FINANCIAL MARKET OPERATIONS (UNIT-3) CAPITAL MARKET (PART-1)

FINANCIAL MARKET OPERATIONS (UNIT-3) CAPITAL MARKET (PART-1) 1. INTRODUCTION Hello viewers, Welcome to the lecture series on Financial Market Operations. Today we are going to take up Unit -3 and we are going to discuss about capital markets. Capital Market is one of the components of Financial Markets and we are going to learn about its composition and structure under this lecture. Our learning objective is:- To acquaint the students with the working of financial markets in India. To understand the structure and composition of Capital Market To learn the roles and function of stock exchange Listing procedure and legal requirement as well as Public issue their Pricing and Marketing When we are learning these objectives we will have an insight of capital market in detail. 1

2. CAPITAL MARKET Now let us understand what capital markets are? The market where investment instruments like bonds, equities and mortgages are traded is known as the capital market. The primal role of this market is to make investment from investors who have surplus funds to the ones who are running a deficit. So let us analyze this definition. Capital Market is a form of market and the capital market instruments are bonds, equity and mortgages. So where any financial asset is being used for raising the funds, such market is known as capital market. Let us take up an example and understand it in a layman language XYZ co. is going to start up a new business and it is in need of certain fund. That fund can acquired fund from the public rather than going to any financial institution. If the investment is taken from the public, the company is going to issue shares. So those who are investing into the company their money they are going to get equities and in turn the company will get money from those who are having surplus because the company is having the deficit fund which they have met up by going for the issue of shares and public at large subscribe those shares and give their contribution to the one who needs it and in turn they get return for their investment. So, this is the basic premises of capital market that the investment from investors will move to one who is getting the shortage of fund again it is also a channelization of the fund or the surpluses into the investment. Let us highlight the nature of capital market. The nature of capital market is brought out by the following facts: It Has Two Segments It Deals In Long-Term Securities It Performs Trade-off Function 2

It Creates Dispersion In Business Ownership It Helps In Capital Formation It Helps In Creating Liquidity The capital market offers both long term and overnight funds. So, one by one let us analyze. It has two segments because it is dealing with issue of new shares as well as their trading of the shares. So Primary and secondary markets are also part of it. It performs trade off function that means trading is being done where the tradeoff is being ascertained by the purchasing and selling of the scripts and securities Dispersion in Business Ownership means the Ownership and Management are being separated those who are investing the funds into the business are owners of the business however the company is the acquirer of the funds. It helps in capital formation as the savings are being channelized into the investments and in turn the idle funds are being transformed into the investments which are getting their returns on it. And the liquidity is also being generated out of the funds which are being released from those who are having them extra to those who need them. The capital market offers both long term and overnight funds. The different types of financial instruments that are trade in the capital markets are Equity instruments that mean equity shares, equity instruments are those instruments which gives the voting right to the investors and the 3

amount of the share which an investor is holding he has been owner or ownership to that extent. Credit market instruments such as debts, insurance instruments, Forex that means foreign exchange instruments, derivatives, options, swaps they can be there. Hybrid instruments: they can be mixture of equity and debt financing Derivative Instruments. Like options, commodity related derivatives. Basically capital market is having instruments which are focused on the equity and debts. The capital market is a market for financial assets which have along or indefinite maturity. Here, financial assets mean those assets which when used, are used in generation of any revenue and they are being used in the production like share capital. Share capital is financial asset because when share is being issued, the amount is being used in the acquisition of long term assets or for working capital. And in turn the investor gets return out of it. So here in the capital market the financial assets have a long or indefinite maturity that means unlike the money market which meets the short term funds requirement; capital market is dealing with financial assets which have a long or indefinite maturity. Generally, it deals with long term securities which have a maturity period of above one year. Capital market may be further divided into three, namely: 1. Industrial Securities Market 2. Government Securities Market and 3. Long-term Loans Market. 4

So here we can analyze that there are certain differences between capital market and money market. Money market is concerned with the funding that is borrowing and accepting of deposits loans and interest spread is the main functioning over there. While in the capital market the primary issue of shares as well as secondary trading of the shares is being taking place here. The maturity period of the securities or investments are low in the money market it varies from one day to 14 days or can extend up to one year in the case of money market while in the case of capital market the maturity can be for indefinite period and generally more than 1 year. So again we have certain segments of (money) capital markets they are known as. Industrial Securities Market 2. Government Securities Market and 3. Long-term Loans Market. Let us analyze these segments one by one 3. INDUSTRIAL SECURITIES MARKET As the very name implies, it is a market for industrial securities, namely: what can be these securities (i) Equity shares (ii) Preference shares and (iii) Debentures or bonds. So, Sources of financing would be equity shares. Equity shares are those shares which give voting right to the subscriber. It is the smallest part of the share capital of the company which a shareholder has and he is having the right to dividend to the extent of his shareholding into the business of any enterprise. Preference shares are those shares which are 5

having preferential rights at the time of liquidation; preferential payments are made to the preference shareholders. There can be redeemable or irredeemable preference shares. Debentures is the acknowledgment of the debt by the company that means equity and preference shares are the part of the share capital of the company while debentures would be the part of long term liabilities or long- term loans. Debentures and bonds are considered to be the long term loans which company has taken from any investor. It is a market where industrial concerns raise their capital or debt by issuing appropriate instruments. It can be further subdivided into two. They are a. Primary market or New Issue Market, b. Secondary market or Stock Exchange So under industrial securities those securities which fulfills the requirements of capital or debt of a company would be dealt in and there can be two types of securities market they are Primary Markets and secondary markets. So we will move ahead and learn what we mean by primary market and secondary market Primary Market: It is that market in which shares, debentures and other securities are sold for the first time for collecting long-term capital. This market is concerned with new issues. Therefore, the primary market is also called NEW ISSUE MARKET. Analyzing it, we can say that when first time any share comes into the market, they will be dealt in the primary market so the subscription to the new issue or the launching of the IPOs will be in the primary market. Primary market is a market for new issues or new financial claim Hence, it is also called new issue market which we have right now discusses. The 6

primary market deals with those securities which are issued to the public for the first time. In the primary market, borrowers exchange new financial securities for long-term funds. Thus, primary market facilitates capital formation. There are three ways by which a company may raise capital in a primary market. They are (i) Public issue (ii) Right issue and (iii)private placement Public issues are those shares which are those shares which are being issued to pubic or a new company is going to issue their first time share or an already existing company coming up with new issues of the shares they can be public issues. Right issues are those issues which are being given to the already existing shareholders, they are given certain rights. For example, if a shareholder is having 5 shares he will be giving 3 new shares. So the exchange ratio or right issue ratio is being decided for the issue of shares. Private placement is the method of selling shares privately to any institution or any group of people. Let us highlight Features of Primary Market It Is Related With New Issues It Has No Particular Place It Has Various Methods Of Float Capital: Following are the methods of raising capital in the primary market: They are further enhancement of 3 methods we have already learned that is public issue, offer for sale and private placement. Here also 7

i) Public Issue ii) Offer For Sale iii) Private Placement iv) Right Issue v) Electronic-Initial Public Offer First time whenever a security will come, it will be sold or come in primary market then the further dealings will be in secondary markets. 4. SECONDARY MARKET So let us understand the secondary market Secondary Market is a market for secondary sale of securities. In other words, securities which have already passed through the new issue market will be dealt in secondary market. Here secondary sale of securities means that first time it is being launched in the primary market now from the one who is having the security will sale or further sale those securities in a market known as secondary market and the general mechanism of buying and selling the secondary security is stock exchange. Generally, such securities are quoted in the stock exchange and it provides a continuous and regular market for buying and selling of securities. (so they) Quoted here means they are listed in the stock market and they are priced over there by a mechanism and they are being sold on stock market and it is being done on a regular and continuous basis. This market consists of all stock exchanges recognized by the Government. And in India there are 23 stock exchanges which are working in the form of secondary market for buying and selling securities 8

The transactions of the secondary market are generally done through the medium of stock exchange. The chief purpose of the secondary market is to create liquidity in securities. Liquidity here means securities are being readily converted into cash because whenever there is need of cash we can go and sell those securities in the stock exchange and when there is surplus fund we need to invest we can buy the securities. So there are certain trends at the time of recession they can be more buying of securities, when the market is on upward side, selling would be there. So again an equilibrium points come and in this way stock exchange work. So in this way, secondary market basically fulfills the need of liquidity for an individual or any enterprise. If an individual has bought some security and he now wants to sell it, he can do so through the medium of stock exchange to sell or purchase through the medium of stock exchange requires the services of the broker presently, there are 24 stock exchanges in India. Buying and selling would be transformed or could be channelized through a broker. Broker is a person who has been registered with stock exchange and who is having membership with the stock exchange and via broker these dealings will be done in stock exchange. Important Features of Secondary Market 1. It Creates Liquidity 2. It Comes After Primary Market 3. It Has A Particular Place 4. It Encourage New Investments Unlike the primary markets, where there is no space or certain particular place, the secondary market transactions will be done at a particular place which is known as stock exchange and of course, it will give way to new investments in the economy. 9

5. GOVERNMENT SECURITIES MARKET Now coming to the second important parameter of capital market It is Government Securities Market. First one was Industrial Securities market in which the requirement of capital and debt were met out. Now it is Government securities market. Let us understand it Government Securities Market It is otherwise called Gilt-Edged securities market. It is a market where government securities are traded. In India there are many kinds of Government securities short term and long term. Long-term securities are traded in this market while short term securities are traded in money market So Government Securities or called Gilt-Edged securities will be dealt in both types of market- the money market or the capital market depending upon their maturity period. Long-term Loans Market is the third segment of capital market. Long-term Loans Market Development banks and commercial banks play a significant role in this market by supplying long term loans to corporate customers. Long term loans market may further be classified into (i) Term loans, (ii) Mortgages and (iii) Financial Guarantees markets. So the third segment of capital market is Long term loan market. Here what happens that development banks, development banks are those banks which are established for some specialized sectorial development such as IDBI, IFCI, ICICI and some commercial banks. These banks play a significant role in supplying long term loans to corporate customers. That 10

means the big entities or big corporate entities when they are in need of funds, those needs will be fulfilled by long term loan markets under capital market and such loans can be term loans, Mortgage loan or financial guarantee markets. 6. CAPITAL MARKET RISK The next aspect related to the capital market is the Capital Market Risk. Let us understand what sorts of risk are involved in the capital market. 1. CAPITAL MARKET RISK Investment in long term financial instruments is accompanied by high capital market risks. Since there are two types of capital marketsthe stock market and the bond market. So risks are present in both the market that is in the stock market there will be risk and in the bond market also there will be risk associated with it. Risk in the Stock Market Stock prices keep fluctuating over a wide range unlike the bank deposits or government bonds because bank deposits and government bonds are risk free investment The efficient market hypothesis shows the effect of fundamental factors in changing the price of the stock market. The Efficient Market Hypothesis shows that all price movements are random whereas there are plenty of studies that reflect the fact that there is a specific trend in the stock market prices over a period of time. That means the slump, boom, these recessions, then revival these phases come at a specific trend for certain securities and it can be random also depending upon the market conditions. So there are two segments of hypotheses. 11

Research has shown that there are certain psychological factors that shape the stock market prices. Sometimes the market behaves illogically to any economic news. This news can be rise in the market prices or interest rate and so market moves accordingly and there are fluctuation in prices the stock exchange may move up or may move down depending upon the psychological impacts of those news. The stock market prices can be diverted in any direction in response to press releases, rumors and mass panic. The stock market prices are also subject to speculation. Speculation means there are certain guess works which are being done. In the short run the stock market prices may be very volatile due to the occurrences of the fast market changing events. Another aspect is Risk in the bond market Capital market risk in the bond market arises due to interest rate changes. There is an inverse relationship existing between the interest rate and the price of the bond. That means if interest rate increases, the price of the bond is going down, if interest rate falls down, prices would be increases. Hence the bond prices are sensitive to the monetary policy of the country as well as economic changes. 7. STOCK EXCHANGES Now let us have an overview about the stock exchanges subject to the government supervision and control they work. Basically they are being governed by two acts: SEBI and Securities Contract and Regulation Act (SECRA) 1956. Total numbers of stock exchanges are 23 there are two national stock exchanges in India one is BSE that is Bombay Stock Exchange and another is NSE that is National Stock Exchange. BSE was set up in 1857 in fact oldest in Asia and NSE was set up in 1993 has 70% share of the total trading. Out of 21 regional stock exchanges, 15 stock 12

exchanges reported NIL transactions. NSE is the harbinger of reforms in the capital market. So this is the scenario of the stock exchanges in India. That there are majorly two stock exchanges BSE and NSE and NSE is capturing 70% share of the total trading and it is bringing up the reforms in the capital marking. 8. SUMMARY Now students we are going to summarize our discussion on capital markets. We have learnt that capital markets are those markets in which financial assets are being dealt which are of long-term nature and there are certain instruments under capital markets that are equity funds, preference shares, debts instrument, foreign exchange instruments. And under capital market there are two types of markets which are primary market and secondary market where issues of shares are done. When shares come first time into the picture primary market is a place where dealing will be done and where regular buying and selling is done through a broker at a particular place that place is known as secondary market. We have also learned the position of stock exchanges in India that there are two main national stock exchanges that is NSE and BSE and we have insight of the market share of NSE and BSE. With this we are ending up our session of today. Hope there was a happy learning about the capital markets. Thank you 13