Capital Markets in India

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Capital market is a market where companies and governments can raise long-term funds for periods longer than a year. Capital markets can be understood on the basis of two basic components – (A) Securities and (B) Markets

(A) Securities

Securities are investment instruments issued by large corporations (private sector and public sector) for borrowing money from investors to raise capital. Investors in turn could be individuals, small-medium-large corporations and governments that invest in these instruments to earn a return. Securities are capital markets instruments, which can be further categorized into – equities and corporate bonds.

Equities

Equities are stocks representing ownership interest, which means the interest or importance shown by the investors in the assets of a corporation that are employed for producing and/or distributing goods and services. For example, and investor Haria invests or purchases stocks of Bharti Airtel that provides network services in Telecommunication industry with expectations that Bharti Airtel as a company would be a profitable investment. Some of the main components of equities based on which one can invest in equities are summarized below:

  1. Open price – The price at which a stock first trades upon the opening of the stock exchange
  2. High price – The price at which a stock has been traded the highest in a day in the stock exchange
  3. Low price – The price at which a stock has been traded the lowest in a day in the stock exchange
  4. Close price – The price which a stock was last traded in a day in the stock exchange. The open, high, low and close prices reflect the overall trend and the way a stock has been affected by the changing economic fundamentals and news during the day that further influence investment decision.
  5. Bid-Offer spread – Bid is the price that an investor is willing to buy a stock and offer is the price that an investor will sell a stock. The bid-offer spread is the difference between bid and offer price. A narrow (or lower) bid-offer spread implies trade of large volumes of the concerned stock, which in turn means that the stock is very liquid and it is easy to buy-sell, volatility is low, uncertainty and risk are at a minimum.
  6. Market capitalization – Market capitalization is also known as ‘market cap’ which represents the market value of all of a company’s outstanding shares[1]. Market cap is considered to determine the size of the company either as large, medium or small cap. Large cap companies are considered less risky in comparison to small cap companies. Medium cap mostly indicate safe returns and medium risks. Broadly, market cap can be calculated by multiplying the number of outstanding shares with the current stock price. Stock exchanges in India consider a different methodology known as the “Free-Float Methodology” to calculate the market cap. They consider a percentage or a free-float factor for each company based on the information on shareholding structure of available shares provided by each company. This free-float is an adjusted and overall percentage that reduces frequency of changes in the value of market cap as an attempt to control volatility and speculation. The BSE Sensex is developed based on the market cap calculation of 30 stocks representing the most well-established and financially sound companies traded frequently on BSE. The Sensex broadly represents the performance of industrial sector in India though NSE’s Nifty that comprises of 50 most financially sound and well-established companies’ stock is a better indicator of the industrial sector’s performance in India.
  7. P/E ratio – P/E ratio also known as Price-to Earnings ratio is calculated as Market Value per share divided by earnings per share. For example, if the current stock price of Airtel is Rs 385 and the earnings over the last 12 months is Rs 2 per share, then the P/E ratio is Rs 192.5 (385/2). A high P/E suggests more earnings growth in the future and low P/E suggests less earnings though P/E ratio does not tell the story behind the change in prices in its entirety and can suggest volatility and speculation.

Example of Equities

Hindustan Petroleum Corporation (HPCL):  Open Price: 368.60; High Price: 381.40; Low Price: 366.25; Close Price: 378.55; Bid price: 0.00 (Bid price can be close price); Offer price: 378.55; P/E: 37.77; Market Cap: 12818.73

Reliance Industries: Open Price: 794.40; High Price: 800; Low Price: 784.25; Close Price: 788.20; Bid price: 0.00 (Bid price can be close price); Offer price: 786.60; P/E: 12.23; Market Cap: 258088.4

Corporate Bonds

Bonds are fixed-income debt securities issued by a large corporation for which an investor lends money to the corporation issuing bonds and the issuer promises to repay the loan amount on a specified maturity date[2]. Corporate bonds work like the dated government securities or T-Bills except for these bonds are issued by large corporations such as Public Sector Units (PSUs)[3], Banks, corporations and financial institutions that are different from government-issued G-Secs. Corporate bonds and G-Secs are however similar in terms of the fixed-returns and low-risks in investments. There are different types of corporate bonds such as zero-coupon bonds issued by corporations for a short-term (mostly less than a year), fixed-coupon bonds issued by banks for medium term (between 1 year and 5 years) and floating-coupon bonds issued by PSUs for a long-term[4] (more than 5 years). Banks also issue corporate bonds with no maturity.

The main components of corporate bonds are similar to G-Secs and are summarized below:

  1. Issue price – The price at which the corporate bond is issued. However, for a zero-coupon bond, the issue price is the same as the discount price (Please refer to notes on Money market for explanation)
  2. Face value – The principal value of a bond is called face value. It is the value the issuer agrees to pay the investor excluding the interest amount during maturity date
  3. Coupon rate – This rate is the interest rate offered during fixed time period (mostly semi-annual)
  4. Coupon frequency – The frequency or the number of times interest is paid to the investor by the issuer. Interest on bonds can be paid in monthly, quarterly, semi-annually or annually but mostly they are paid on semi-annual basis
  5. Maturity date – This is the date when the bond matures and the investor’s principal amount will be paid.
  6. Call/pull option date – Call option on a bond gives the right to a bond issuer but not the obligation to redeem or buy back their issue of bonds before the bond’s maturity period, at a predetermined price and date. The put option gives bond holder or investors the right but not obligation to sell their bonds back to the issuer at a predetermined price and date. Bonds with put option feature allow protection to investors from interest rate risks. Call option features are mostly found with medium-term bonds issued by banks, whereas put-option features are mostly found with short-term zero-coupon bonds issued by corporations.

Example of corporate bond

Security with face value Rs 1000 was issued on April 01, 2011 for a period of 10 years at Rs 1000/- coupon of 12% per annum is paid every 6 months on April and October 01, 2011.

Issue price – Rs1000

Face value – Rs 1000

Coupon – 12%

Coupon frequency is – half yearly or semi-annually

Maturity date – April 01, 2011

Put option – Not Applicaton

Redemption value – Rs 1000

The advantages of investing in corporate bonds include –

  1. Corporate bonds provide higher returns in comparison to G-Secs and savings deposit accounts
  2. Corporate bonds have low risk in comparison to equities
  3. Corporate bonds provide fixed and regular income
  4. There are different types of corporate bonds to invest
  5. It enables capital appreciation. This implies that the value of corporate bonds in the market exceeds the actual cost of investments making investment returns favorable.

(B) Markets

Major developments in capital markets have occurred during 1990s especially after the securities scam of March 1992 (The Harshad Mehta Scam) that mostly led to reforms for capital markets by institutionalizing –

  • The Securities Exchange Board of India (SEBI) as the regulator for capital markets,
  • National Stock Exchange (NSE) and the Over the Counter Exchange of India (OTCEI) as an online screen-based electronic trading system encouraging transparency in prices
  • National Securities Clearing Corporation Ltd (NSCCL) and National Securities Depository Limited (NSDL) as an organized system for clearing and settlements of trade and transaction especially through the process of dematerialization (DEMAT account).
  • Bombay Stock Exchange (BSE)[5] as a competitive stock exchange to NSE with improved operations and adoption of modern technology

Capital markets include primary and secondary markets wherein new securities (equities and corporate bonds) are issued in primary markets for raising funds and existing securities are traded in secondary markets through stock exchanges. There are different types of primary issues for securities that include the following[6]:

  1. Public issue – An institution or a company (an Issuer) offers or issues securities to new investors so that they can become a part of issuer’s shareholder family. Public issue can be classified as Initial Price Offer (IPO) when an unlisted company makes fresh issues of securities for the first time and Further Public Offer (FPO) when an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public.
  2. Private Placement – An issuer issues securities to select number of investors not exceeding 49 is called private placement. Private placement is the opposite of public issue and investors are mostly large banks, insurance companies, mutual fund companies and pension funds companies.

Secondary markets are where already existing securities are traded after being initially offered in public through the primary market. Secondary market can be auction market or stock exchanges like BSE, NSE, etc or a dealer market like the OTCEI where small and medium firms look into gaining access to capital markets. There are various characteristics of secondary markets some of which are explored below:

  1. SEBI regulates the secondary markets
  2. There are 19 recognized stock exchanges in India of which the prominent ones are
  3. Instruments in secondary markets include the following:
  4. Equities – Please refer to the previous section for explanation
  5. Rights Issue (RI) – When the issuer’s existing shareholders can buy new stock at discount price then it is called rights issue. A certain percentage of shares is kept aside for these shareholders upto a particular date
  6. Bonus Issue – Free shares issued out of the issuer’s reserves for existing shareholders as an alternative to dividend payout is called bonus issue. A certain percentage of these free shares is kept aside for these shareholders upto a particular date
  7. G-Secs – Government securities issued by goverments in primary markets and then auction in secondary markets for all kinds of investors including retail investors or individuals
  8. Corporate bonds – Refer to notes in previous sections
  9. T-Bills and CPs – Refer to notes on money market
    • There are stock exchange registered brokers or sub-brokers who assist investors to execute trade transactions in secondary markets. Investors should have a DEMAT account with the broker to carry out transactions
    • Investors can also have individual DEMAT accounts provided by Depository Participants (DPs)
    • Secondary markets offer day trading that allows buying and selling securities within the same trading day and this is allowed only to retail or individual investors
    • Secondary market also consists of rolling settlement where settlement occurs in T+2 day basis. ‘T’ stands for trade and ‘2’ is the number of days. Hence, trades executed on Monday are typically settled on the following Wednesday.
    • Investors require the following account to invest in secondary markets:
    • Demat account – Refer to notes on Type of Banks
    • Trading account – An account opened by broker in the name of the respective investor for maintenance of transactions executed while buying and selling securities
    • Bank account – This account is utilized for debiting and/or crediting money for trading in the securities market

Merchant Banks

News issues of securities in primary markets and creating secondary markets for bills and discounting and rediscounting bills are done by merchant banks. Merchant banks offer services to large corporations and wealthy individuals for raising capital in the form of equities, bonds, etc. They act as advisors (but not financers) for these corporations and individuals. They do not accept cheque-related deposits (like the savings account with SCBs) and operate on fees for their services. Accordingly, their main functions include:

  1. Underwriting and issue management – Merchant bankers mainly underwrite new issues of securities in primary markets for raising long-term funds for their clients. They determine the number of stocks to be issued, price of the stock to be issued, manage paperwork of all securities and conduct marketing activities in collaboration with the issuing company
  2. Corporate counseling – Merchant banks provide financial services such as portfolio management, fixed deposits, mutual funds, etc. and provide advice on operational aspects of corporations, organizational goals and future business expansions
  3. Credit syndication – Merchant bank try to allocate short-term and long-term loans for their clients from Indian financial institutions like IFCI, IDBI, State Financial Corporations (SFCs), mutual funds, etc. These loans are targeted towards running day-to-day operations of their clients as well as meet long-term goals of companies.
  4. Arranging Offshore financing – Merchant banks also assist their clients in financing export and imports of the client’s products, provide long-term foreign currency loans, encourage collaborations with foreign companies.


[1] Outstanding shares are stocks currently held by investors, including restricted shares owned by the company’s officers and insiders as well as those held by public

[3] PSUs are government-owned companies like HPCL, MTNL, BSNL, SBI, LIC, etc

[5] BSE was the most affected stock exchange during the securities scam of 1992 and though this stock exchange is the most popular exchange for trading securities, BSE lacks liquidity and subject to various scams before and after the reforms in 1990s