CAPITAL MARKETS – Basic Concepts

What are equity assets?

Corporates can raise money in two ways; by either borrowing (debt instruments) or issuing stocks
(equity instruments) that represent ownership and a share of residual profits. The equity
instruments are in turn typically of two types – equity shares and preference shares

Equity Shares : This represents an ownership position and provides voting rights

Preference Shares: It is a "hybrid" instrument since it has features of both common stock and
bonds. Preferred-stock holders get paid dividends which are stated in either percentage-of-par
(the value at which the stock is issued) or rupee terms. If the preferred stock had an Rs.100/- par
value, then a Rs.6/- preferred stock would mean that a Rs. 6/- per share per annum in dividends
will be paid out. This fixed dividend gives a bond-like characteristic to the preferred stock.

How does an investor in equities make money?

Investors get returns on their investments in two ways - dividend and capital gains. The former
depends on earning levels of the particular company and the decision of its management. The
latter happens when the market price of the shares rises above the level at which the investment
was made. Say, you invested into 100 shares of X Company at a price of Rs.50/- and sold all the
100 shares later at a price of Rs.100/-, you would have made a capital gain of Rs.5000/-.

Sale value of Shares (Rs.100 x 100) Rs.10,000/-

Value of original investment (Rs.50 x 100) Rs. 5,000/-
Capital Gain Rs. 5,000/-

Why do stock prices move up and down?

The market price of a particular share is dependent on the demand/supply for that particular scrip.
If the players in the market feel that a particular company has a track record of good performance
or has the potential to do well in the future, the demand for the shares of the company increases
and players are willing to pay higher prices to buy the share. And since the number of shares
issued by the company is constant at a given point in time, any increase in demand would only
increase the market price.

Fluctuations in a stock's price occur partly because companies make or lose money. But that is
not the only reason. There are many other factors not directly related to the company or its
sector. Interest rates, for instance. When interest rates on deposits or bonds are high, stock
prices generally go down. In such a situation, investors can make a decent amount of money by
keeping their money in banks or in bonds.

Money supply may also affect stock prices. If there is more money floating around, some of it may
flow into stocks, pushing up their prices. Other factors that cause price fluctuations are the time of
year and public sentiments. Some stocks are seasonal, i.e. cyclical stocks; they do well only
during certain parts of the year and worse during other parts. Publicity also affects stock prices. If
a newspaper story reports that Xee Television has bought a stake in Moon Television, odds are
that the price of Xee's stock will rise if the market thinks it’s a good decision. Otherwise it will fall.
The price of Moon Television stocks may also go up because investors may feel that it is now in
better hands. Thus, many factors affect the price of a stock.

What are main approaches used for analyzing stocks and forecasting future movements?
The behaviour of the price movement of a stock is said to predict its future movement. One such
approach is called technical analysis and is based on the historical movements of the individual
stocks as well as the indices. Their belief is that by plotting the price movements over time, they
can discern certain patterns which will help them to predict the future price movements of the
stocks. On the other hand we have "fundamental analysis", where the forecasting is done on the
basis of economic, industry and company data. Technical analysis is used more as a supplement
to fundamental analysis rather than in isolation.

What are equity markets?

These are markets for financial assets that have long or indefinite maturity i.e., stocks. Typically
such markets have two segments - primary and secondary markets. New issues are made in the
primary market and outstanding (existing) issues are traded in the secondary market (i.e., the
various stock exchanges)
There are three ways a company can raise capital in the primary market -
Public Issue : Sale of fresh securities to the public

Rights Issue: This is a method of raising capital from existing shareholders by offering additional
securities to them

Private Placement: Issuers make direct sales to investor groups i.e., there is no public issue.

What are bonus issues and stock splits? What is their impact?
Bonus Issues: Instead of cash dividends, investors receive dividends in the form of a stock. The
investor receives more shares when a bonus issue is announced. For example, when there is a
bonus issue in the ratio of 1:1, the number of shares owned by an investor would double in
number. However, the market price of the share would decrease as well. At times the decrease
might not be proportionate to the extent of bonus because market players might push the price up
if they view the bonus issue as a positive development. Some companies might announce bonus
issues to bring the market price of its share to a more popular range and also promote active
trading by increasing the number of outstanding shares.

Stock Splits: Whenever a stock split occurs, the company ends up with more outstanding shares
which will not only have a lower market price but also lower par value. Stock splits are prompted
when the company thinks its stock price has risen to a level that is out of the "popular trading
range".

For example, X Corporation has 1 million outstanding shares. The par value is Rs.10/- and the
current market price is Rs.1000/- per share. If the management feels this price is resulting in a
decrease in trading volumes, they can declare a 1 -for-1 split. By doing this, there will be 2 million
outstanding shares with a par value of Rs.5/- and a theoretical market price of Rs.500/- per share.
Sometimes when the market price is very low, the company might announce a "reverse split"
which has the opposite effect of the normal stock split.

In the case of splits, there is no change in the reserves and surplus of the company unlike the
bonus issue.

What are derivatives?

A derivative is an instrument whose value is derived from the value of one or more underlying
securities, which can be commodities, precious metals, currency, bonds, stocks, stock indices,
etc. Four most common examples of derivative instruments are Forwards, Futures, Options and
Swaps.

What are index futures?

In a forward contract, two parties irrevocably agree to settle a trade at a future date, for a stated
price and quantity. No money changes hands at the time the trade is agreed upon. First, the
contracting parties only reach an agreement that is legally enforceable. The parties entering into
a futures contract do so with the purpose of protecting themselves from a steep rise or fall in
prices respectively.
Currently in India, index futures are allowed. These are nothing, but future contracts with the
underlying security being the stock market index such as BSE SENSEX or NSE NIFTY.

Index futures of different maturities would trade simultaneously on the exchanges. For instance,
the Bombay Stock Exchange may introduce three contracts on BSE SENSEX index with one, two
and three months’ maturities. These contracts of different maturities are also called near month
(one month), middle month (two months) and far month (three months) contracts. The month in
which a contract will expire is called the contract month. For example, contract month of "Nov.
2001 contract" will be November 2001.

All these contracts will expire on a specific day of the month (expiry day for the contract) say on
last Wednesday or Thursday or any other day of the month; this would be defined in the contract
specification before introduction of trading.

What are Options?

Options give a buyer the right to buy a particular scrip and the seller the right to sell that scrip at a
pre-determined price on a particular date. Unlike futures contract, there is no obligation only a
"right" There are two types of Options:

Call Option: Here, the buyer decides to buy a scrip at a particular price on a particular date. For
e.g. the buyer takes a call Option on RIL @Rs.150/- after 3 months. For this, he pays a premium
which is determined by the demand-supply equation. For e.g., if a particular stock is in favour with
investors, there would be more people willing to buy the stock at a future date, resulting in a
higher premium. In this example, let us assume the premium is Rs.10/-.

Put Option: This is used to manage downside risk. A seller today agrees to sell TISCO @
Rs.130/- after 3 months and pays the required premium. If the price of TISCO is in excess of
Rs.130/-, he decides not to sell to the other party. He would prefer to sell it at higher price to
someone else. In the process, he would lose the premium (which is the profit of the Option
Writer). However, if the price is below Rs.130/-, he "calls" his right and cushions his loss.

The Option Buyer has the right to exercise his choice of buying or selling in the Call and Put
Option respectively. The Option Writer or Seller has to meet his commitment based on the choice
exercised by the Option Buyer.

Options have finite maturities. The expiry date of the Option is the last day (which is pre-
determined) when the owner can exercise his Option.
What are the main differences between options and futures?

1. Obligation
With futures, both parties are under an obligation to perform as per the terms of the contract.
With options only the seller (writer) is under obligation to perform.

2. Premium
With options, the buyer pays the seller (writer) a premium.
With futures, no premium is paid by either party.

3. Risk
With futures, the holder of the contract is exposed to the entire spectrum of downside risk and
has the potential for all the upside return.
With options, the buyer limits the downside risk to the option premium but retains the upside
potential.

4. Specific performance of contract

The parties to a futures contract must perform on the settlement date. They are not obligated to
perform before that date.
The buyer of an options contract can exercise his right any time prior to the expiration date

Debt Funds – What you wanted to know about Debt Funds

What are Money Markets and money market instruments?

Money Markets allow banks to manage their liquidity as well as provide the Central Bank means
to conduct monetary policy. Money markets are markets for debt instruments with a maturity up to
one year.

The most active part of the money market is the call money market (i.e. market for overnight and
term money between banks and institutions) and the market for repo transactions. The former is
in the form of loans and the latter are sale and buyback agreements - both are obviously not
traded. The main traded instruments are Commercial Papers (CPs), Certificates of Deposit (CDs)
and Treasury Bills (T-Bills).

Commercial Paper
A Commercial Paper is a short term unsecured promissory note issued by the raiser of debt to
the investor. In India, Corporates, Primary Dealers (PD), Satellite Dealers (SD) and Financial
Institutions (FIs) can issue these notes.

It is generally companies with very good ratings which are active in the CP market, though RBI
permits a minimum credit rating of Crisil-P2. The tenure of CPs can be anything between 15 days
to one year, though the most popular duration is 90 days. Companies use CPs to save interest
costs.

Certificates of Deposit
These are issued by banks in denominations of Rs 5 lakhs and have maturity ranging from 30
days to 3 years. Banks are allowed to issue CDs with a maturity of less than one year while
financial institutions are allowed to issue CDs with a maturity of at least one year.

Treasury Bills
Treasury Bills are instruments issued by RBI at a discount to the face value and form an integral
part of the money market. In India Treasury Bills are issued in four different maturities - 14 days,
90 days, 182 days and 364 days.

Apart from the above money market instruments, certain other short-term instruments are also in
vogue with investors. These include short-term corporate debentures, bills of exchange and
promissory notes.

What are debt markets and debt market instruments?

Typically those instruments that have a maturity of more than a year and the main types are -
Government Securities (G-secs or Gilts)
Like T-bills, gilts are issued by RBI on behalf of the Government. These instruments form a part
of the borrowing program approved by Parliament in the Finance Bill each year (Union Budget).
Typically, they have a maturity ranging from 1 year to 20 years.

Like T-Bills, Gilts are issued through the auction route but RBI can sell/buy securities in its Open
Market Operations (OMO). OMOs include conducting repos as well and are used by RBI to
manipulate short-term liquidity and thereby the interest rates to desired levels
The other types of Government Securities are
• Inflation linked bonds
• Zero coupon bonds
• State Government Securities (State Loans)
Bonds/Debentures
What is the difference between bonds and debentures?
World over, a debenture is a debt security issued by a corporation that is not secured by specific
assets, but rather by the general credit of the corporation. Stated assets secure a corporate bond,
unlike a debenture. But in India these are used interchangeably.

A bond is a promise in which the issuer agrees to pay a certain rate of interest, usually as a
percentage of the bond's face value to the investor at specific periodicity over the life of the bond.
Sometimes interest is also paid in the form of issuing the instrument at a discount to face value
and subsequently redeeming it at par. Some bonds do not pay a fixed rate of interest but pay
interest that is a mark-up on some benchmark rate .

Typically bonds are issued by PSUs, Public Financial Institutions and Corporates. Another
distinction is SLR (Statutory Liquidity Ratio) and non-SLR bonds. SLR bonds are those bonds
which are approved securities by RBI which fall under the SLR limits of banks.

Statutory Liquidity Ratio (SLR): It is the percentage of total deposits a bank has to keep in
approved securities.

What affects bond prices?

Largely it will be the interest rates and credit quality of the issuer.

Interest Rates: The price of a debenture is inversely proportional to changes in interest rates that
in turn are dependent on various factors. When the interest rates fall down, the existing bonds will
become more valuable and the prices will move up until the yields become the same as the new
bonds issued during the lower interest rate scenario (for a detailed explanation see "what affects
interest rates").

Credit Quality: When the credit quality of the issuer deteriorates, market expects higher interest
from the company and the price of the bond falls and vice versa.

Another factor that determines the sensitivity of a bond is the "Maturity Period" - a longer maturity
instrument will rise or fall more than a shorter maturity instrument.

What affects interest rates?

The factors are largely macro-economic in nature -

Demand/Supply of money: When economic growth is high, demand for money increases, pushing
the interest rates up and vice versa.

Government Borrowing and Fiscal Deficit: Since the government is the biggest borrower in the
debt market, the level of borrowing also determines the interest rates. On the other hand, supply
of money is done by the Central Bank by either printing more notes or through its Open Market
Operations (OMO).

RBI: RBI can change the key rates (CRR, SLR and bank rates) depending on the state of the
economy or to combat inflation. RBI fixes the bank rate which forms the basis of the structure of
interest rates and the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), which
determines the availability of credit and the level of money supply in the economy.

(CRR is the percentage of its total deposits a bank has to keep with RBI in cash or near cash
assets and SLR is the percentage of its total deposits a bank has to keep in approved securities.
The purpose of CRR and SLR is to keep a bank liquid at any point of time. When banks have to
keep low CRR or SLR, it increases the money available for credit in the system. This eases the
pressure on interest rates and interest rates move down. Also when money is available and that
too at lower interest rates, it is given on credit to the industrial sector that pushes the economic
growth)

Inflation Rate: Typically a higher inflation rate means higher interest rates. The interest rates
prevailing in an economy at any point of time are nominal interest rates, i.e., real interest rates
plus a premium for expected inflation. Due to inflation, there is a decrease in purchasing power of
every rupee earned on account of interest in the future; therefore the interest rates must include a
premium for expected inflation. In the long run, other things being equal, interest rates rise one for
one with rise in inflation.

What is Yield Curve?

The relationship between time and yield on securities is called the Yield Curve. The relationship
represents the time value of money - showing that people would demand a positive rate of return
on the money if they were willing to part today for a payback into the future.

A yield curve can be positive, neutral or flat.

A positive yield curve, which is most natural, is when the slope of the curve is positive, i.e. the
yield at the longer end is higher than that at the shorter end of the time axis. This is as a result of
people demanding higher compensation for parting their money for a longer time into the future.
A neutral yield curve is that which has a zero slope, i.e. is flat across time. This occurs when
people are willing to accept more or less the same returns across maturities.
The negative yield curve (also called an inverted yield curve) is one of which the slope is
negative, i.e. the long-term yield is lower than the short-term yield. It is not often that this happens
and has important economic ramifications when it does. It generally represents an impending
downturn in the economy, where people are anticipating lower interest rates in the future

What is Yield to Maturity (YTM)?

Simply put the annualized return an investor would get by holding a fixed income instrument until
maturity. It is the composite rate of return of all payouts and coupon.

What is Average Maturity Period?

It is a weighted average of the maturities of all the instruments in a portfolio.

What are LIBOR and MIBOR?

LIBOR: Stands for London Inter Bank Offered rate. This is a very popular benchmark and is
issued for US Dollar, GB Pound, Euro, Swiss Franc, Canadian Dollar and the Japanese Yen. The
British Bankers Association (BBA) asks 16 banks to contribute the LIBOR for each maturity and
for each currency. The BBA weeds out the best four and the worst four, calculates the average of
the remaining eight and the value is published as LIBOR.

MIBOR: Stands for Mumbai Inter Bank Offered Rate and is closely modeled on the LIBOR.
Currently there are two calculating agents for the benchmark - Reuters and the National Stock
Exchange (NSE). The NSE MIBOR benchmark is the more popular of the two and is based on
rates polled by NSE from a representative panel of 31 banks/institutions/primary dealers

Credit Ratings

What is a credit rating?

Credit Rating is an exercise conducted by a rating organisation to evaluate the credit worthiness
of the issuer with respect to the instrument being issued or a general ability to pay back debt over
the specified period of time. The rating is given as an alphanumeric code that represents a
graded structure or creditworthiness. Typically the highest credit rating is that of AAA and the
lowest being D (for default). Within the same alphabet class, the rating agency might have
different grades like A, AA and AAA and within the same grade AA+, AA- where the "+" denotes
better than AA and "-" indicates the opposite. For short-term instruments of less than year
maturity, the rating symbol would be typically "P" (varies depending on the rating agency).
In India, currently we have four rating agencies –
• CRISIL
• ICRA
• CARE
• Fitch