example, for every 100 shares of stock owned, a 4 percent stock dividend will yield four extra shares.

Property dividends

Property dividends are generally paid in the form of products or services that the corporation
produces. They are paid with assets owned by the issuing company.

Often the corporation, when paying property dividends, will use securities of other companies owned
by the issuer.

Did you know? Quarter stock refers to a stock with a par value of $25 per share

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Q 12.9. State some of the classification of stocks.

A 12.9. Classification of stocks can be done according to their behaviour or performance in the
market. The name of the stocks may come from the size of the company that issued it or by its
investment objectives. These include

• Growth stocks
• Income stocks
• Value socks
• Blue chip stocks
• Penny stocks

Growth stocks
Growth stocks are those that strive for large capital gains. These stocks generally have investors’
expectations of above average future growth in earnings and valuations as a result of high P/E ratios.
Investors expect these stocks to perform well in the future and will be willing to pay high multiples for
this expected growth.
Income Stocks
Income stocks are those stocks that concentrate heavily on high interest and high dividend yielding
securities. These stocks pay higher-than-average dividends over a sustained period. Income stocks
are popular with investors who want steady income for a long time and who do not need much growth
in their stock's value. In this sense, investors who choose income stocks have something in common
with bondholders.

Value stocks

Value stocks are those that feature cheap assets and strong balance sheets. A value stock is a stock
that is currently selling at a low price. The stocks of the companies that have good earnings and
growth potential but whose stock prices do not reflect the same are considered value stocks.

Blue chip stocks

Large established firms with a long and good record of profit growth, dividend payout and a reputation
for quality management, products and services are referred to as Blue Chip companies. These firms
are generally leaders in their industries and are considered likely candidates for long-term growth.

Penny stocks

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Penny stocks are low-priced, speculative stocks that are very risky. Companies with a short or
variable history of revenues and earnings issue them. They are the lowest of the low in price and
many stock exchanges choose not to trade them. Penny stocks are also called as designated
securities. Even though the odds are against it, if the company that issued them finds itself in the
growth tracks, their share price can rise rapidly. These stocks are common among small speculators.

Did you know?Bear is an investor who believes the market will fall.

Q 12.10. Discuss about Preferred stocks.

A 12.10. Preference stock holders also called preference share holders have a greater claim to
company’s assets and earnings in case of good times when the company has excess cash and
decides to distribute money in form of dividends to its investors. In this case preference shareholders
will get preference over common stock holders. Preference stock is the one, which has its
characteristics some where between a bond and a common stock. Some investors favour preferred
stock over bonds because the periodic payments are formally considered dividends rather than
interest payments and may therefore offer tax advantages. Preference stock is also called as a hybrid
security as it has features of common stock and a bond.

Did you know? Bull is an investor who thinks the market or a specific security or industry will rise

Q 12.11. State some of the classifications of preference shares.

A 12.11. In general there are eight different types of preferred stock. They are

• Cumulative
• Non-cumulative
• Redeemable
• Non Redeemable
• Convertible
• Non convertible
• Participating
• Non participating

Cumulative preferred stock

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In case of a cumulative preference share, if the amount of dividend payable remains due, in full or in
part, in any of the years, such balance amount gets carried over to the next successive years, till the
entire outstanding are cleared up to date.

Non-cumulative preferred stock

Preferred stocks on which unpaid dividends do not accrue are called as non-cumulative preferred
stocks. In case of a non-cumulative preference share, if the dividend payable remains due, in part or
in full, the balance amount would not get automatically carried over. It would instead lapse that very
year.

Redeemable preferred stock

In case of the redeemable preferred stock, the company buys them back at a specified future date as
specified in the issue documents.

Non-redeemable preferred stock

Non-redeemable preference share are supposed to be perpetual in nature. They cannot be redeemed
at any point in time till the existence of the company. These shares do not have any maturity period.
In India, most of the preference shares are redeemable in nature.

Convertible preferred stock

Convertible preferred stocks are those where the shareholders have the right at their option to convert
them in to equity shares after a certain period.

Non-convertible preferred stock

Non-convertible preferred stock cannot be converted in to equity stock at any point of time.

Participating preferred stock

As well as providing a preferential fixed dividend, participating preference shares entitle the holders to
additional payment when the dividends on ordinary shares exceed a defined percentage.

Non-participating preferred stock

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Shareholders who have been issued non-participating preference shares are not entitled to any
additional payment. They cannot participate in the surplus profits or in the residual assets at the time
of liquidation of the company.

Did you know? Stag is an investor who, predicting a new issue of shares will increase in value, buys
them up to sell them immediately as they go on the market.

Question 12.12

Q 12.12. What are Warrants?

A 12.12. Warrants will offer the holder the opportunity to purchase a firms common stock during a
specified time period in the future at a predetermined price. The predetermined price is known as the
exercise price or the strike price. The difference between the market price and the strike price is
called as the tangible value. Tangible value = market price – strike price. If the tangible value when
the warrants are exercisable is zero or less, the warrants have no value, as the stock can be acquired
more cheaply in the open market.

Question 12.13

Q 12.13. What are Depository receipts?

A 12.13. Depository receipts are the negotiable financial instruments issued by a bank to represent a
foreign company’s publicly traded securities.

• American depository receipts

When the depository bank is in U.S.A then the instruments are known as American depository
receipts. They are the negotiable financial instruments issued by the U.S bank, which represent a
specified number of shares in a foreign stock that is traded on a U.S. exchange. ADRs are
denominated in U.S. dollars.

• Global depository receipts

Global depository receipts are the financial instruments used by private markets to raise capital
denominated in either U.S dollars or Euros. GDRs are the bank certificates issued in more than one
country for shares in a foreign company. These share trade as domestic shares but are offered
globally through the various bank branches.
Session 12 : Equities:

Question 12.14
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Q 12.14. What are Exchange traded funds?

A 12.14. Exchange traded funds are some thing that trades like a stock on exchange. It has another
dimension to it. I.e. it acts as a security that tracks an index and represents a basket of stocks like an
index fund. Given its similarity to a stock, it also experiences price changes through out the day as it
is bought and sold.

Q 12.15. What are closedend funds ?

A.12.15 Closed ended funds are those that will be sold as a fixed number of shares at one time in the
initial public offering after which shares will typically trade in the secondary market. The price of the
closed end funds is determined by the market and may be greater than or less than the shares net
asset value (NAV). Closed end funds are generally not redeemable. Some closed end funds normally
referred to as interval funds can be repurchased at specified intervals

Summary

Summary

• Equity simply means “Ownership”. Unlike other types of financing, equity represents the
owners’ investment in the firm. Equity holders are also called the owners of residue.
• Types of equities include common stock, preferred stock, warrants, depository receipts
exchange traded funds and closed-end funds (the first two being the most important).
• Common stockholders are the true owners of the company and are entitled to dividend if and
when declared by the board of directors.
• A preferred stock is one that enjoys preference over common stockholders in terms of
payment of dividend and in terms of distribution of assets in case of liquidation of the firm.

Q 13.1. What are fixed income securities?

A 13.1. Fixed-income securities are nothing but an alternative investment opportunity to choose from.
However the term fixed income may confuse us to think of it as an instrument, which promises a
minimum, guaranteed payment. But it may not be necessarily so. In other words “fixed income”
suggests that though returns from these securities are certain, the realized returns may differ from the
expected returns. Therefore, the misconception that returns are certain and the vast array of fixed
income securities may finally confuse many investors. It is to be noted that all the cash flows promised

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might not be received because in many cases there is at least some risk that a promised payment will
not be made in full and on time.

Question 13.2

Q 13.2. What are the primary reasons to study Fixed Income Securities?

A 13.2. The primary reasons are:

• The addition of fixed-income securities to universe of investment alternatives provides new

diversification opportunities.
• While fixed income securities usually possess lower risks and returns than equities, periods of
increased uncertainty concerning inflation may substantially increase the risk associated with
fixed income securities.
• Of late, fixed income securities have become an integral part of most investors’ portfolios
because of the growth of money market funds, and fixed income securities may dominate the
composition of pension funds in the future.

Q 13.3. Discuss the classes of fixed income securities.

A 13.3. A vast menu of fixed income securities exists in the market today. However for the sake of
simplicity we have separated fixed income securities into two groups based on the maturity period,
where maturity period is defined as the time elapsed between the date of issue and the date when the
issuer will pay for the principal.

Types Constituents
Money marketUS Treasury bills, Commercial paper, Certificate of deposits,
Instruments Bankers acceptance, Euro dollars & Repurchase agreements.
Bonds US Treasury bonds & notes, Municipality bonds & notes,
Corporate bonds & notes

Q 13.4.What are Money market securities?

A 13.4. Certain types of short term (meaning arbitrarily, one year or less), highly marketable loans
play a major role in the investment and borrowing activities of both financial and non-financial

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corporations. Individual investors with substantial funds may invest in such money market instruments
directly, but most do so indirectly via money market accounts at financial institutions

Question 13.5

Q 13.5. What are the various constituents of money market securities?

A 13.5. The various constituents of money market securities are:

• US Treasury bills
• Commercial paper
• Certificate of deposits
• Bankers acceptance
• Euro dollars
• Repurchase agreements.

Q 13.6. Discuss each of these constituents of money market.

A 13.6. They are discussed as under:

US Treasury Bills

These are simply 91-360 day instruments with denominations of $10,000 to $1 million sold by the
federal government. Usually on every Monday, the US Treasury sells T-bills through a competitive or
non-competitive bidding process. After all the bids are received, the Treasury accepts those
competitive bids with the highest prices down to the point where the amount offered is reached. The
Treasury allocates usually 10% or less of the offering to non-competitive bids. T-bills are sold at a
discount, which means the return on a T-bill is the difference between the purchase price and the face
value. This method of computing yields is called the bank discount method and is also used to
determine the yields of bankers’ acceptance and commercial paper.

Question 13.6 Conti

Commercial Paper
Commercial paper is an unsecured short-term promissory note. The dollar amount of commercial
paper outstanding exceeds for Treasury bills, with the majority being issued by the financial
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companies such as bank holding companies as well as companies involved in sales and personal
finance, insurance and leasing. Both financial and non-financial companies usually issue instruments
of this type. Such notes are often issued by large firms that have unused lines of credit at banks,
making it highly likely that the loan will be paid off when it becomes due. The interest rates on
commercial paper reflect this small risk by being relatively low in comparison with the interest rates on
other corporate fixed income securities.
Commercial paper is usually sold in denominations of $ 100,000 or more, with the maturities of up to
270 days (this is the maximum allowed without requiring the registration of the Securities and
Exchange Commission) to large institutional investors such as money market mutual funds. Typically
these investors hold onto the paper until maturity, resulting in a very small secondary market.

Question 13.6 Conti

Certificates of Deposit
Certificates of deposit correspond to a type of interest-bearing deposit at savings or commercial banks
and loan associations. We also have large denominations (or jumbo) CDs which are issued in
amounts of $100,000 or more having a specified maturity, and are generally negotiable, meaning that
they can be sold by one investor to another. More often than not, all interest is paid along with the
principal, at the time of the maturity. The Federal Deposit Insurance Corporation (FDIC) or the
National Credit Union Administration insures such certificates.
Bankers Acceptance
An instrument called “bankers' acceptance” was invented to suit the needs of a party requiring
temporary finance to facilitate the trading of specific goods. The party needing finance would
approach investors for this temporary finance. The investors or lenders would then lend a certain
amount to the borrower in exchange for a document stating that the debt would be paid back on a
certain date in the short-term future. For this arrangement to be attractive to the lender, the amount
paid back by the borrower (called the nominal amount) would have to be more than the amount
advanced by die lender. The difference between the amount advanced and the amount paid back (the
nominal amount) is known as the discount on the nominal amount.

Example:

Face value of Bankers Acceptance $1,000,000

Minus 2% per annum commission -$20,000
Amount received $980,000

A bank would normally bring the two parties together. The redemption of the loan would have to be
guaranteed by a bank, called the acceptance by the bank making the arrangement. Thus, the name

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"bankers' acceptance”. The holder of the document may, at the redemption date approach the bank
that will pay the nominal amount to the holder. The bank will then claim the nominal amount from the
borrower.

Euro Dollars

Eurodollars are U.S. dollar-denominated deposits at banks outside of the United States. This market
evolved in Europe (specifically London), hence the name, but Eurodollars can be held anywhere
outside the United States. The Eurodollar market is relatively free of regulation, and so banks can
operate on narrower margins than their counterparts in the United States. As a result, the Eurodollar
market has expanded largely as a way of circumventing regulatory costs.

The average Eurodollar deposit is very large (in the millions) and has a maturity of less than 6
months. A variation on the Eurodollar time deposit is the Eurodollar certificate of deposit. A Eurodollar
CD is basically the same as a domestic CD, except that it's the liability of a non-U.S. bank, and they
are typically less liquid and so offer higher yields.

The Eurodollar market is obviously out of reach for all but the largest institutions. The only way for
individuals to invest in this market is indirectly through a money market fund.

Re-Purchase Agreements

A repurchase agreement (or Repos or RPs), as the term is used in the financial markets, is an
acquisition of funds through the sale of securities, with a simultaneous agreement by the seller to
repurchase them at a later date. Basically they are a secured means of borrowing and lending short-
term funds. RPs frequently is made for one business day (overnight), although longer maturities are
not uncommon.

An illustration of a “typical” RP transaction is helpful in understanding this financial instrument.

Suppose that the treasurer of a large corporation calculates the firm’s cash position for the day and
determines that the firm has funds that are not required immediately, but will likely be needed to meet
expected expenditures in a day’ or two. The treasurer, wishing to earn interest on these “excess”
funds for a day, arranges to purchase a government security from a commercial bank with an
accompanying agreement that the bank will repurchase the security on the following day’. This short-
term maturity and government backing means, RPs provide lenders with extremely low risk .

A 13.7. Bonds can be simply defined as an interest-bearing certificate of debt. It can either be an
obligation of the government (or business corporation), or a formal promise by the borrower to pay to
the lender a certain sum of money at a fixed future day with or without security, and signed and
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sealed by the maker (borrower). It is usually a series of interest payments (usually semi-annually) and
the principal, which is paid on the stated future date.
Did you know? Bonds are often confused for what is known as promissory notes. The only way that a
bond is distinguished from an ordinary promissory note is by the fact that it is issued as part of a
series of like tenor and amount, and, in most cases, under a common security. By rule of common law
the bond is also more formal in its execution. The note is a simple promise (in any form, as long as a
definite promise for the payment of money appears upon its face), signed by the party bound, without
any formality as to witnesses or seal.

Q 13.8. What are the various bond instruments available in the market?

A 13.8. The various bond instruments are

• US Treasury bonds & notes

• Municipality bonds & notes
• Corporate bonds & notes.

Q 13.9. Discuss the various bond instruments.

A 13.9. They are discussed as under

U.S. Treasury bonds and notes

These are coupon issues with a broad appeal. Notes have maturities of 1 to 7 years while bonds
maturities exceed 5 years. Both are available in bearer form where the interest is paid to whoever
presents the coupon to the treasury on each coupon date, or in registered form where the owner of
record (as recorded at the treasury) receives the coupon interest. The minimum purchase for most
notes and bonds is $1000, but the denominations may be large as $1 million. The treasury generally
offers new issues in exchange for maturing securities. This method of exchange refunding allows the
investor to either exchange the maturing bonds for new bonds or receive the principal or final coupon
payment. If the investor chooses to receive cash, he or she will sell the subscription rights for the new
issue in the open market.

If an investor buys or sells notes or bonds on dates other than the semi-annual coupon dates, the
accrued interest is part of the sellers return. For example, an investor who sells the bond 1 month
prior to the coupon date receives 5 months of accrued interest from the buyer. This way the seller

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receives interest for the number of months he or she actually held the security, whether or not the sale
date falls on the coupon date. .

Question 13.9 Conti

Municipal Bonds & Notes

These are securities issued by state and local governments and whose interest payments are exempt
from tax. While many US government and agency securities are exempt from state and local taxes,
only municipal securities are state and local taxes. The rate of return on municipal securities reflects
this tax treatment. This means for an investor in a 35% tax bracket, a tax free return of 9.61% on a
municipal bond is equivalent to a 14.78% return on a fully taxable bond, such as corporate or US
government bonds.
There are several types of structures within municipal bonds. Below we give their description based
on USA practice. In other countries some other types of municipal bonds can be used, but usually
they are copying the US experience.
There are basically two types of municipal securities in United States:
1. Tax-backed debt
2. Revenue bonds

Question 13.9 Conti

Taxed-backed debt obligations are instruments that are secured by some form of tax revenue. Tax
revenues do not secure revenue bonds. They are used for financing certain projects and are secured
by revenues generated by the completed projects themselves.
Also, both project revenues and municipality’s creditworthiness back some bonds, called Double-
barreled bonds. In USA many municipal bonds, especially revenue bonds, have an interesting
additional feature: They may be insured by outside agencies ( insured bonds ). These insurers
guarantee that they will pay the bondholder the interest and principal in case the bondholder defaults.
Revenue bonds are issued for project financing, for example, construction of a new road, tunnel or
bridge. These projects can generate their own cash flows that can be used for servicing debts. For
example, a city may issue revenue bonds to pay for a new stadium. It will pay bondholders their
interest and principal from the stadium's revenues. This type of bonds is obviously more risky than
taxed-backed debt obligations. In some features municipal revenue bonds are close to corporate
bonds because both require analyzing cash flows generated by project.

Corporate Bonds and Notes

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Corporate bonds (also called corporates) are bonds issued by private and public corporations. Within
corporate bonds universe, the important characteristics of the debt is whether it is secured or not. By
secured debt it is meant that there is some form of collateral, which is pledged to ensure repayments
of the debt. Without this collateral the debt is unsecured. Recently the so-called mortgage-backed
and asset-backed securities have emerged and grew in the importance. Underlying pools of assets
backs these securities.

Q 13.1. State some of the risks associated with investing in bonds.

A 13.1. Investors should be aware that even investments in fixed income securities also come with its
share of risk. Some of the risks that apply to them are as follows,

• Interest Rate Risk

If interest rate rise, bond price usually decline. If interest rates decline, bong prices usually rise .
When rates are rising, market prices of existing debt securities will fall, as demand increases for new-
issue securities with the higher rates. As prices decline, yields are brought into line with the prevailing
rates. When rates are falling, market prices will rise, because the higher rates on outstanding debt
securities will be more valuable.

• Credit Risk

The safety of a fixed-income investor’s principal depends on the issuer’s credit quality and ability to
meet its financial obligations. Issuers with lower credit ratings usually have to offer investors higher
yields to compensate for the additional credit risk. A change in either the issuer’s credit rating or the
market’s perception of the issuer’s business prospects will affect the value of its outstanding
securities.

Question 13.10 Conti

• Prepayment Risk

Some classes of individual bonds, including mortgage-backed bonds, are subject to prepayment risk.
It is when the issuer of a security will repay principal prior to the bonds maturity date, thereby
changing the expected payment schedule of the bonds.

• Price Risk

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Investors who need access to their principal prior to maturity have to rely on the available market for
the securities. Although investors in fixed-rate capital securities may take advantage of the exchange
listing for retail offerings to sell their shares prior to maturity, the price received may be more or less
than the purchase price as a result of these dynamic risk factors.

• Reinvestment Risk

During periods of declining interest rates, the investor may be forced to buy new bonds at lower
interest rates, since the existing investments are nearing maturity. This becomes a potential risk to an
investor in fixed income securities.

Summary

Summary

• Money market instruments are nothing but highly marketable short-term instruments. These
instruments include Commercial paper, Certificates of Deposit, and Bankers acceptances,
Eurodollars, Repurchase agreements etc.
• US Treasury bills are simply 91-360 day instruments with denominations of $10,000 to $1
million sold by the federal government.
• Bonds can be simply defined as an interest-bearing certificate of debt. It is usually a series of
interest payments (usually semi-annually) and the principal, which is paid on the stated future
date.
• Investments in fixed income securities also have some inherent risk, which the investor should
take, guard against.

Question 14.1

Q 14.1. What is a debt market?

A 14.1 A market where fixed income securities of various types and features are issued and traded is
known as a “debt market”. Just in case you can’t recall what is meant by fixed income securities, they
are securities issued by the central and state governments, municipal corporations, government
bodies and commercial bodies such as financial institutions, banks, public sector units etc. These
securities are structured in nature.
The table below gives a proper insight into India’s current standing in the Asian debt market.

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Session 14 : Debt Business:

Question 14.2

Q 14.2. Explain the rationale behind Debt Markets:

A 14.2 India’s debt market has a substantial growth potential. If it is converted into per capita size, the
market is not necessarily large at present, accounting for approximately 30% of her GDP. Given the
expected growth of India's GDP, the debt market can be expected to grow at an annual rate of
approximately 15% in nominal rupee terms.

Question 14.3

Q 14.3. What are the advantages to Investors in a debt market?

A 14.3 The advantages that accrue to investors who invest in debt market are

• Steady Income

Probably the biggest incentive of investing in fixed income securities is that they ensure steady and
constant return by way of interest and repayment of principal at the maturity of the instrument. Further
investors are assured of a dependable income.

• Safety

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Fixed income securities are issued by eligible entities of standing against the moneys borrowed by
them from the investors. This in turn guarantees safety of funds invested on these securities.

• Risk Free

Some of the fixed income securities such as government securities offer a risk free rate of return on
the investor’s money. The default on such securities is zero or near zero. Besides, there is a
sovereign guarantee on those instruments.

Q 14.4. What are the advantages to the Indian Financial System?

A 14.4 The benefits that accrue to the Indian financial system on account of the debt market are:

• Reduction in the borrowing costs thus facilitating mobilization of resources.

• Enhanced resource mobilization by unlocking illiquid retail investments like gold.
• Assisting in the development of a reliable yield curve.
• Development of heterogeneity of market participants.

Question 14.5

Q 14.5. What are the disadvantages/Risks to Investors in the debt market?

A 14.5 In case the reader can recall some of the risks that had been previously mentioned for fixed
income securities, understanding the below stated risks shouldn’t pose any problems.

• Default Risk

It is also known as credit risk and refers to the inability of the issuer to make prompt payment of the
interest and the principal amount.

• Interest Rate Risk

The risk emerging from an adverse change in the rate of interest prevalent in the market so as to
affect the yield on the existing instrument is known as “interest rate risk”. An investor may have to lose
in a situation where there is a sudden upswing in the prevailing interest rate scenario where he has
already invested his money.

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• Investment Rate Risk

The risk arising from the probability of a fall in the interest rate resulting in a lack of options to invest
the interest received at regular intervals at higher rates or comparable rates in the market is known as
“re-investment rate risk”.

• Counter Party Risk

The risk arising from the failure or the inability of the opposite party to the contract to deliver either the
promised security or the sale value at the time of settlement is known as “counter-party risk”.

• Price Risk

The risk arising from the possibility of not being able to receive the expected market price of the debt
instrument, due to an adverse movement in price is known as “price risk”.

Question 14.6

Q 14.6. What are Debt Market Instruments?

A 14.6 Traditionally when a borrower takes a loan from a lender, he enters into an agreement with the
lender specifying when he would repay the loan and what return (interest) he would provide the lender
for providing the loan. This entire structure can be converted into a form wherein the loan can be
made tradable by converting it into smaller units with pro rata allocation of interest and principal. This
tradable form of the loan is termed as a debt instrument. Therefore, debt instruments are basically
obligations undertaken by the issuer of the instrument as regards certain future cash flows
representing interest and principal, which the issuer would pay to the legal owner of the instrument.
The key terms that distinguish one debt instrument from another are as follows:

• Issuer of the instrument

• Face value of the instrument
• Interest rate
• Repayment terms (and therefore maturity period/tenor)
• Security or collateral provided by the issuer

Question 14.7

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Q 14.7. List down the different types of debt instruments:

A 14.7 Debt instruments are primarily traded in the market in the following types:
1.Money Market Instruments

• Certificate of Deposits
• Treasury Bills
• Commercial Paper
• Bills of Exchange

2. Long term debt instruments

• Government of India dated securities ( GOISECs)

• State government securities (state loans)
• Public Sector Undertaking Bonds (PSU Bonds)
• Bonds of Public Financial Institutions (PFIs)
• Corporate debentures

Question 14.8

Q 14.8. Explain the various types of long-term debt instruments:

A 14.8 The Money market instruments have already been covered as a separate module. And so we
go ahead discussing the long-term debt instruments.

• Long term debt instruments

Simply stating, these are instruments having a maturity exceeding a year. At any given point of time,
any such instrument has a certain amount of accrued interest with it i.e. interest, which has accrued
(but is not due) calculated at the "coupon rate" from the date of the last coupon payment.
Government of India dated securities (GOISECs)
Similar to treasury bills, GOISECs are issued by the Reserve Bank of India on behalf of the
Government of India. They are issued in dematerialized form but can be issued in denominations as
low as Rs.100 in physical certificate form, with maturities ranging from 1 year to 30 years. Very long
dated securities i.e. those having maturity exceeding 20 years were in vogue in the seventies and the
eighties while in the early nineties, most of the securities issued have been in the 5-10 year maturity
bucket.

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State government securities (state loans)

These are instruments issued by the respective state governments but the RBI coordinates the actual
process of selling these securities. Each state is allowed to issue securities up to a certain limit each
year. The planning commission in consultation with the respective state governments determines this
limit. While there is no central government guarantee on these loans, they are deemed to be
extremely safe. Generally, the coupon rates on state loans are marginally higher than those of
GOISECs issued at the same time.

Public Sector Undertaking Bonds (PSU Bonds)

These are long-term debt instruments issued by Public Sector Undertakings (PSUs). The term usually
denotes bonds issued by the central PSUs (i.e. PSUs funded by and under the administrative control
of the Government of India). Typically, they have maturities ranging between 5-10 years and are
issued in denominations (face value) of Rs1000 each. Most of these issues are made on a private
placement basis at market determined interest rates. Often, investment bankers are roped in as
arrangers for these issues.

Bonds of Public Financial Institutions (PFIs)

Apart from public sector undertakings, Financial Institutions are also allowed to issue bonds, that too
in much higher quantum. They issue bonds in 2 ways – through public issues targeted at retail
investors and trusts and also through private placements to large institutional investors. On an
incremental basis, bonds of PFIs are second only to GOISECs in value of issuance.

Corporate Debentures

These are long-term debt instruments issued by private sector companies and are issued in
denominations as low as Rs.1000 and have maturities ranging between one and ten years. Long
maturity debentures are rarely issued, as investors are not comfortable with such maturities.

Generally, debentures are less liquid as compared to PSU bonds and the liquidity is inversely
proportional to the residual maturity.

Q 14.9. What is the difference between Debenture and Bonds?

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A 14.9 A key feature that distinguishes debentures from bonds is the stamp duty payment. Debenture
stamp duty is a state subject and the quantum of incidence varies from state to state. There are two
kinds of stamp duties levied on debentures via issuance and transfer. Issuance stamp duty is paid in
the state where the principal mortgage deed is registered. Over the years, issuance stamp duties
have been coming down and are reasonably uniform. Stamp duty on transfer is paid to the state in
which the registered office of the company is located. Transfer stamp duty remains high in many
states and is probably the biggest deterrent for trading in debentures resulting in lack of liquidity

Q 14.10. Who are the issuers of debt instruments?

A 14.10 The issuers of debt instruments play a crucial in judging the functioning of the debt market
and subsequently the debt business.

• Government of India and other sovereign bodies

• Banks and Development Financial Institutions
• PSUs
• Private sector companies

Government of India and other Sovereign bodies

The largest volumes of instruments issued and traded in the debt market fall in this category. Issuers
within this category include the Government of India, various State Governments and some statutory
bodies. Instruments issued by the central Government carry the highest credit rating because of its
ability to repay its obligations.

Banks and Development Financial Institutions

Instruments issued by DFIs and banks carry the highest credit ratings amongst non-government
issuers primarily because of their linkage with the Government. Prominent DFI issuers include ICICI,
IDBI, IFCI, IRBI, as well as some state level DFIs like SICOM, GIIC etc. ICICI and IDBI have been the
most aggressive issuers.

Public Sector Undertakings (PSUs)

PSUs issue PSU bonds, which enjoy special concessions. These concessions are indirect i.e. these
PSU bonds are approved securities for investment by various trusts, provident funds etc. The
prominent PSU issuers include Mahanagar Telephone Nigam Ltd. (MTNL), National Thermal Power
Corporation (NTPC), Indian Railway Finance Corporation (IRFC), and Konkan Railway Corporation
(KRC) etc.

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Private sector companies

Private sector companies issue commercial papers (CPs) and short and long-term debentures. The
total value of outstanding debentures issued by private sector corporates is estimated at Rs500bn.
There were large issues of debentures by private sector companies in the early and mid nineties.

Summary

• A market where fixed income securities of various types and features are issued and traded is
known as a “debt market”.
• Given the expected growth of India's GDP, the debt market can be expected to grow at an
annual rate of approximately 15% in nominal rupee terms.
• Debt instruments are basically obligations undertaken by the issuer of the instrument as
regards certain future cash flows representing interest and principal, which the issuer would
pay to the legal owner of the instrument.
• Some of the fixed income securities such as government securities offer a risk free rate of
return on the investor’s money
• A key feature that distinguishes debentures from bonds is the stamp duty payment
• Similar to treasury bills, GOISECs are issued by the Reserve Bank of India on behalf of the
Government of India

Question 16.1

Q 16.1. What are Hedge funds?

A 16.1. Hedge funds are used as a tool to reduce the volatility and risk there by increasing the returns
and preserving capital under any type of market conditions. Hedge funds can be well defined based
on their characteristics rather than on their hedging nature. The common characteristics of most of the
hedge funds include

• They are primarily private investment vehicles.

• Performance based fee structure.
• Managing fund as a general partner.

Q 16.2. Why are hedge funds in news?

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A 16.2. A hedge fund can take both short and long positions, make use of arbitrage, buy and sell
undervalued and over valued securities, trade options or bonds and invest in almost any type of
market where it can foresee reduced risk and higher returns. Hedge funds charge high fee, they lack
liquidity and are less transparent. Even after having these disadvantages, they are highly attractive for
their high returns and the availability of various investment alternatives. The objective of most of the
hedge funds is, consistency of returns and capital preservation rather than on the magnitude of
returns.

Question 16.3

Q 16.3. State the advantages of hedge funds.

A 16.3. Hedge funds of late gained tremendous importance in the global financial market. Some
specific advantages accrued are as follows:

• Many of the hedge fund strategies have the ability to generate positive returns in both rising
and falling markets (equity and bond).
• Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility
there by increasing returns.
• There are a huge variety of hedge fund investment styles that provides investors with a wide
choice of hedge fund strategies to meet their investment objectives.
• Generally hedge funds have higher returns and lower overall risk than traditional investment
funds.
• Hedge funds provide an ideal long-term investment solution by eliminating the need to
correctly time entry and exit from markets.
• Adding hedge funds to an investment portfolio provides diversification, which is not otherwise
available in traditional investing.

Q 16.4. State some of the most commonly used Hedge fund strategies.

A 16.4. There are many different types of hedge fund strategies and styles depending on different
degrees of risk and return. It would be quite helpful to know about different hedge fund strategies, as
all hedge funds are not the same. The investment returns, volatility and risk vary enormously among
the different hedge fund strategies. These strategies can be classified into

• Very high risk strategies

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o Emerging markets
o Short selling
o Macro

• High risk strategies

o Aggressive growth
o Market timing

Question 16.4 Conti

• Moderate risk strategies

o Special situations
o Value
o Funds of hedge funds

• Low risk strategies

o Distressed securities
o Income
o Market neutral securities hedging
o Market neutral arbitrage

• Variable risk strategies.

o Opportunistic
o Multi strategy
Session 16: Hedge Funds:

Question 16.5

Q 16.5. What are the Very high-risk strategies?

A 16.5. The following are referred to as very high-risk strategies

• Emerging markets:

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This strategy includes investing in equity or debt of emerging markets where there is a huge scope for
significant future growth. This means, investing in less mature markets that tend to have high inflation
and volatile growth. Many of the emerging markets do not allow short selling and therefore effective
hedging is not available.

• Short selling:

Short selling means selling shares with out owning them hoping to buy back at a future date with a
lower price. Short selling is done when the stock is overvalued at present, i.e. if the share price is
expected to drop in the future as according to the fundamentals of the underlying company. In order to
short sell, the manager borrows securities from a prime broker and sells them in the market
immediately. He then repurchases the securities at a later date at a price lower than what he sold foe
and returns the securities to the broker.

Macro:

This strategy aims to profit from the changes in the global economies because of the change in
government policies. The changes in the government policies in turn impact the interest rates,
currency, stocks and bond markets. Manager constructs the portfolio based on the global economic
trends rather than on the individual securities.

Q 16.6. What are High-risk strategies?

A 16.6. The following are referred to as high-risk strategies

• Aggressive growth:

This strategy involves investing in equities that are expected to experience a strong growth in their
EPS. This includes companies that have less or no dividends and smaller or micro capitalization of
stocks; these may also include sector specialist funds such as banking or technology. Managers will
consider the companies’ fundamentals before investing and they generally utilize short selling where
earnings disappointment is expected.

• Market timing:

This strategy involves moving capital from one asset class to another there by capturing market gains
and avoiding market losses. This strategy is based on the movement of the various markets and the
predictions that can be made through the market movements. The volatility of this strategy is mainly

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because of the unpredictability of market movements and to decide upon the entry and exit timings
from the market.

Q 16.7. What are the moderate risk strategies?

A 16.7. The following are referred to as moderate-risk strategies

• Special situations:

This strategy makes use of the event driven situations like mergers and acquisitions or leveraged
buyouts. This includes investing both long and short in stocks that are expected to change in price
because of the underlying event. Here the manager simultaneously purchases and sells the stock in
the company being acquired and acquirer respectively there by getting profit from the spread between
the current price and the purchase price of the company.

• Value:

This strategy includes investing in securities that are supposed to be selling at a less or discounted
price than its intrinsic value. Managers take long and short positions in stocks that are believed as
undervalued and overvalued respectively. This strategy requires patience and long term holding until
the final or the expected value is recognized by market.

A fund of hedge funds is generally a diversified portfolio of uncorrelated hedge funds. This strategy
makes use of the mix of hedge funds and other pooled investments. This mix of different strategies
helps in providing a more stable long-term investment return than any of the stock portfolios, mutual
funds or individual hedge funds. The risk, return and volatility can be controlled by the underlying
strategies and funds. An important consideration of this strategy is capital preservation and the
volatility depends on the mix of the strategies employed.

Q 16.8. What are the low risk strategies?

A 16.8. The following are referred to as low-risk strategies

• Distressed securities:

This strategy includes investing in the equity, debt or trade claims that are issued at less or
discounted prices of the companies that are facing bankruptcy, reorganization or heading toward that

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situation. The logic behind this strategy is that the securities of companies in such situations often
trade at a discount for a variety of reasons. The effect of bankruptcy will lead to under valuation of the
shares. Managers can take short positions in companies whose position will worsen in the short term.

• Income:

The primary focus of this strategy is to invest in such a way to get yield or current income rather than
on capital gains. It may also make use of leverage to buy bonds or fixed income derivatives to profit
from both interest income and principal appreciation.

Question 16.8 Conti

• Market neutral- securities hedging:

This strategy involves investing both long and short in the same sectors of the market. Long positions
will be taken in securities that are expected to rise in value and short positions in securities that are
expected to fall in their value. The logic in this strategy lies in picking up the stock and effective stock
analysis to get better results.

• Market neutral- arbitrage:

This strategy involves making use of the inefficiencies of the market by offsetting long and short
positions. The market risk can be greatly reduced by pairing individual long positions with related
short positions

Q 16.9. What are the Variable risk strategies?

A 16.9. The following are referred to as variable-risk strategies

• Opportunistic:

Opportunistic strategy makes use of different events such as issuing IPOs, sudden price changes
because of low interim earnings, or bids etc. This involves changing the investment idea from strategy
to strategy according to the opportunities that arise rather than on selecting the securities with the
same strategy. The characteristics of the portfolio will vary from time to time. Managers can also make
use of the combinations of different approaches at a given time.

• Multi strategy:

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Multi strategy makes use of various strategies and can underweight or overweight different strategies
to best capitalize on current investment opportunities. The weight of different strategies may vary over
time. This strategy is used to simultaneously realize both short term and long-term gains.

Question 16.10

Q 16.10. Distinguish between mutual fund & hedge fund.

A 16.10. There are 5 major differences between a hedge fund and a mutual fund.
Mutual fund Hedge fund
Mutual funds are measured on relative performance Hedge funds are expected to deliver
absolute returns by making profits under
all circumstances.
Mutual funds are highly regulated, restricting theHedge funds are regulated to far less
use of short selling and derivatives oversight and can make use of short
selling and derivatives
Mutual funds generally remunerate managementHedge funds remunerate management
based on the percentage of assets under thewith performance related incentives as
management well as a fixed fee.
Mutual funds are not able to effectively protectHedge funds are often able to protect
portfolios from declining markets other than byportfolios from declining markets by
going into cash making use of different hedging strategies.
The future performance of the mutual fund isFuture performance of many hedge fund
dependent on the direction of the equity markets. strategies is highly predictable and is not
dependent on the direction of equity
markets.

Summary:

• Hedge funds are used as a tool to reduce the volatility and risk there by increasing the returns
and preserving capital under any type of market conditions.
• A hedge fund can take both short and long positions, make use of arbitrage, buy and sell
undervalued and over valued securities, trade options or bonds and invest in almost any type
of market where it can foresee reduced risk and higher returns.
• Depending on different degrees of risk and return, hedge funds are categorized in to different
styles and strategies. These include, very high risk, high risk, moderate risk, low risk and
variable risk.

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• The areas of difference between the hedge fund and mutual fund are regulatory over sight,
remuneration, relative and absolute performance, protection against declining markets and
future performance.

Did you know – bonds?

Z bond: A bond on which interest accrues but is not currently paid to the investor but rather is added to the
principal balance of the Z bond and becoming payable upon satisfaction of all prior bond classes.

Junk bonds are so called because they have a better than 50% chance of default, carrying a Standard &
Poor's rating of CC or lower.

Baby bond a bond with a par value of less than $1000

Brady bonds are issued by emerging countries under a debt reduction plan

Bulldog bond is a foreign bond issue made in London

Citizen bonds are certificate less municipals that can be registered on stock exchanges and are listed in
newspapers

Cushion bonds are High-coupon bonds that sell at only at a moderate premium because they are callable
at a price below that at which a comparable non-callable bond would sell. Cushion bonds offer considerable
downside protection in a falling market

Deep-discount bond A bond issued with a very low coupon or no coupon that sell at a price far below par
value. A bond that has no coupon is called a zero-coupon bond.

Samurai bond is a yen-denominated bond issued in Tokyo by a non-Japanese borrower. Related: Bulldog
bond and Yankee bond.

Convertible Bond is a bond that can be converted into shares in a company.

Coupon is the interest payment on a bond.

Junk bonds are high risk, high yielding bonds.

Full coupon bond is a bond with a coupon equal to the going market rate; the bond is therefore sold at par.

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Payment-in-kind (PIK) bond is a bond that gives the issuer an option (during an initial period) either to
make coupon payments in cash or in the form of additional bonds.

Pure discount bond is a bond that will make only one payment of principal and interest. Also called a zero-
coupon bond or a single-payment bond

Yankee bonds are foreign bonds denominated in U.S. dollars and issued in the United States by foreign
banks and corporations. These bonds are usually registered with the SEC. Such as, bonds issued by
originators with roots in Japan are called Samurai bonds.

Hybrid Securities Finally Hit Corporate Segment

Karsten Frankfurth, Fitch Ratings - 18 Oct 2005

Hybrid securities have so far mainly been a financing vehicle for financial institutions in Europe but
now corporate issues have become more active in issuing them. This article discusses how hybrid
securities can be a useful addition in the capital structure and shore up the credit profile of an issuer.

In Europe, hybrid securities have so far been largely a financing vehicle for financial institutions, i.e.
banks and insurance companies. The sheer volume of hybrid issues clearly illustrates the dominance
of this instrument within the financial institutions sector. During 2005 (until August), the market has
seen hybrid issues worth €9bn (22 issues) in the insurance segment, €24bn in banking (59 issues -
tier 1) and €6bn (10 issues) in corporate. The dominance of hybrids in the financial institutions sector
is caused by the fact that this instrument qualifies as 'regulatory' capital, provided such securities
meet certain structural criteria as set out by the relevant regulatory bodies. For a bank, the maximum
amount of lending activity is limited by the amount of regulatory equity. By issuing hybrid instruments
that qualify for regulatory capital, a bank can enhance its lending activities without having to issue
straight equity.

Corporate issuers have been less than active in issuing hybrid securities in Europe. This was in part
driven by uncertainty over potential investors' perception of the instrument. Activity has therefore
been concentrated in mid-sized corporates and frequently in situations to finance a restructuring
exercise or an ambitious growth plan. This has changed, however, and highly rated issuers seem to
have discovered corporate hybrids. There are three principal motivations behind this:

1. With the low-interest rate environment, fixed-income investors are looking for
better yield. As hybrids are similar to common equity, issuers must compensate for such
risks and therefore pay a higher coupon.

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2. Driven by the low interest-rate environment, corporate issuers are able to add an
equity-like instrument to their capital structure at low cost.

3. Finally, hybrid issues relieve pressures from investors and credit analysts on
companies to increase financial flexibility. For example, the capital structure profile of
German pharmaceuticals/chemicals group Bayer was weakened following the acquisition of
the OTC business of Roche in 2004. To shore up its capital structure, Bayer in 2005 issued
a €1,300m hybrid with a maturity of 100 years, an instrument that includes strong equity-
like features. Bayer used the majority of the proceeds to replace existing senior debt (by
repurchasing outstanding bonds). Bayer's issue attracted so much interest that the volume
was subsequently upsized, further contributing to the strong investor interest in hybrids.

Chart: Evolution of European Corporate Hybrid Issue Volumes

What are Corporate Hybrids?

Corporate hybrids are financial instruments that combine certain elements of debt and equity; the
latter is taken into account by Fitch's assignment of a certain amount of equity credit in its rating

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assessment. Equity is marked by the lack of a maturity date, an absence of fixed payment obligation,
and it is the most 'junior' form of capital, meaning that no capital provider ranks below it. Therefore, a
hybrid security will typically be considered more equity-like the more distant its maturity date, the
more discretion the issuer has in making payments, and the more junior the issue.

The Rating Perspective

Depending on the structural features of a specific hybrid, Fitch will assign an amount of equity credit
to an instrument accordingly. But what are the analytical implications of this? From the viewpoint of
credit metrics, this means that the issuer's capital structure ratios will improve, i.e. those credit
metrics that are primarily balance sheet based (total debt/total capital) and all 'dynamic leverage'
ratios, such as total or net debt/EBITDA. Taken to the extreme, this would mean that the more
hybrids a corporate issues the better its capital structure will become and consequently the better its
rating should be. To avoid this, Fitch limits the amount of hybrid securities eligible for equity credit
within the equity-capital structure of any issuer. For issuers in the single A-category, the cap is at 15
per cent, whereas it is 25 per cent for a BBB issuer and 35 per cent for the sub-investment grade
territory (below BBB-). The reason for this sliding scale is that, in Fitch's view, the higher the issuer's
rating the more likely the hybrid security will perform like straight debt, and therefore a stricter limit is
adequate. This means that a lower-rated issuer may stand to benefit more than a higher-rated issuer
from issuing a hybrid security. A simple example illustrates the effect.

Table 1: Comparison - Equity Benefit from Issuing Hybrids (€m unless otherwise stated)

High-Grade Sub-Investment Grade

Company
Company Company
Senior Unsecured Rating A- BB+
Common Equity + Reserves 1520 1520
Soft Ceiling 15 per cent 35 per cent
1788-1520 = 2682338-1520 = 818
Hybrid Headroom
(1520/0.85 = 1788) (1520/0.65 = 2338)
Hybrids Issue Considered 500 500
Assumed Equity Credit Given for the
65 per cent 65 per cent
Instrument
Equity Credit Amount 268 325
Adjusted Equity 1788 1845

The companies in the table both have equity of €1,520m and are considering a hybrid issue of
€500m each. Based on assumptions about the hybrid's structural features Fitch has given it 65 per
cent equity credit. The high-grade company, however, only receives €268m in additional equity from
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the issue due to the stricter soft ceiling of 15 per cent. If the full €325m was assigned to this issuer,
the hybrid instrument would correspond to more than 15 per cent of the total equity. Only the sub-
investment grade issuer receives the full 65 per cent equity credit on the €500m, corresponding to
€325m. As a result, the incremental equity effect is stronger for the sub-investment grade company.

A further analytical consideration is whether the inclusion of a hybrid instrument improves coverage
ratios, i.e. the interest cover based on EBITDA. Fitch does not view it appropriate to exclude the
interest expense on a hybrid security in its primary analysis as it bases its assessment on 'normal
circumstances'. If skipping coupon payments were to be assumed at the outset, this would imply a
prospective substantial deterioration in credit metrics, and this would have to be factored into the
senior unsecured rating. Also, it would not be possible to place the instrument with investors if
coupon deferrals would almost be certain. However, Fitch runs scenario analysis to evaluate how
much relief is provided by the deferral options of the instrument. This is the heart of the hybrid
concept: hybrids need to unfold their equity like-features in a financial crisis as this is when they
provide the most benefits. Under normal circumstances, it is assumed that they perform like regular
debt instruments.

How do Hybrids Perform in a Financial Crisis?

There is evidence that hybrids do perform in a financial crisis. In 2004, the Hybrid Securities
Committee within Fitch undertook an extensive back-test on those instruments during 2000-2003, a
difficult period for the credit market. Included in this test were 89 issuers and 209 securities. The total
volume of securities included in the back-test was a substantial $48bn. It is important to note,
however, that the statistical population is entirely US-based. This is because only the US market
provided a sufficient amount of publicly outstanding securities to derive any meaningful statistical
results. However, Fitch is of the opinion that the results would remain applicable to European
hybrids. While the overall criteria and features that lead Fitch to assign equity credit have not
changed, the examination reveals some very interesting results.

First, it is found that a three-year coupon deferral feature is sufficient. By theory, the longer the
deferral option the better, but practice has shown that within three years companies either go into
liquidation or manage to re-structure. Secondly, a maturity period in excess of 10 years is considered
long and provides substantial cash-flow relief in stress times. Finally, securities that include financial
covenants, cross-defaults and/or cross acceleration clauses have not performed as well. Also,
documentations that are marked by 'excess complexity' do not provide sufficient equity-like
characteristics in stress times.

Increased Issue Volume in Europe

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Europe has recently seen substantial hybrid issue volumes, with bonds of considerable size. The
table below outlines some of the currently outstanding European issues.

Table 2: Outstanding European Issues

Issuer Volume
Vattenfall €1bn
DONG €1.1bn
Suedzucker €700m
Casino €600m
Bayer AG €1.3bn
Thomson €500m

Fitch believes that the issues observed in Europe generally qualify for a high equity credit allocation.
The issues have coupon deferral features that vary in their details. Some issues leave the payment
of the coupon fully at the discretion of the issuer, which is a strong equity-like feature. Some issues
go even further by including a mandatory deferral on top of the optional deferral. In others, the
deferral is tied to certain provisions; for example, coupon payment cannot be deferred if a distribution
to common equity has taken place. These differentiations will have an impact on how Fitch allocates
equity credit to each hybrid issue. Fitch also assesses the circumstances under which management
may defer coupon payment, which in turn requires qualitative analysis.

In terms of tenor, the market standard has been either perpetuals or very long maturity dates, i.e.
100 or 1,000 years, the latter of which is a de-facto perpetual security. However, what has also
become a market feature is the call option on these instruments. Such hybrids can be called after a
call date, usually 10 years after the issue date. This raises the analytical question whether a call date
should be viewed as a de-facto maturity. The answer is that it depends namely on three factors: the
senior unsecured rating of the issuer, the step-up conditions after the call date and the existence or
lack of protective replacement language.

The higher the issuer's rating (senior unsecured rating), the more likely it is that the issue will be
replaced. This is because investors probably expect the issuer to be obliged to replace the security if
he aims to keep his access to this market open. The step-up condition refers to the amount by which
the coupon rises if the call is not exercised. If this is excessively high, then it must be assumed that
the issuer will take all efforts to replace the security to avoid the rise in funding expenses after the
call date. Finally, replacement language is considered. Replacement language refers to a provision
by which the issue can only be replaced by an issue that is of equal 'subordination'. Strong
replacement language reduces the likelihood of the call-date being viewed as a de-facto maturity.

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Conclusion

Hybrid securities can be a useful addition in the capital structure and shore up the credit profile of an
issuer. The current low interest-rate environment and ample liquidity make it fairly easy for issuers to
place those instruments. The majority of the issues observed so far fulfil conditions for high equity
credit allocations. Detailed analysis is required including a qualitative analysis of the issuer and, in
particular, an evaluation of the likelihood whether the instrument will be called at the call date.
Investors should be aware that they are investing in a strong credit environment, and that the hybrids
have yet to be tested during stress times.

Q 17.1 Who are Custodians?

A 17.1 Custodians in general refer to a bank / agent or any other organization responsible for
safeguarding an individual’s or a firm's financial assets. It is definetely one of the important functions
being performed by the financial intermediaries nowadays, besides being a great source of revenue.

Question 17.2

Q 17.2 What role do the custodians play?

A 17.2 The role of a custodian in such a case would be the following:

• Hold in safekeeping assets such as equities and bonds

• Collect information on and income from such assets (dividends in the case of equities and
interest in the case of bonds),
• Arrange settlement of any purchases and sales of such securities,
• Undertake foreign exchange transactions where required and provide regular reporting on all
their activities to their clients.
• Provide information on the underlying companies and their annual general meetings, manage
cash transactions

Did you know? Custodian banks are also known as 'Global Custodians' if they hold assets for their
clients in multiple jurisdictions around the world, either using their own local branches or other local
custodian banks in each market to hold accounts for their underlying clients. Assets held in such a
manner are typically owned by pension funds.

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Question 17.3

Q 17.3 What do the Custodial Services include?

A 17.3 Typical custodial services will include:

Q 17.4 What do you mean by Safe Custody of Shares?

A 17.4 Safe custody of shares encompasses the following activities

Safe keeping methods:
Custodians usually take safety measures, like placing shares in pouches and storing them in fireproof
cabinets with in vaults. Barcodes are then affixed to individual certificates that can be scanned for
identification.
Custodians are insured against risks arising from theft. However the actual insurance policies do vary
from custodian to custodian. Some custodian banks have a better coverage than others. In case of
any damage or mutilation of the scrips, the scrips are replaceable and the risk of the loss or damage
of scrips while in the safe custody of the custodian should be borne by the custodian concerned.

Inspection of records:

On an annual basis SEBI and RBI conduct external audits with respect to physical verification and
reconciliation of records. The periodicity of verification and reconciliation of records is custodian
specific and as per the internal checks are concerned, the procedures vary among custodians.

Protection of clients’ assets:

As per SEBI, custodians are required to segregate their clients’ assets and cash from that of the
custodians’ own assets and cash. In addition, SEBI wants to maintain separate cash and securities
accounts for each of their clients.

Question 17.5

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Q 17.5 What does the Custodial Charge consist of?

A 17.5 Custodial charges generally consists of the following:

• Transaction fee
• Safe Custody Fee

Q 17.6 Explain in brief the above-mentioned custodial charges?

A 17.6 The details of each of the above mentioned expenses are

• Transaction fee

For each transaction that the investor settles through the custodian the transaction fee is charged. It
may be a certain percentage of a transaction value or an amount per transaction.

• Safe custody fee

As is understood by the term, safe custody fee is charged for the custodial services to the investors’
portfolio in safe custody. The fee is usually quoted at a certain percentage of the value of the portfolio
on an annual basis, but the portfolio is valued on a monthly or a quarterly basis and the fee is payable
accordingly.
One important thing to be noted is that each investors trading pattern significantly affect the economy
of the custodial fees. Say, some custodians operating in India have their custodial service networks
outside the country on a regional or global basis too. It also goes to say that if the investor uses a
particular custodial banks service anywhere else, he or she may have an additional bargaining edge
in order to lower the fees.

Q 17.7 What do you mean by Corporate Actions?

A 17.7 Sources of corporate action information:

According to listing guidelines, every company listed on the exchange has to notify the exchange of its
corporate actions well in advance. The company informs the stock exchange where its shares are
listed and the in turn the exchange informs the members and investors through various channels.
Did you know? BSE circulates daily notices while NSE transmits it online. The exchange sends
circulars on listed companies corporate actions to its members from time to time. Financial / Business

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magazines and local newspapers are a reasonable source of such information. Some brokers also
maintain database on corporate actions and provide such information on a regular basis to their
clients.
Date for determining corporate entitlements:
The book closure or the date record date will be used to analyse all corporate entitlements. This is
more so because different stock exchanges will have different settlement cycles and the ex dates are
announced by the exchanges themselves. However the responsibility of fixing the record date rests
with the concerned company itself. Meanwhile this situation may result in the occurrence of the
possibility of having an ex-date fixed after the official record date or the book closure date. When such
a situation takes place, both the trades done cum benefit and the trades settled after the official book
closure date would still be entitled to corporate action benefit.

Notification to foreign investors:

As the corporate benefit gets declared, the custodian will inform his or her FII clients of the same, on
completion of which the custodian monitors his or her clients feed back in order to ensure that proper
instructions are obtained from the clients.

If it so happens that some shares are kept in street name instead of being registered, the FII must
make sure that his or her custodian has such a system so as to ensure that all stocks, whether
registered or in street name are monitored at the same time.

Proxy service to foreign investors:

Providing proxy services to foreign investors like FIIs is a dreary area. In spite of formal inquiries,
neither SEBI nor RBI has announced its official position in this matter. It is a general understanding in
the market that custodians do not provide proxy services to their foreign clients. However, some
custodians have been offering such services in respect of those companies whose registered offices
are located in metropolitan areas.

Q 17.8Explain the service of Dividend Payment and Sale Proceeds

A 17.8 Dividend payment:

The amount of dividend to be declared is proposed to and approved by the company’s board of
directors. At its annual general meeting the company declares payment of dividend. The notice of
dividend amount proposed that is to be declared is given to the stock exchange at least 42 days
before the record date. Thereafter, the shareholders approve and declare the dividend payment the
annual general meeting of. Dividends are paid with in 42 days.
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Payment of dividends is usually done on an annual basis. However, some companies pay an interim
dividend, which requires the approval of its board of directors during the financial year. Though not
legally required, interim dividends are paid with in 42 days of the date of approval by the board of
directors.

Repatriation:

• Sales proceeds

Once the securities have been sold, the FII has to first obtain a certificate providing the computation
of tax payable on capital gains from a chartered accountant. The FIIs custodian with holds the tax and
then credits the net rupee sales proceeds to the FIIs non-resident foreign currency account and
repatriate them to the FIIs account outside India. All in all, it takes approximately three weeks to
repatriate the net sales proceeds, from the date of sale of securities assuming a normal settlement
period.

• Dividends

Dividend cheques are issued in the form of demand drafts, usually drawn on banks located in big
towns. Payee banks designated in these demand drafts are obliged to pay the dividend cheque
proceeds with in 48 hrs upon presentation of these drafts to the named payees. In case of a high
value cheque (a cheque more than Rs.1, 00,000) the same may be cleared on the same day, while
the cheques of smaller amount may take two days to be cleared.

Did you know? In case the FII intends to repatriate the cleared dividend proceeds, the custodian
bank is responsible for ascertaining and with holding the proportion of tax amount payable, if any,
before converting the funds into a foreign currency and crediting the foreign currency denominated
funds to the FIIs foreign account. Thereafter the repatriation of funds is allowed. Such a process
should be completed with in 48 hours.

Q 17.9 What is the scope of Foreign exchange control?

A 17.9 FII does not require exchange control clearances for Dividend income repatriation. Indian
rupee-denominated positions in Indian fixed income securities and yields on their investments in
terms of a foreign currency like the US dollar can be covered by FIIs . However in connection with the
repatriation of dividends or sales proceed from FIIs equity investments; RBI does not allow FIIs to
enter into forward foreign exchange contracts with any locally registered foreign exchange dealer.
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Q 17.10 Who uses Custody Services?

A.17.10 Custodial services are used by Institutional investors; money managers and broker/dealers
who rely on custodians and other market participants for the efficient handling of their worldwide
securities portfolios

Summary

• Custodian refers to a bank / agent or any other organization responsible for safeguarding an
individual’s or a firm's financial assets.
• Custodian banks are often referred to as 'Global Custodians' if they hold assets for their
clients in multiple jurisdictions around the world.
• Custodial Services can be classified as Safe custody of shares, Corporate action, custodial
charge and dividend and sale proceeds.
• FII does not require exchange control clearances for Dividend income repatriation
• Dividend cheques are issued in the form of demand drafts, usually drawn on banks located in
big towns

Q 18.1 What are Settlement procedures?

A 18.1 In the developed and Southeast Asian countries, trades commonly settle on a daily rolling
basis, while a certain number of business days after the trade date, which is commonly expressed as
T. For United States it is T+5 and for Japan it’s T+4. In India, a batch of securities traded during a
period of 7 calendar days settle all together through the clearing house on a predetermined day after
the end of such period.

Q 18.2It’s often said that the Indian Settlement system revolves around 3 keywords. What are
they?

A 18.2 The three key words are

• Settlement period

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In India Stock exchanges divide one-year periods into periods of 7 calendar days, known as a ‘trading
period’ on the NSE and a ‘settlement period’ on the BSE. In general there are 5 trading days during a
settlement period. The transactions entered during a settlement period are to be settled on a set of
‘pay-in day’ and ‘pay-out day’.

• Pay-in day

This is the day when brokers have to settle payments to the clearinghouse of the exchange for all
purchases made by them in the preceding settlement period. Besides in the same settlement period,
there is also a need to deliver security certificates, together with the transfer deeds for all sales made
through them.

Question 18.2 Conti

• Payout day .

The day on which brokers receive the payments from the clearing house of the exchange for all sales
made through them in the preceding settlement period and also to receive security certificates,
together with transfer deeds, for all purchases made through them in the same settlement period.
Did you know?A transfer deed (also known as share transfer form) is basically an instrument of
transfer. A transfer deed will be required on a physical delivery basis for the settlement of every trade
in addition to a certificate of the traded shares, because a transfer deed that has been duly stamped
and executed will accompany a certificate of shares to register a transfer of ownership of shares.

Q 18.3 How are settlement periods defined for BSE listed stocks?

A 18.3 From the point of view of settlement periods there are two segments of equity trades on the
BSE.

• Ordinary settlement segment

• Rolling settlement segment, also known as ‘sunshine’ segment.

There is also another segment called as the negotiated trade segment.

Did you know? The Bombay Stock Exchange (1875) is the oldest stock exchange in Asia, much older
than the Tokyo Stock Exchange (1878).

Q 18.3 How are settlement periods defined for BSE listed stocks?
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A 18.3 From the point of view of settlement periods there are two segments of equity trades on the
BSE.

• Ordinary settlement segment

• Rolling settlement segment, also known as ‘sunshine’ segment.

There is also another segment called as the negotiated trade segment.

Did you know? The Bombay Stock Exchange (1875) is the oldest stock exchange in Asia, much older
than the Tokyo Stock Exchange (1878).

Q 18.4 Discuss in detail the constituents of the Ordinary settlement segment?

A 18.4 In the ordinary settlement segment the trades executed are settled in two ways:

 Settlement through the clearinghouse

 Hand delivery

1. Settlement through clearinghouse:

The settlement period starts on Monday. The clearinghouse in turn obtains the members’ delivery
obligations and generates settlement statements for its members. Securities and funds are paid-in on
the first Thursday after the settlement period ends. It also checks for short delivery. The custodian or
selling broker who commits short delivery gives the clearinghouse a notice of short delivery, attached
with a cheque for a value of the short delivered securities, on Thursday evening or on Friday morning.
The selling broker or custodian is required to makeup for the short delivery (if any) by 5:00 p.m. on
Friday. If a make up delivery is made, the cheque is returned to the selling broker or custodian.
The settlement process completes unless there is any bad delivery. After that, the buying broker or
custodian examines the delivered securities for bad deliveries with in 48 hours of the delivery, and has
to report a prima facie bad delivery to the BSE’s clearinghouse by the end of the following Tuesday.
Any bad delivered shares that are left unmatched after the auction are closed out at the highest price
for the shares from the trade day or 20% above the closing price on the day of auction, whichever is
higher.

2. Hand delivery trades:

The selling and buying member brokers mutually decide on the price at which a transaction is
effected, the delivery and payment terms of the transaction. The selling broker subsequently delivers
the securities directly to the buying broker in exchange for the funds on a DVP basis. However as they

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do not go through the clearinghouse, these trades are not protected by the facilities that the
clearinghouse provides (like automatic buys-in, bad delivery cells).

Question 18.5

Q 18.5 What constitutes the Sunshine segment?

A 18.5 This segment aims at wooing institutional investors back to the BSE. In this segment, trades
settle on a daily rolling basis on the fifth working day from their trade day. Conventionally this
settlement cycle is termed as T+5. The sellers have to be institutional investors, but this excludes
NBFCs for the purpose of sunshine segment. Institutions or individuals can be potential buyers.
Did you know? In Negotiated trade segment, BSE members can execute off-the-market transactions
at negotiated execution prices and still settle them through the BSE’s clearinghouse. SEBI reportedly
suggests that a single transaction should be more than 10,000 shares or Rs.25, 00,000 in order to be
executed in this manner.

Question 18.6

Q 18.6 How does the settlement system vary for NSE listed stocks?
A 18.6 The NSE conforms to a 7-day period. Securities listed on the NSE can be settled either
through the clearinghouse of the NSE, the National Securities Clearing Corporation Limited (NSCCL)
called as ‘cleared deals’, or through a delivery versus payment route without involving the NSCCL
called as the ‘non cleared deals’.
NSE comprises of two main markets:

• Wholesale debt market for trading of pure debt instruments

• Capital market for trading in equities, convertible debentures, etc.

1. Normal market segment, in which the NSE provides the settlement facilities for institutional
investors.
2. Book entry segment

Q 18.7 What are the Special settlement facilities provided for institutional investors?

A 18.7 Institutional investors are provided with special facilities for their settlements. These
settlements facilitate substantial reduction of settlement risks for institutional investors by minimising
paper movements.
Book entry segment:
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The settlement in the book entry sub-segment of the NSE is much simpler than that in the normal
market segment, because no bad delivery is expected in the book entry sub-segment. The settlement
in the book entry sub-segment is different from that in the normal-market-segment in two aspects

• The settlement for funds and securities takes place on the fifth working day from the trade day
on a daily rolling basis
• There are no procedures to rectify bad deliveries or objections of transfer.

Question 18.8

Q 18.8 Mention some of the important reports prepared in this field?

A 18.8 The following are some of the important reports prepared in this field.
Execution confirmation
Local brokers who execute orders usually report all executed transactions to the FIIs by fax
immediately after trading hours. Upon execution of orders some brokers confirm them via faxing a
transaction.
Contract notes
When the market closes down, the original contract notes for FIIs are forwarded to their custodians.
Settlement confirmation
The custodian sends a settlement confirmation to his or her FII client and his or her broker via SWIFT,
fax or telex. [SWIFT (Society For Worldwide Inter bank Financial Telecommunication) is a cross
border system in the world extensively used for exchanging banking specific electronic messages]
Account settlement
The broker and the custodian both, either mail or courier an account statement to their FII client on a
fortnightly or a monthly basis as per its requirements.

Q 18.9 What is this phrase called Delivery Versus Payment?

A 18.9 One term that finds extensive use under clearing and settlements is ‘delivery versus payment.
In this section we will try to bring to lo light some related aspects.

Partial delivery:

A short delivery gives rise to a partial delivery in the case of trades that settle on a DVP basis. A
partial delivery is not an issue for trades that settle through the clearinghouse, because any short
delivery is auctioned or closed out in the prescribed time frame.

Delayed settlement:

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As is generally seen a delayed settlement occurs in the case of a DVP settlement between the broker
and the custodian (or investor). The broker is supposed to settle trades with the custodian or investor
on a settlement date right after the pay out. Moreover the custodian follows up with the broker over
the phone or through any other means prior to a settlement date to avoid the delayed settlements. In
case the trade still fails, the custodian and the broker set up another settlement date.

Q 18.10 What are the most commonly faced Settlement troubles?

A 18.10 Settlement troubles are generally of two types.

• Short deliveries.
• Bad deliveries.

Short delivery:
When a custodian or the clearinghouse delivers fewer securities than what were contracted a short
delivery takes place. Short deliveries between the custodian and broker, or between the brokers, have
no specific time limit with in which these must be rectified. Short deliveries between the clearinghouse
and the broker are taken care of by the ‘Buy-in’ procedures.
Bad delivery:
A bad delivery on the other hand is a delivery of share certificates and their accompanying transfer
deed that have an obvious defect, such as the absence of a brokers stamp from the transfer deed.
This should apparently disqualify the ownership of the share certificates from being transferred to the
buyer of the share if these are submitted to the company’s transfer agent for registration of transfer.

Summary

• Developed and Southeast Asian countries, trades commonly settle on a daily rolling basis,
while a certain number of business days after the trade date, which is commonly expressed as
T.
• A transfer deed is also known, as share transfer form is basically an instrument of transfer.
• The settlement period starts on Monday
• The selling and buying member brokers mutually decide on the price at which a transaction is
effected, the delivery and payment terms of the transaction.
• Institutional investors are provided with special facilities for their settlements

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Q 19.1. How many stock exchanges are there in India?

A 19.1 There are 24 stock exchanges in the country, with 21 of them being regional in nature. The
other three have been set up in the reforms era, viz., National Stock Exchange (NSE), the Over the
Counter Exchange of India (OTCEI) and the Interconnected Stock Exchange of India Limited (ISE)
have mandate to nation wide trading network.

Q 19.2. How did the Interconnected Stock Exchange of India Limited (ISE) come to existence?

A 19.2 The ISE has been promoted by 15 regional stock exchanges in the country and is based in
Mumbai. The ISE provides a member/broker of any of these stock exchanges an access into the
national market segment, which would be in addition to the local trading segment available at present.

Q 19.3. Which are the major exchanges to provide screen based trading system?

A 19.3 The NSE, ISE and majority of the stock exchanges have adopted the Screen Based Trading
System (SBTS) to provide automated and modern facilities for trading in a trans parent, fair and open
manner with access to investors across the country.

Q 19.4. Discuss the genesis of the Bombay Stock Exchange.

A 19.4 An informal group of stockbrokers have been trading under a banyan tree opposite the Town
Hall of Bombay from mid-1850s. This banyan tree still stands in Horniman Circle Park, Mumbai. This
informal group of stockbrokers has organized themselves as “The Native Share and Stockbrokers
Association” which, in 1875, was formally organized as the Bombay Stock Exchange (BSE). BSE is
the oldest stock exchange in Asia, the second being the Tokyo Stock Exchange, established in 1878.

As of today, there are around 3,500 companies in the country, which are listed and have a significant
trading volume. As of January 2005, the market capitalization of BSE is about Rs.2 trillion. The BSE
`Sensex' is a widely used market index for the BSE. As of 2005, it is among the 5 biggest stock
exchanges in the world in terms of number of transactions.

Q 19.5. Besides BSE Sensex, which are the other stock-indices used by BSE?

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A 19.5 The other stock-indices are

• BSE 100
• BSE 500
• BSEPSU
• BSEMIDCAP
• BSESMLCAP
• BSEBANKEX

Q 19.6. Write a few lines on the management of BSE.

A 19.6 It comprises of a governing board, consisting of 9 elected directors (1/3 rd of them retire every
year by rotation), an Executive Director, 3 Government nominees, a Reserve Bank of India nominee
and 5 public representatives, is the Apex body, which regulates the exchange and decides its policies.
A President, Vice-President and Honorary Treasurer are annually elected from among the elected
directors by the Governing board following the election of directors.

However, as per SEBI orders issued in March 2001, the elected directors have been restrained from
acting as directors and the Governing body presently comprises of only 10 directors, viz., 3
government nominees, a RBI nominee, 5 public representatives and a Executive Director. The
Executive Director, as the Chief Executive officer, is responsible for day-to-day administration of the
Exchange.

Q 19.7. What are listing requirements for BSE?

A 19.7 Under current Indian Laws, securities offered to the public for subscription have to be listed.
Therefore an applicant company for listing on the BSE has to first satisfy the eligibility criteria for
initial public offering (IPO). Additionally, the applicant company is required to make disclosure in
accordance with the stipulated rules and regulations.

Such criteria and disclosure requirements are virtually the conditions precedent to listing on the BSE.
Following are the major requirements, which need to be fulfilled by an unlisted company for being
listed on BSE:

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i. Issued Capital: The issued and subscribed equity capital of the applicant company, including that
proposed to be issued before listing, shall not be less than Rs.100 million (US$ 2.78 million
approximately).

ii.Minimum Public Offer of Capital: At least 25% of each class of securities issued by a company
has to be offered to the public for subscription. The central government may relax this minimum public
offer for government companies. (However, the public shareholdings should not be reduced to less
than 20% of the voting capital of the company).

iii. Public Shareholders: As a result of public issue, a company has to have at least 5 public
shareholders for every Rs.1, 00,000 of net capital offered to the public. In the case of an offer for sale,
the company has to have at least 10 shareholders for every Rs.1, 00,000 of net capital offered to the
public. “Public Shareholder” means a person who is neither a promoter nor a holder of more than 1%
equity capital of the company.

Did you know? A different set of listing criteria applies to an applicant company, which has been
already listed on another recognized stock exchange in India and seeks listing on BSE. The criteria
are as follows:

• Issued Capital: Rs.50 million (approximately US$ 1.39 million) or more;

• Net worth: Rs.100 million (approximately US$ 2.78 million) or more; and
• Market Capitalization: Rs.150 million (approximately US$ 4.18 million) or more.

Q 19.8. What are the primary advantages of listing your stocks in BSE?

A 19.8 There are some arguments in favour of trading in BSE. Being aware of such distinctions will
help an investor make a rational decision.

• Broader Market: Nearly 6,000 stocks are listed on the BSE while the NSE has approximately
1,500 listed or permitted stocks. BSE thus provides investors with a broader choice of Indian
Companies to invest in.
• Odds lots trading: The BSE’s trading system facilitates trading odd lots of shares and such
transactions settle through the exchange’s clearinghouse. The NSE allows its members to
trade odd lots outside the exchange
• Realistic Approach: The BSE is an association of people and is run by people who are
primarily brokers and who have years of experience in securities business. Under such

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management, professionals have been recruited to key administrative positions of the
exchange. Therefore, the exchange’s approach to problems tends to be more realistic and
practical and does not upset the whole brokers community.
• More time for settlement: The BSE gives an investor’s broker or custodian more time to
make payments and effect deliveries.

Q 19.9. Discuss the genesis of the National Stock Exchange of India?

A 19.9 The National Stock Exchange of India Limited was set up on the basis of the recommendations
of the High Powered Study Group on Establishment of New Stock Exchanges. On its recognition as a
stock exchange under the Securities Contracts (Regulations) Act, 1956 in April 1933, NSE
commenced operations in the Wholesale debt market (WDM) segment in June 1994. The Capital
Market (Equities) segment commenced operations in November 1994 and operations in Derivatives
segment. The NSE is not an exchange in the traditional sense of the term, where brokers own and
mange the exchange. Its two tier administrative set up involves a company board and a governing
board of the exchange. It is a professionally managed national market for shares, PSU bonds,
Debenture and Government Securities with the entire necessary infrastructure and trading facilities.

Q 19.10. Name some of the stock indices set up by NSE.

A 19.10 NSE also set up as index services firm known as India Index Services & Products Limited
(IISL) and has launched several stock indices, including:

• S&P CNX Nifty

• CNX Nifty Junior
• CNX IT
• S&P CNX 500
• S&P CNX Defty
• CNX MIDCAP 200

Q 19.11. Write a few lines on the management of NSE.

A 19.11 The Board of NSE comprises of senior executives from promoter institutions, eminent
professionals in the fields of law, economics, accountancy, finance, taxation, etc, public

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representatives, three nominees of SEBI and one full time executive of the exchange. While the board
deals with broad policy issues, the Board to an Executive Committee (EC) formed under the Articles
of Association and Rules delegates’ decisions relating to market operations. The day-to-day
management of the Exchange is delegated to the Managing Director who is supported by a team of
professional staff.

Q 19.12. What are listing requirements for NSE?

A 19.12 Both Stocks and Bonds get listed on the NSE. We will however limit our discussions to
stocks. Secondly, to distinguish listed stocks from permitted stocks, it is worthwhile to define the word
“listing” here. “Listing” means the admission of a stock to a stock exchange for trading on the
exchange for trading on the exchange under a listing agreement between the exchange and the issuer
of the stock. A company applying for listing of its stock has to satisfy NSE’s listing guidelines listed
below:

i. Issued capital or market capitalization: the issued and subscribed equity capital of the applicant
company including that proposed to be issued before listing shall not be less than Rs.200 million.

ii. Minimum public offer of capital: At least 25% of each class of securities issued by a company
must be issued to public for subscription. The central government may relax this minimum public offer
of capital for government companies.

iii. Track record: One of the following three parties must have a track record of at least 3 yrs.

• The aspirant company seeking listing

• The promoting company
• Another company of the same core promoters provided that the company is listed on another
recognized stock exchange in India for at least 3 yrs.

iv. If applicant company is not listed on another stock exchange in India for at least 3yrs, its project or
activity plan must have been appraised by a financial institution under section 4A of companies act or
a state financial corporation, or a scheduled commercial bank with a paid up capital exceeding Rs.500
million.

Q 19.13. What are the advantages of trading in NSE?

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A 19.13 There are some arguments in favour of the NSE. They are

• Unconditional counter party guarantee: the NSE’s clearinghouse guarantees the timely
settlement of trades executed in their normal market segments against short and bad
deliveries.
• Depository: NSE introduced the first depository system in India. The system as freed trades
from persistent problems of the Indian securities markets such as paper work, bad delivery
and stamp duty.
• Options and futures trading: The derivative trading added more liquidity and also a hedging
tool to the current system.
• Professionalism: NSE is a body corporate run by professionals and has no representations
of brokers on its board. NSE also has dedicated trained staff with the responsive attitude on
the full time basis. This enables NSE to quickly develop a stock exchange that is efficient and
fair to investors.
• Public relations: NSE has established various programs for public relations. It is well
prepared to disseminate information on the exchange’s rules and regulations and activities to
the public through printed and Internet publications.

Question 19.14

Q 19.14. What do you mean by the term “Over-the-Counter” market?

A 19.14 One more dimension to the securities markets besides primary and secondary markets is
Over-The-counter market. Securities that are not traded on organized exchanges are traded in the
Over-The-Counter market. This market consists of a network of thousands of dealers in particular
securities. Each dealer maintains inventories of one or more securities and has a bid price for which
he or she is willing to buy the stock to add to inventory and an ask price for which he or she is willing
to sell the stock from inventory.
There are two levels of prices, wholesale and retail. Retail prices are offered to individual investors
who are usually executing orders through brokers. Wholesale prices are offered to other dealers who
wish to make changes in their inventory positions.
The terms of trade are communicated through out the market system through the national association
of security dealers automated quotations system. This system allows all brokers in the network to
know the terms being offered by all dealers in a given stock at any given time. Actual trades are
subject to negotiation between brokers and dealers, but the system report completed transactions.

Question 19.15

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Q 19.15. Discuss some of the well-known Global Stock Markets.

A 19.15 Some of the well-known Global stock markets are:
New York Stock Exchange (NYSE).
The New York Stock Exchange (NYSE) celebrated its bicentennial in 1992. Securities brokers took up
trading under a buttonwood tree at 68 Wall Street. They reached an agreement on May 17,1992 to
deal with each other and fixed the commission at 0.25%. Since then it has grown to be the worlds
largest stock exchange. The shares of 2907 companies were listed in 1996 with capitalization of $7.3
trillion. The number of shares traded in 1996 was 104.6 trillion. The market value of NYSE stocks
formed 95.8 % of GDP in 1996. NYSE is open for six and half hours every day from 9:30 a.m. to 4:00
p.m. five days a week. Registered representatives on the trading floor who executes the order on
behalf of the customer can convey orders. Orders can also be processes electronically through what
is known as Super Dot 250 which is an electronic order routing system linking member firms all over
USA directly to the trading floor of NYSE. The system completes the trading loop within seconds. In
1992 Super Dot processed an average of 180,000 orders per day for 201 subscribers.

NASDAQ (National Association of Securities Dealers Automated Quotations)

NASDAQ stock exchange is the second largest stock exchange in the USA. NASDAQ began
operations on February 8, 1971. It was the world's first electronic stock market and is now the largest
U.S. electronic stock market. It is a nation wide electronic screen based trading network blended with
market maker competition. More than 50 percent of the shares traded in USA are traded in the
NASDAQ market. The companies listed on NASDAQ exceed those on all exchanges combined. It is
also highly automated with more than 60 percent of the orders executed automatically over the
computers at the best prices available.

NASDAQ uses a screen-based system that centralizes trading information to enable securities firm to
compete with one another via the computer. It has an electronic rather than physical trading floor.
Trading takes place over the telephone and through automated execution and trading systems.
Trades are executed at the prices displayed and size on NASDAQ terminals.

Tokyo Stock Exchange:

The Japanese stock market has a history of over 131 years beginning with the establishment of Tokyo
Stock exchange in 1878. Of the eight stock exchanges in Japan, three exchanges – Tokyo, Osaka
and Nagoya are the largest. The Tokyo Stock exchange in its present form was established in 1949
and accounts for about 80% of trades in both volume and value in Japan. At the end of 1977 there

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were 2387 companies quoted on the stock exchanges in Japan with a market capitalization of
2,216,699 million yen. Tokyo is the second most active stock exchange in the world after the NYSE.
The 30 actively traded shares account for about 20 percent of the total turnover of $12,51,750 million.

London Stock Exchange.

The London Stock Exchange (abbreviated LSE) is one of the leading stock exchange markets of UK
and the World. Founded in 1801, it is one of the largest stock exchanges in the world, with many
overseas listings as well as UK companies. The LSE is the most international of all stock exchanges
with 350 companies from more than 50 countries, and it is the premier source of equity-market
liquidity, benchmark prices and market data in Europe. Linked by partnerships to international
exchanges in Asia and Africa, the LSE aims to remove cost and regulatory barriers of capital markets
worldwide

Summary

• The BSE is the oldest stock exchange in Asia, even older than the Tokyo Old Exchange.
• NSE and BSE together form the two most important stock exchanges in India.
• Both of the stock exchanges are governed by set of laws, which prevents any practise against
public interest.
• Some of the prominent stock exchanges in the world are the NYSE, NASDAQ, Tokyo Stock
Exchange and the London Stock Exchange.

Question 20.1

Q 20.1Define “Asset Management”?

A 20.1 Asset management is a methodology to efficiently and equitably allocate resources amongst
valid and competing goals and objectives. Some other notable definitions of the same, given by
premier world bodies are as follows,
“…A methodology needed by those who are responsible for efficiently allocating generally insufficient
funds amongst valid and competing needs.”
— The American Public Works Association Asset Management Task Force
“…A comprehensive and structured approach to the long-term management of assets as tools for the
efficient and effective delivery of community benefits.”
Strategy for Improving Asset Management Practice, AUSTROADS, 1997

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Q 20.2 How do you describe the Asset Management Framework?

A 20.2 The Asset management is depicted by the following figure.

The “who and how” drive the need for an effective practice of asset management, while the “asset
management enablers” are those components which make the functioning of asset management a
success.

Q 20.3 Detail your understanding on Asset Management and list out the guiding principles of
the same.

A 20.3 Asset Management is a set of processes, tools, and performance measures and shared
understanding that glues the individual improvements or activities together. Or rather, since it is a very
dynamic and self-adjusting set of techniques, it is the lubricant that keeps all the cogs from grinding
against each other. Asset Management comprises of some fundamental guiding principles that make
it a success. These fundamental principles are,

• Customer focused
• Mission driven
• System oriented
• Long-term in outlook
• Accessible and user friendly
• Flexible

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Q 20.4 What makes Asset Managers so important?

A 20.4 It has been common phenomenon worldwide that some of the areas of work that had been
previously supervised by the government (road constructions, airports, banks etc) are increasingly
being privatised. In such a scenario, an asset manger is the best person to have on the work
premises, who can be entrusted with the job of taking care of the assets in use. Asset management is
about effectively managing physical assets and facilities to enable an organisation to maximize its
corporate objectives or charter.

Question 20.5

Q 20.5 List out the services offered by an Asset Manager.

A 20.5 As pointed out in the last question, asset management is about effectively managing physical
assets and facilities to enable an organisation to maximize its corporate objectives or charter. This
can only be achieved by aiming to maximise the effectiveness of current assets and facilities. In such
case an asset manger can effectively,

• Establish and identify the actual cost of owning and operating these assets and facilities
• Aligning the cost of assets and facilities with the organisation’s business or service direction
• Reducing the recurrent costs of asset and facilities ownership without impacting on the
business or service level requirements;
• Maximising the utilisation of current and future assets and facilities to avoid unnecessary
capital expenditure.

Q 20.6 What is the scope of operation for an Asset Manager? Stating differently, where does he
actually fit in the scheme of things.

A 20.6 The following diagram illustrates the role of an asset manager.

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Question 20.6 Conti

As is evident from the above diagram, the role of an asset manager lies somewhere in between the
business managers and the engineers and/or technical specialists. The boxes on the right-hand side
extreme give us the competitive edge/distinctive features of each of the role, while the boxes on the
left define the work responsibility each of the role are entrusted with.

Q 20.7 Is an Asset Manager same as the facility manager or the service provider? If not what
differentiates his scope of action?

A 20.7 An Asset Manager is often confused with a Facility Manager (and is even substituted for
Service Provider). The following diagram has been provided to bring out the relevant differences
between all the three roles.

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Q 20.8 How do you make Asset Management work?

A 20.8 The following steps ensure the same.

• Coordinated objectives

First and foremost in establishing Asset Management regime is involves making the objectives clear
to everyone. There may be many interests to satisfy, and some of them are naturally conflicting. The
regime must ensure that all business objectives are considered, and minimise the inherent clashes
between key performance indicators.

• Linking the activities, processes & responsibilities

The overall map of Asset Management processes is very complex. Underpinning all of the activities of
Asset Management are some vital enablers – without which the individual activities grind together,
and we would end up back where we started.

Question 20.9

Q 20.9 State the Asset Management enablers.

A 20.9 Following are some of the asset management enablers.

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• Organisation alignment: agreed objectives, shared understanding, excellent leadership and
communication.
• Integrated data, information and knowledge management: the right data collected, to the
appropriate quality/detail, available to those who need it in a timely and appropriate form,
based on the actual business (decision) needs for that information.
• Risk awareness and acceptance: building risk evaluation into normal decision-making.
• Long term-ism: taking account of long-term repercussions in short-term actions and decisions
(e.g. Life Cycle Cost analysis).

Q 20.10 What are benefits that accrue to the organization with effective Asset Management?

A 20.10 To summarize, Asset management is one such concept, the successful implementation of
which will result in following advantages/benefits to the organization.

1. Highlighting the economic importance of the concerned asset.

2. Recognising the income (and costs) of infrastructure within a framework that is clearly
understandable by all stakeholders.

3. Control and perhaps even reduction of costs.

• Assets management is a methodology to efficiently and equitably allocate resources amongst

valid and competing goals and objectives.
• With more professionalism creeping into business operations, asset managers have gained
tremendous importance.
• An asset manager is a distinct designation and should not be confused with a Facility Manager
or a Service Provider.
• Successful implementation of Asset management can result in huge monetary
benefits/savings to the organisation.

• Assets management is a methodology to efficiently and equitably allocate resources amongst

valid and competing goals and objectives.
• With more professionalism creeping into business operations, asset managers have gained
tremendous importance.
• An asset manager is a distinct designation and should not be confused with a Facility Manager
or a Service Provider.
• Successful implementation of Asset management can result in huge monetary
benefits/savings to the organisation.
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Question 21.1

Q 21.1 What led to the evolution of advisory services?

A 21.1 With the growing importance of investment banking across the globe, its advisory functions are
beginning to find worldwide acceptance. People are looking at these advisory functions, with
increased confidence. One of such functions is corporate advice. However, these services are spread
over a vast spectrum of corporate activity. Some of them are very well suited for investment banks,
with the rest finding place with specialist advisory firms. The essence of corporate advisory services
for investment banking relates to Business advisory, Restructuring advisory, Project advisory and
Merger & Acquisition advisory.

Q 21.2 What do you understand by corporate advisory services?

A 21.2 “Corporate Advisory Services” is an umbrella term that encompasses specialised advices
rendered to corporate houses by professional advisers such as accountants, investment banks, law
practitioners and host of similar service providers.

Q 21.3 What makes corporate advisory services important?

A 21.3 The factors that necessitate the need for corporate advisory services are.

• With the world growing at a rapid pace, the company would not want to lose out on some vital
opportunities. It may look out for expansion opportunities, go in for strategic alliances, seek
profitable mergers and acquisitions etc, to improve upon its current standing. The transactions
and formalities involved in such a case need to be professionally handled and there tends to
be a need for a specialist intermediary to the proposed transaction. Such specialists enable a
hassle free service, which in turn will enable the company to get done with the job easily and
effectively.

• A company may have thousands of complex business processes to be handled and much of it
can even be on a daily basis. A majority of these transactions can have several implications
e.g. business and legal angles, and so as to arrive at an effective structure that can further the
interests of the company. Besides, the above activities will be better done with someone with
the requisite experience and expertise. It is here that corporate advisory services find a place.

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• There may be several areas (which are of interest to the company) that may need specialised
advice before initiating a business plan. Suppose a person X plans to start a business. He
may have to study the feasibility of the project, the environmental conditions, the political
aspects, sources of financing and many similar aspects. All this needs specialised handling
and may not be done very efficiently by anyone and everyone and demand professionals with
exposure in such areas of service.
• Often a company finds itself in the need of restructuring its operations or its financial
statements, with a motto to revamp its current state of affairs or to bring about a much-needed
change in the current state of affairs. On the other hand, it might just be a financial
compulsion. But no matter what the reason is, restructuring has to take place and need be
looked at from business and financial (and legal) perspective. Corporate advisers in such
cases come in as very handy in meeting these considerations.

Q 21.4 Given the dynamics of advisory functions, what is the scope of Corporate Advisory
Services?

A 21.4 The functions that are covered by the corporate advisory services fall under a broad spectrum
and address a wide range of corporate objectives; they also necessitate a multi-disciplinary approach.
There are many professional bodies that provide such services. These professional bodies can be
classified under three broad categories.

• Starting with professional firms such as company secretaries, chartered accounting firms, law
firms etc, who provide corporate advisory services. The services of these firms are mostly two
fold:

1. Firms that provide a specialised service (which matches their core competency) in the form of
complete solution. Some of these services can be taxation advice, legal vetting, statutory
compliance work, evaluating a business proposal etc.
2. There are other firms who provide complementary services wherein the investment banks
provide the necessary transaction support. For example, two companies X and Y (who have
their own investment banks for advise) have agreed on a merger. Now these firms can rope in
accounting firms to provide for the necessary paper work like company valuation etc. Similarly,
a law firm can also be roped in to look after the legal aspect connected with the merger.

• There are sets of Investment banks and other financial institutions with merchant banking
licenses. The important advisory services provided by these investment banks and merchant

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banks relate to numerous services like business advisory, restructuring advisory, project
advisory etc. Companies do appreciate the expertise, which investment banks bring along with
them in dealing with such issues.
• Lastly, we have a set of pure advisory firms that provide a wide range of corporate advisory
services. These firms are specialists in some selected verticals. We have Mckinsey & Co.,
which specialise in strategy consulting and advise governments and corporates on strategy
and policy issues. Likewise, there may be firms specialising in technology, marketing, human
resource, risk management, foreign exchange etc. In some case these consulting firms also
take up issues of providing advice on M&A, joint ventures, formulation of business plan (which
are primarily investment banking activities).

Q 21.5 What are services that make up the Business Advisory Services?

A 21.5 Business advisory services relate to considerations involved in corporate restructuring, joint
ventures and collaborations and cross-border investments. This entails rendering of advisory services
pertaining to a company’s present and future businesses from a strategic and financial perspective.

Q 21.6 What are the services rendered by Investment Banks?

A 21.6 Investment banks render the following services:

• Entry Strategy Plans

• Project Feasibility Plans
• Corporate Plans
• Business Alliances
• Cross Border Investments

Q 21.7 What do you mean by Entry Strategy Plans?

A 21.7 This advice is required by a company when it plans to venture in to a new business either in a
new line of business or existing line of business in a new market be it local or international. The
strategy can be in terms of corporate structure of a product and pricing strategy, target market
segment, strategic alliance etc. Let us consider an example of an Indian company planning to set
shop in a foreign country. The strategic recommendation required by the company can be a decision
between establishing a wholly owned subsidiary vis-à-vis a joint venture with a local partner.

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Q 21.8 What do you mean by Project Feasibility Plans?

A 21.8 The viability of a proposed business has to be examined from a business, technology and
financial perspective before any fund raising activity is carried out by the corporate. Investment banks
have the capability to conduct such feasibility studies from a business and financial perspective since
they have in-depth information on each industry space.

Q 21.9 What do you mean by Corporate Plans?

A 21.9 Companies need to formulate medium to long-term corporate plans in order to carry out their
expansion and business strategy. Those companies which do not have in-house corporate planning
department, depend on investment banks for these services and those companies which have an in-
house corporate planning department, believe in getting the same vetted by an investment bank. The
formulation of corporate plans involve:

• In-depth examination of the industry

• In-depth examination of the business
• Identification of growth drivers
• Market positioning
• Product policies
• Diversification strategies
• Corporate and group structure etc

Q 21.10 What do you mean by Business Alliances?

A 21.10 This relates to joint ventures, collaborations and other such strategic relationships between
two corporate entities that are brought about due to business compulsions or to harness synergies
and complementary strengths. Investments bankers carry out the following tasks in this regard:

• Identification of partners with complementary strengths or synergies

• Due diligence and valuation aspects
• Negotiation and deal making

Question 21.11

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Q 21.11 What do you mean by Cross-Border Investments?

A 21.11 Strategic business investments are made in foreign entities owned or controlled by the
investing corporate in the parent country or in other foreign entities. Investment banks carry out an in-
depth examination of the financial and regulatory issues that are necessary to arrive at the optimum
size of the investment, valuation methodology, investment structure and taking necessary regulatory
clearances.

Summary

Summary

• With the increased acceptance of investment banking across the globe, corporates,
government bodies, individuals are looking at advisory functions with renewed confidence.
• The term “Corporate advisory services” encompasses many a functions like accounting, legal
advice, taxation advice and a host of similar activities.
• Besides equipping companies with its huge store of knowledge, corporate advisory services
ensure multi-disciplinary approach.
• Corporate advisory services include highly specialised and complementary activities to further
the business interests of the company.
• Business advisory services relate to considerations involved in corporate restructuring, joint
ventures and collaborations and cross-border investments
• Business Alliances relate to joint ventures, collaborations and other such strategic
relationships between two corporate entities.

Q 22.1 What does project advisory services imply?

A 22.1 Project advisory services falls under one of the core branches of corporate advisory services.
It deals with the decision of financing a project based on its strength of assuring the future cash
inflows. In other words Project financing deals with financing a project, which can in turn generate
return for its stakeholders and help in repaying the interest and loan on the proposed project. The
assets used for undertaking that project are used as collateral for financing that project.

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Q 22.2 Differentiate between Project financing and other types of financing?

A 22.2 The following constitute the differences between project financing and the other types.

• In project financing, the lenders look at the strength of the project to perform and generate
sufficient returns to serve the interest and loan on that project. Even if the assets are taken as
collateral, they may not be able to cover the entire loan through the sale of assets. Hence the
lenders mainly look about the profitability of the project. Where as in asset financing, the
lenders are mainly interested in the value of the asset if sold.
• The level of risk for the lender in financing a project can fall under both business risk and
financing risk. Business risk is the one that is associated with the business of the borrower
and the financing risk is the risk of financing that particular borrower. Where as if we talk
about asset financing, the risk involved is only up to financing risk.
• The risk of financing a project is more, as the project has to be analyzed even before testing
the market. The amount financed will be totally utilized in running the project and then the risk
will totally be dependent on the profitability of the project.

Q 22.3 What is the genesis of the Project financing process?

A 22.3 The process of project financing starts from the very initial stage of analyzing the project and
then moving on to the requirements of lenders, the statutory provisions, the sponsors and other
investing parties in the project and finally ends at the repayment of the long-term borrowings related
to it.

Q 22.4 What are the various components that aid the project financing process?

A 22.4 The following components take care of the financing process.

• Project Conceptualization
• Project Structuring
• Project Consortium
• Key Project Contracts

Q 22.5 Discuss Project Conceptualization.

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A 22.5 The main requirement of financing depends on the concept of the project, the business
opportunity for it in the market and also the revenue model. Convincing the lenders for financing a
project becomes comparatively easy if the project is not first of its kind. If the project uses a
technology that is already in use and perceives profitability it becomes easier to convince the lenders.
The project should also satisfy the policy requirements of the government, the lending institutions and
the banks

Q 22.6 Discuss Project structuring.

A.22.6 Project structuring focuses on reducing the risks associated with the project in areas like
location, operational, production and distribution, technology identification, marketing issues and the
promoter resourcefulness.

Q 22.7 Discuss Project consortium.

A 22.7 A strong project consortium helps in reducing the time required to achieve the financial
closures of the project. Depending on the nature and size of the project, the consortium may consist
of the combination of project sponsors, technology providers, suppliers, contractors and various other
investors.

Q 22.8 Discuss Key project contracts.

A 22.8 These are the contracts that should be kept ready before the company enters in to any of the
financial contracts. Some of the key project contracts in infrastructure and other projects consist of
shareholders agreement, license agreement, EPC (Equipment procurement and construction
contractors) contract, operations and maintenance agreement, product buy back or usage agreement,
foreign collaboration and technology transfer agreement, joint venture agreements etc.

Q 22.9 What are the major options available to the company to finance its projects?

A 22.9 The major options available are as follows

• Project financing through long term debts

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• Project financing through equity

Q 22.10 Discuss Project financing through long-term debt?

A 22.10 Project financing through long term debts takes three forms. They are

• Domestic rupee term loans:

The project can be financed by short term or long-term loans from domestic financial institutions and
commercial banks. They can finance the project through rupee loans or the foreign currency loans
and guarantees. These loans can be either fixed interest rate or floating interest rate pegged to some
benchmark rate.

• External commercial borrowings:

Loans raised for financing a project from outside India are called as external commercial borrowing.
These borrowings are named so because they also add to the external debt of the country.

• Debentures and other debt securities:

In some cases, the project can be financed through debentures, bonds and other debt securities. The
projects can make use of private institutional investors or IPOs for getting the debentures and other
debt securities

Q 22.11 Discuss Project financing through equity?

A 22.11 The main source of equity for a project will be its promoters. Other sources include
consortium partners, investors, collaborators, JV partners, and institutional buyers.

Q 22.12 List out the Project advisory and transaction services provided by investment banks.

A 22.12 The different services offered by the investment banks in project advisory and transaction
services are as follows

• Investment banks can help in formation of the consortium and also in structuring the
consortium agreements.

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• Means of finance in project structuring.
• Incase the project is awarded to a particular consortium through bidding process; investment
bank can offer bid advisory services.
• Investment banks can advise in shareholders agreements, equity shareholding pattern and
subscription agreements.
• Advising for entering in to other vital project contracts.
• Helping in project report, linked documents and loan applications.
• Investment banks can act as “arranger” in behalf of the client for representing and negotiating
with lenders and investors.
• § Investment banks can help in private placements or public offers of equity and debt.
• § Investment banks can help in achieving the financial closure in the optimal terms and time
for the project.

Summary:

• Project financing deals with the decision of financing a project based on its strength of
assuring the future cash inflows.
• The process of project financing covers different stages like project conceptualization, project
structuring, project consortium, key project contracts, financing through long-term debt and
equity financing
• Investment banks also provide project advisory services and transaction services for running a
project.

Q 23.1What do you understand by financial restructuring?

A 23.1 Financial restructuring is the process of reshuffling or reorganizing the financial structure,
which primarily comprises of equity capital and debt capital. Financial restructuring can be done
because of either compulsion or as part of the financial strategy of the company. This financial
restructuring can be either from the assets side or the liabilities side of the balance sheet. If one is
changed, accordingly the other will be adjusted.

Q 23.2Name the two components of financial restructuring.

A 23.2 The two components of financial restructuring are

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• Debt Restructuring
• Equity Restructuring

Q 23.3What does debt restructuring imply?

A 23.3 Debt restructuring is the process of reorganizing the whole debt capital of the company. It
involves reshuffling of the balance sheet items as it contains the debt obligations of the company.
Debt restructuring is more commonly used as a financial tool than compared to equity restructuring.
This is because a company's financial manager needs to always look at the options to minimize the
cost of capital and improving the efficiency of the company as a whole which will in turn call for the
continuous review of the debt part and recycling it to maximize efficiency.54

Q 23.4What are possible ways of making debt restructuring a possibility?

A 23.4 Debt restructuring can be done based on different circumstances of the companies. These can
be broadly categorized in to 3 ways.

1. A healthy company can go in for debt restructuring to change its debt part by making use of the
market opportunities by substituting the current high cost debt with low cost borrowings.

2. A company that is facing liquidity problems or low debt servicing capacity problems can go in for
debt restructuring so as to reduce the cost of borrowing and to increase the working capital position.

3. A company, which is not able to service the present financial obligations with the resources and
assets available to it, can also go in for restructuring. In short, an insolvent company can go for
restructuring in order to make it solvent and free it from the losses and make it viable in the future.

Q 23.5Mention the components of debt restructuring?

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A 23.5 The components of debt restructuring are as follows

• Restructuring of secured long-term borrowings

• Restructuring of unsecured long-term borrowings
• Restructuring of secured working capital borrowings
• Restructuring of other term borrowings

Q 23.6Detail on the components of debt restructuring mentioned in the previous question.

A 23.6 By and large, a company takes different types of borrowings each having different terms.
These are generally classified in to the following:

• Restructuring of secured long-term borrowings

Restructuring of secured long-term borrowings will be done for the following reasons such as reducing
the cost of capital for healthy companies, for improving liquidity and increasing the cash flows for a
sick company and also for enabling rehabilitation for that sick company.

• Restructuring of unsecured long-term borrowings

Restructuring of the long-term unsecured borrowings will be done depending on the type of borrowing.
These borrowings can be public deposits, private

loans (unsecured) and privately placed, unsecured bonds or debentures. For public deposits, the
terms of deposit can again be negotiated only if the scheme is approved by the right authority.

• Restructuring of secured working capital borrowings

Credit limits from commercial banks, demand loans, overdraft facilities, bill discounting and
commercial paper fall under the working capital borrowings. All these are secured by the charge on
inventory and book debts and also on the charge on other assets. The restructuring of the secured
working capital borrowings is almost all the same as in case of term loans.

• Restructuring of other short term borrowings

The borrowings that are very short in nature are generally not restructured. These can indeed be
renegotiated with new terms. These types of short-term borrowings include inter-corporate deposits,
clean bills and clean over drafts.
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Q 23.7 What role does Investment banking play in debt restructuring?

A 23.7 Investment banks provide services for companies undergoing debt restructuring.

The various steps involved in advising are:

1. Formulating a viability plan for the company

2. Floating the debt restructured scheme

3. Presenting the debt restructuring scheme to the lenders and representing the client in discussions
and negotiations.

4. Investment banks provide transaction services, which are important for meeting the stated
requirements.

5. After the debt-restructuring scheme is approved, it has to be ratified by the concerned approving
authorities in each of the lenders organizations.

6. Investment bankers work closely with other professionals for the legal work and the compliance
required for debt restructuring services.

Q 23.8 What doe equity restructuring imply?

A 23.8 Equity restructuring is the process of reorganizing the equity capital. It includes reshuffling of
the shareholders capital and the reserves that are appearing in the balance sheet. Restructuring of
equity and preference capital becomes a complex process involving a process of law and is a highly
regulated area. Equity restructuring mainly deals with the concept of capital reduction.

Q 23.9 What are various methods of giving effect to equity restructuring?

A 23.9 The following are the some of the various methods of restructuring.

• Repurchasing the shares from the shareholders for cash can do restructuring of share capital.
This helps in reducing the liability of the company to its shareholders resulting in a capital

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reduction by returning the share capital. The other method that falls in the same category is to
change the equity capital in to redeemable preference shares or loans.
• Restructuring of equity share capital can be done by writing down the share capital by certain
appropriate accounting entries. This will help in reducing the amount owed by the company to
its shareholders without actually returning equity capital in cash.
• Restructuring can also be done by reducing or waiving off the dues that the shareholders need
to pay.
• Restructuring can also be done by consolidation of the share capital or by sub division of the
shares.

Q 23.10 State the reasons behind equity restructuring.

A 23.10 The following are the reasons for which equity restructuring is done:

• Correction of over capitalization

• Shoring up management stakes
• To provide respectable exit mechanism for shareholders in the time of depressed markets by
providing them liquidity through buy back.
• Reorganizing the capital for achieving better efficiency
• To wipe out accumulated losses
• To write off unrecognized expenditure
• To maintain debt-equity ratio
• For revaluation of the assets
• For raising fresh finance

Summary

• Financial restructuring is the process of reshuffling or reorganizing the financial structure,

which primarily comprises of equity capital and debt capital.
• Debt restructuring is the process of reorganizing the whole debt capital of the company.
• The components of debt restructuring include restructuring of secured and unsecured long-
term borrowings, restructuring of secured working capital borrowings and other short term
borrowings
• Equity restructuring is the process of reorganizing the equity capital. It includes reshuffling of
the shareholders capital and the reserves that are appearing in the balance sheet.

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