We had the opportunity to watch the action from the ring side seat – and the things we saw, heard and experienced stirred some deeper thoughts in our mind about our wisdom or lack of it, in matters related to financial markets and money.
Many investors in spite of distressing evidence all around still get carried away by hype. Financial business is all about informed decisions. We realize that discerning data if not readily available in one place can make it difficult for anyone to choose intelligently. In an effort to capture the diverse issues of financial markets in a single summary, we share our experiences; views and insights in this chapter.
1.1 Types of Markets
The Securities Market, however, refers to the markets for those financial instruments/ claims/obligations that are commonly and readily transferable by sale.
The Securities Market has two interdependent and inseparable segments, the new issues (primary) market and the stock (secondary) market.
This secondary market has further two components.
Before discussing the equities market, we should first understand the basic meaning of markets, their functions and classification.
1.2.1 What is a Market?
each other employing advance means of communication. There is another form of market where actual buyers and sellers achieve their objectives through intermediaries.
• Enactment of the Securities and Exchange Board of India Act, 1992 to provide for the establishment of the Securities and Exchange Board of India (SEBI) to regulate and promote development of securities market;
• Setting up of NSE in 1993, passing of the Depositories Act, 1996 to provide for the maintenance and transfer of ownership of securities in book entry form;
The corporate securities market in India dates back to the 18th century when the securities of the East India Company were traded in Mumbai and Kolkotta. The brokers used to gather under a Banyan tree in Mumbai and under a Neem tree in Kolkata for the purpose of trading those securities. However the real beginning came in the 1850’s with the introduction of joint stock companies with limited liability. The 1860’s witnessed feverish
Furthermore, each exchange has a Settlement Guarantee Fund to meet with any unpredictable situation and a negligible trade failure of 0.003%. The Clearing Corporation of the exchanges assumes the counter-party risk of each member and guarantees settlement through a fine-tuned risk management system and an innovative method of online position monitoring. It also ensures the financial settlement of trades on the appointed day and time irrespective of default by members to deliver the required funds and/or securities with the help of a settlement guarantee fund.
1.2.6 Style of Operating
The question of automating trading has always been under the active consideration of the Bombay Stock Exchange for quite sometime. It has decided to have trading in all the non-specified stocks numbering about 4,100 totally on the computer on a quote-driven basis with the jobbers, both registered and roving, continuously keying in their bids and offers into the computer with the market orders getting automatically executed at the touch and the limit orders getting executed at exactly the rate specified.
In March 1995, the BSE started the computerized trading system, called BOLT - BSE on-line trading system. Initially only 818 scripts were covered under BOLT. In July 1995, all scripts (more than 5,000) were brought under the computerized trading system. The advantages realized are: (a) improved trading volume; (b) reduced spread between the buy-sell orders; c) better trading in odd lot shares, rights issues etc.
1.4.1 Derivatives Defined
Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.
1.4.2 Products, Participants and Functions
Derivative contracts have several variants. The most common variants are forwards, futures,
1.4.3 Types of Derivatives
The most commonly used derivatives contracts are forwards, futures and options, which we shall discuss these in detail in the FMM-II later. Here we take a brief look at various derivatives contracts that have come to be used.
but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
• Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer- dated options are called warrants and are generally traded over-the-counter.
Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
• Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.
1.5.1 Difference between Commodity and Financial Derivatives
The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features, which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of assetdoes not really exist as far as financial underlying is concerned. However in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues.
there is no clear regulatory oversight of warehousing services.
Quality of Underlying Assets: A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/certification procedures. A good grading system allows commodities to be traded by specification.
1.6.1 Types of Companies
A company can be a public or a private company and could have limited or unlimited liability. A company can be limited by shares or by guarantee. In the former, the personal liability of members is limited to the amount unpaid on their shares while in the latter; the personal liability is limited by a pre-decided nominated amount. For a company with unlimited liability, the liability of its members is unlimited. Apart from statutory government owned concerns, the most prevalent form of large business enterprises is a company incorporated with limited liability. Companies limited by guarantee and unlimited companies are relatively uncommon.
• The maximum number of its shareholders is limited to 50 (excluding employees).
• No offer can be made to the public to subscribe to its shares and debentures.
or more public company.
• The private company holds 25 percent or more of the paid-up share capital of a
1.6.3 Public Companies
A public company is defined as one, which is not a private company. In other words,
the form of a liaison office/representative office, a project office and a branch office
by registering themselves with Registrar of Companies (ROC), New Delhi within 30 days