Professional Certificate Program

‘Risk Management in Banking and Financial Markets’

- Prof. PC Narayan

Equity Stock Markets: Concepts, Instruments, Risks

and Derivatives

Week 01 – Summary

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Financial Market: An Overview

Financial markets are real and virtual market places where financial instruments of varying
maturities are traded i.e. bought and sold.

Financial markets are broadly classified into:

Ø Short Term Markets (or Money Markets) where instruments up to 180 days maturity
(sometimes up to one year maturity) are issued and traded. These include call money
market (fed funds), Treasury bills market, REPO market, commercial paper market,
market for certificate of deposits, banker's acceptance (commercial bills market), etc.
Ø Long Term Markets where instruments of maturity from one year to perpetuity are
issued and traded. These include government securities market, equity stock market,
corporate bond market, etc.

Please note that ‘short term’ or ‘long term’ in the context of financial markets and
instruments refers to the ‘maturity period’ of the instruments that are issued and traded,
not to the ‘holding period’ by the investor. The instrument could, for instance have a
maturity period of ten years and hence be part of the long-term market (or capital market)
but the ‘holding period’ by the investor could be for a short term.

Financial Markets: OTC vs Exchange Traded

Financial markets operate in two modes:

§ Over The Counter (OTC)

§ Exchange Traded

Over the Counter (OTC) transaction, the counterparty risk (i.e. the risk arising from the
failure of the other party) in the transaction is completely borne by the two entities
participating in the transaction. In an "Exchange Traded" transaction, on the other hand, the
counterparty risk is the responsibility of the exchange where the transaction is executed.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

How and Why are Financial Markets Different From Product Markets?

Markets may be distinguished in many ways.

§ Product Markets are the markets where Goods and services produced by firms are sold
to customers, Cost is a reality (normally within the control of the company) and Price is
driven by the market forces (supply and demand)
§ Factor Markets are the markets where the pre-requisites for production are bought and
sold. Example: Labour Market, Capital Market, Market for CEOs and other managerial
resources, etc.
§ Financial Markets are the markets where securities (such as equity shares, bonds, etc.)
and commodities (such as precious metals, agricultural commodities, etc.) are bought
and sold.

In financial markets, specially, in the stock and bond markets, price is determined not
merely by ‘supply and demand’ but by:

• ‘News Flows’ (Information Intermediation) – Firm-level and County-level

• Exogenous variables such as change in interest rates announced by the country’s
Monetary Authority

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Equity Market
Equity stock market is one of the two biggest segments of the long-term financial markets,
where firms issue equity stocks to fund their long-term capital needs.

Equity stocks (or equity shares or common stocks, as they are known is some countries)
issued by a firm is perpetual in nature and represent an ownership claim in the firm. Equity
investors earn a residual return proportionate to their equity stock holding in the firm,
which is turn is dependent entirely on the profits (to be more precise, profit after tax) of the
firm. The return to equity shareholders is therefore significantly more volatile and risky than
investments in bonds.

In the event a firm is declared insolvent or shuts its operations for any reason, equity
stockholders have the lowest priority claim on the assets of that firm and only get the
residual value, after all other liability holders are paid off. On the other hand, the liability of
the equity shareholders, and consequently their potential maximum loss, is limited to the
extent of their investments in the equity stock of that firm.

Preference stocks are different from equity stocks due to the following reasons:

§ Fixed dividend; prices do not vary

§ Claim on the assets of the firm that is higher than that of the equity stockholders but
lower than the bond-holders, lenders, and the other creditors of the firm
§ Dividend on preference stocks is paid out of the profit after tax

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Estimating the Price of Equity Stocks:

The price of an equity stock, using the concept of ‘time value of money, is the present value
of all future cash flows attributable to that equity stock.

There exist a striking similarity between the formula to estimate the price of equity stocks,
and the formula to determine the price of bonds, as both of them follow the principle of
present value of all future cash flows.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Despite the apparent similarities, there are several differences as shown in the table below:

There are several alternate methods to estimate the price of a stock that are explained in a
separate downloadable document available at the end of the relevant video.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Equity Stock Market: Market Mechanism

A privately held firm goes public to raise equity capital enabling its equity stocks to be
traded publicly. The first round of issuing equity stocks is referred to as the Initial Public
Offer (IPO) and all subsequent rounds of issuing equity stocks are referred to as Follow-on
Public Offer (FPO).

Intermediaries, such as investment banks and similar such entities, bring together the firms
issuing the equity stocks with prospective investors, for an additional fee and sometimes
also underwrite the offer.

The trading mechanisms (i.e., how equity stocks are bought and sold) is shown below:

TRADING:

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

SETTLEMENT:

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Equity Stock Market: Indices and Regulatory mechanism

A Stock Market Index comprises a statistically significant sample of equity stocks that
represent that market and effectively capture the price movement of the entire population
of equity stocks traded in that market. Examples of stock market indices around the world
include:

• The Dow Jones Industrial Average,

• The NYSE Composite Index of New York,
• FTSE of London,
• Nikkei of Tokyo, etc.

Firms depend hugely on the equity stock market and the bond market to raise financial
resources to meet their long-term capital needs. Investors would not want to come to these
markets unless they have full confidence that those markets are functioning effectively and
transparently.

Capital market regulators have a major role to play in monitoring the integrity of these
markets and protect the investors' interest in the best possible manner.

Regulators achieve this goal by:

ü Ensuring a high level of disclosures by all the firms whose equity stocks are listed
ü Being empowered by law to bring to book any participant who wilfully or otherwise
engages in activities such as insider trading.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore (bfmrm-support@iimb.ac.in)