CHAPTER 10 Financial Market

Transcription

1 CHAPTER 10 Financial Market A financial market refers to a market where the creation and exchange of financial assets (such as shares and debentures) takes place. Allocative Function of Financial Market An important function of the financial market is known as the allocative function. A financial market acts as a link between the savers and the investors. It provides a platform for the mobilisation of savings from the households to the investors. Thus, it allocates funds from households to the investors. Consequences of Allocative Function A well-performed allocative function has the following consequences: i. A higher rate of return would be offered to the households. ii. Resources are allocated to those firms that have the highest productivity. Some terms related to allocative function Financial Intermediation- It refers to the process through which the allocation of funds is carried out. Financial Transactions- It refers to the transactions in the form of creation of new financial assets or sale and purchase of the existing financial assets. Functions of Financial Market 1

2 Financial markets play a vital role in allocating scarce resources of the economy by performing the following functions: 1) Transfer of savings and alternatives for investment- A financial market acts as a platform for the mobilisation of savings from the households to the investors. In this way, it provides the investors with various alternative choices for investment. 2) Establishes the price- It provides a platform for the interaction of the demand and the supply of funds, thereby helping in determining the price of the asset being traded. 3) Facilitates liquidity- It renders liquidity to the assets in the sense that through trading (sale and purchase of assets) in the financial market, the assets can easily be converted into cash or cash equivalents. 4) Reduces the cost of transaction- It provides useful information about the various securities that are traded. In this way, it helps in reducing the cost of transaction in terms of time, effort and money for both the buyers and sellers. Classification of Financial Market Financial market can be classified into two broad categories: Capital market and Money market. The following diagram depicts the difference between the two. Money Market It refers to the market for trading of short-term securities and funds. Securities traded in this financial market have a very short maturity period ranging from one day to one year. 2

3 Instruments of Money Market The following diagram depicts the various instruments of money market: i. Treasury Bill (T-Bills) These are highly liquid promissory notes used by the government for short-term borrowings. They are auctioned and issued by the RBI on behalf of the Central Government. T-bills are available for a minimum of Rs 25,000 and in multiples thereof. They are issued at a discount and redeemed at par. T-bills are also known as zero-coupon bonds. ii. Call Money Call money are used by the commercial banks to maintain their CRR (cash reserve ratio) requirements. That is, through call money, any bank that faces shortage of funds to maintain the minimum CRR borrows from other banks that have surplus funds. This instrument has a very short maturity period (ranging from 1 to 15 days). Interest paid on call money is termed as call rate. Call rate is highly volatile and varies on a day-to-day basis. 3

4 iii. Commercial Paper It is an unsecured, negotiable and transferable promissory note. They are mainly issued by large companies to raise short-term funds and serve as an alternative to bank borrowings and borrowings through capital market. Companies use commercial papers for bridge financing. Commercial papers have a maturity period ranging from a minimum of 15 days to a maximum of one year. The rate of interest payable on commercial papers is lower than the market rates. iv) Certificate of Deposit They are negotiable, unsecured instruments in bearer form. CDs are issued to individuals, corporations and companies by commercial banks and financial institutions. They are used by commercial banks to meet the demand for credit during periods of tight liquidity. They are issued for a specified time period ranging from one month to more than five years. Higher interests are offered for higher deposits. v) Commercial Bill Commercial bills are used by companies to finance their working capital requirements (for instance, to finance their credit sales). It is a short-term negotiable instrument used by companies to finance their credit sales. Herein, the seller draws a bill of exchange and gives it to the buyer. Once the buyer accepts the bill, it becomes a tradable instrument. The seller can then discount the commercial paper with a commercial bank and obtain cash. Commercial paper is also known as bill of exchange. Capital Market A capital market refers to the market that deals in the trading of medium and long-term securities (having a maturity period of greater than or equal to one year). The instruments traded in capital market comprise equity and preference shares, debentures, bonds, etc. Capital market can further be divided into two categories: Primary Market and Secondary Market 4

5 Characteristics of Capital Market 1) It solely deals in trading of long-term securities. 2) It acts as a platform that links the savers and investors. It directs the savings of the households to their most productive use. In this way, it adds to the growth prospects of an economy. 3) It works strictly according to the guidelines and policies issued by the government. 4) Major intermediaries involved in the capital market include banks, brokers, transfer agents, etc. Importance of Capital Market 1) Long-term resources- It facilitates the raising of long-term funds in the form of both debt and equity. 2) Facilitates growth- By channelising the savings to the most productive use, it facilitates growth and development of the economy. 3) Capital formation- It helps in capital formation by increasing and stimulating the level of savings and investments through productive channels. 4) Mobilises savings- It helps in channelising and mobilising the savings only in those places where they can be utilised efficiently and effectively. 5

6 Primary Market (New Issue Market) Primary market refers to a market that deals with the issue of new securities. It directs funds towards those entrepreneurs who either want to start a new enterprise or wish to expand the existing one. Methods of Floatation in Primary Market i. Offer through prospectus- Under this method, a prospectus is published in newspapers, magazines, etc., in accordance with the guidelines and rules listed under the Companies Act and SEBI disclosure. The subscriptions are then invited from the public through this prospectus. ii. Offer through sale- In this method, securities are issued through intermediaries by following the below-mentioned two steps: A company sells its securities to the intermediaries at the face value. Intermediaries in turn resell the securities to the investing public at a higher price than the face value, in order to earn profits. iii. Private placement- In this method, the securities are sold only to some selected individuals and big institutional investors rather than to the general public. Herein, companies either allot the securities themselves or sell them to intermediaries who in turn sell these securities to selected clients. 6

7 iv. Rights issue- In this method, existing shareholders are offered subscription of new shares of the company in proportion to the number of shares possessed by them. v. e-ipos- It is a system of issuing securities through online system. Herein, the company gets into an agreement with the stock exchange. Then, it appoints brokers for accepting applications and placing orders for the securities. Secondary Market Secondary market refers to a market that deals in the sale and purchase of existing securities. In other words, it deals in the trading of those securities that were initially issued in the primary market. It is also known as stock exchange. Functions of Secondary Market/Stock Exchange 1) One of the basic functions of secondary market is to provide liquidity and marketability to the already existing financial assets and securities. It provides a ready platform for the trading of existing securities. 7

8 2) It enables a constant valuation of the securities and helps in building the demand and supply. In this way, it helps in determining the price of the securities. 3) It ensures safety and fairness in transactions. 4) It provides a platform for channelising the savings to the most productive use. In this way, it facilitates growth and development of the economy. 5) It takes various measures to educate people about investment and encourage wider ownership of securities. In this way, it spreads equity cult. 6) A stock market acts as an economic barometer. It indicates the level of economic activity in the country. Differences in some important terms Difference Between Capital Market and Money Market Basis of Difference Capital Market Money Market Time Span of Securities It mainly deals in the trading of medium and long-term securities wherein the maturity period is more than one year. Liquidity Expected Returns Instruments Risk The securities traded are liquid in nature as they are tradable on stock exchanges. However, they are less liquid in comparison to the money market securities. Expected returns are higher due to the possibility of capital gains in the long term and regular dividends or bonus. Instruments traded comprise of equity shares, preference shares, debentures, bonds and other long-term securities. Capital market securities involve greater risk in terms of repayment of the principal amount. It deals in the trading of short-term securities wherein the maturity period can vary from one day to a maximum of one year. The securities traded are highly liquid in nature. This is because DFHI (Discount and Finance House of India) discounts money market securities and offers a ready market for them. Expected returns are lower due to shorter duration. Instruments traded comprise of treasury bills, commercial bills, certificate of deposits and other shortterm securities. Money market securities are less risky due to the short time period and sound financial position of the issuers. 8

9 Difference Between Primary and Secondary Market Basis of Difference Primary Market Secondary Market Securities Traded Securities Issued Price of Security Geographical Area Primary market deals solely in the sale and purchase of newly issued securities. Securities are directly issued by the companies. The prices of securities are determined by the company and its management. There is no fixed place for a primary market. That is, all institutions and companies constitute a primary market. Secondary market deals in the sale and purchase of already existing securities. Securities are transferred between the investors only. There is no involvement of a company here. The prices of securities are determined by the forces of demand and supply. Under a secondary market, trading takes place at specified locations and areas. Purchase and Sale Securities can only be purchased. Securities can be purchased as well as sold. Promotion of Capital Formation Capital formation is directly promoted funds from savers to investors are directly channelised to their most productive uses. Capital formation is indirectly promoted as the liquidity of securities is augmented. Steps Involved in Trading of Securities 1) Getting listed- The companies that want to sell their securities in the market first need to get them listed or quoted in the stock exchange. 2) Selecting a broker- After getting listed, the company appoints a broker for looking into the trade transactions. 3) Placing the order- As a next step, the company specifies the number and type of securities that it intends to sell. 9

10 4) Execution of the transaction- The brokers execute the order as per the instructions of the client. The transactions are executed through a computerised system. 5) Final settlement- The transactions of the stock exchange are finally settled on a cash or carry-over basis (which is also known as badla in the Indian stock market). Dematerialisation Account- A Dematerialisation Account (also known as Demat Account) is a pre-requisite for electronic trading in securities. In other words, if a person wants to trade the listed securities in electronic form, then it is mandatory for him/her to open up a Demat account in a depository bank. Depository- It is basically an organisation or an institution that holds the securities which are traded in the market. The services offered by a depository are known as depository services. Benefits of Demat Account and Depository Services Transparent and easy transactions Reduces the costs of transactions Saves time and efforts Enables trading of shares and stocks of any company Counterfeiting of securities is not possible Steps to Open a Demat Account The owner first approaches the depository participant. Documents such as identity proof, proof of address and PAN card are needed. The owner signs an agreement that states the rights of both the owner and the depository participant. The depository participant gives a copy of the agreement to the owner and the latter pays the due charges. The depository participant now opens an account in the computerised electronic system and gives the owner a unique number i.e., Beneficial Owner Identification Number. The owner approaches the clearing houses/corporations 10

11 SEBI- Securities and Exchange Board of India Role of SEBI Towards issuers- To provide a fair and efficient market for securities such that they can confidently raise finance in an easy manner. Towards investors- To provide protection to the investors against any kind of malpractices. Towards intermediaries- To offer a competitive and professionalised market such that the intermediaries are able to render their services in an efficient manner. Objectives of SEBI 11

12 The following are the primary objectives of SEBI: 1) Regulation- The primary objective of SEBI is to regulate the functioning of the stock exchange. It aims at providing a place where the issuers can raise funds in an easy and confident manner. 2) Protection- Another objective is to educate the investors by providing them valuable information regarding various securities and companies. 3) Prevention- It aims at combating various malpractices in trading of securities such as insider trading, violation of rules and regulations and non-adherence to Companies Act. 4) Code of Conduct- It aims to develop a code of conduct for fair trade practices by intermediaries such as brokers, merchant bankers and underwriters. Functions Performed by SEBI SEBI performs three broad functions, namely protective, regulatory and development functions as depicted in the following diagram. Each of these functions is discussed below: i) Regulatory Functions Registration- Registers brokers, sub-brokers, agents and other players in the market. 12

13 Regulating the work- Regulates the working of intermediaries such as stock brokers, underwriters and merchant bankers by framing rules and regulations for their operations. Regulation by legislation- Performs and exercises other authorities and powers which are delegated by the Government of India under the Securities Contracts (Regulation) Act, ii) Development Functions Training- Provides training and development to the intermediaries of the securities market so as to promote healthy growth of the secondary market. Research- Conducts research in the important areas of the securities market so as to help investors and other market players make wise investment decisions. Flexible Approach- Adopts a flexible approach in trading by permitting internet trading, IPOs, etc. iii) Protective Functions Prohibition- Prohibits fraudulent and unfair trade practices. In addition, it prevents the spreading of misleading statements which are likely to affect the functioning of the securities market. Checks on insider trading: Insider trading refers to a situation wherein an individual connected with the company leaks out crucial information regarding the company which may adversely affect its share prices. SEBI keeps a strict check on such practices. Promotion and protection- Encouraged fair trade practices and promotes a code of conduct for the intermediaries. Primary Market Advisory Committee and Secondary Market Advisory Committee- These committees comprise of various players that are involved in the primary and secondary market such as investor associations and persons from capital market. The main role of such committees is to provide suggestions and inputs in the formulation of the policies by SEBI. Objectives of the Two Advisory Committees 1) To advise in matters related to the regulation of intermediaries. 2) To advise in matters related to development of primary market and the secondary market. 3) To suggest on matters related to the disclosure requirements for the companies. 4) To advise on bringing about changes in legal framework. 13

14 National Stock Exchange of India (NSE) It was recognised as Stock Exchange in the year 1993 and began operations in It has two main market segments under it, namely wholesale debt market segment and capital market segment. Objectives of NSE 1) It aims at setting up a single nationwide trading system for providing trading facility in all types of securities. 2) It ensures that investors all over the country get easy and equal access to securities through an appropriate communication network. 3) By using an electronic trading system, NSE aims at providing a fair, efficient and transparent securities market. 4) Enables shorter settlement cycles and book entry settlements. 5) Meets the international standards and benchmarks of stock exchange. Over the Counter Exchange of India (OTCEI) It is a stock exchange which commenced its operations in the year It aims at providing the small and medium companies an easy access to the capital market through a fully computerised and single window exchange system that is modelled along the lines of NASDAQ. Advantages of OTCEI 1) It provides a platform for smooth trading of securities of small and less liquid companies. 2) OTCEI is economical in the sense that new issues are purchased at a low cost and lower expenses are attached with servicing of the investors. 3) It allows trading in newly issued securities as well as the already existing ones. 4) As OTCEI is a single window exchange, it provides the players a direct mode of communication. 5) Being a fully computerised exchange system, OTCEI helps in providing a transparent and safe trading system. 14