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The role of the financial system can be broadly classified into the following:
Financial system evolved due to certain complexities associated in performing these functions.
This chapter contains the following sections
The financial markets channel the savings of the households and other surplus budget units to those individuals and institutions that need funds. While performing this role the financial markets aid in increasing production and income for the various units.
The main segments of the organized financial markets are as follows:
Money Market
The money market is a wholesale debt market for low-risk, highly- liquid, short-term instruments. Funds are available in this market for periods ranging from a single day up to a year. Government, banks and financial institutions dominate this market.
Capital Markets
The capital market is designed to finance long-term investments. The transactions taking place in this market are for periods over a year.
Forex Market
The forex market deals with multi-currency requirements, which are met by the exchange of currency. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated markets across the globe.
Credit Market
Credit market is a place where banks, financial institutions and NBFCs purvey short, medium and long-term loans to corporates and individuals.
Such a segregation of the financial market into various subgroups has enhanced the efficiency of resource allocation. Each market is unique in terms of the nature of participants, instruments etc.
| Financial Market | Purpose | Players | Regulator | ||||
|---|---|---|---|---|---|---|---|
| Money Market | Short-term rupee finance | Banks, Government, FIs, Corporates, FIIs, MFs, individuals | Central Bank | ||||
| Capital Market | Long-term rupee finance | Corporates, Banks, FIs, individuals, MFs, FIIs | E.g. US SEC | ||||
| Forex Market | Short/Long-term foreign currency finance | Banks, corporates, forex dealers | Central Bank | ||||
| Credit Market | Short/long-term rupee finance | Banks, FIs, NBFCs | Central Bank |
Within the above mentioned sub-markets, based on the transactions, financial markets can further be classified into open markets and negotiated markets. The basic distinction between these two types of markets is based on how the securities are bought and sold. In an open market, the securities will be offered to a large number of investors who can buy and sell them any number of times before the maturity period. The public issue of securities takes place in an open market. On the other hand, the negotiated market will have only a selected group of investors to whom the securities are offered and sold. It will generally be a private contract between the seller and the buyer. A bought-out deal and a car loan are good examples of transactions in a negotiated market.
Another useful and important distinction between markets in the financial system is the primary market and the secondary market. The primary market is a place for the fresh issue of securities. Corporates, banks, FIs and government can issue new securities and raise funds for investment purposes. The secondary market deals in securities previously issued in the primary market thereby providing liquidity to the investors. Investors can buy and sell securities in the secondary market on a continuous basis. Due to this the volume of transactions taking place in the secondary market are far greater than those taking place in the primary markets. Except for the capital market, the other sub-markets present in the financial system either do not have a secondary market or their operations in the same are negligible. The secondary market transactions of the capital market take place at the stock exchanges. All securities that are issued in the primary market will have to be listed on the stock exchanges to enable trading activity. The secondary market helps in undertaking ‘maturity intermediation’ by bringing together savers and users with conflicting maturity targets.
Having designed the instrument the issuer should ensure that these financial assets reach the ultimate investor in order to garner the required amount. When the borrower of funds approaches the financial market to raise funds, mere issue of securities may not suffice. Adequate information of the issue, issuer and the security should be passed on the supplier of funds for the exchange of funds to take place. To serve this purpose, financial intermediaries came into existence. Major changes have been witnessed in the type of issuers and investors participating in the market. Financial innovations, technological up gradations and most importantly changing regulatory mechanism made the process of raising funds from the market place a complex task. Investors’ preferences for financial assets have also changed. Designing instruments that catch the investors’ attention has now become a specialized service. Likewise, proper expertise is also necessary for establishing transactions in the financial markets. Large volume of transactions taking place in the markets will have to be recorded promptly and accurately.
Some of the important intermediaries operating in the financial markets include investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio managers, mutual funds, financial advertisers, financial consultants, primary dealers, secondary dealers, self-regulatory organizations etc. The role of these intermediaries is summarized in the following table.
| Intermediary | Market | Role | |||
|---|---|---|---|---|---|
| Stock Exchange | Capital Market | Secondary market for securities | |||
| Investment Bankers | Capital Market, Credit Market | Corporate Advisory services, Issue of securities | |||
| Underwriters | Capital Market, Money Market | Subscribe to un-subscribed portion of securities. | |||
| Registrars, Depositories, Custodians | Capital Market | Issue securities to the investors on behalf of the company and handle share transfer activity. | |||
| Primary Dealers, Secondary Dealers | Money Market | Market making in government securities | |||
| Forex Dealers | Forex Market | Ensure exchange in currencies |
In a market, which is not well regulated, these intermediaries increase the risks for the investor. In order to prevent any misappropriation of the lenders’ funds and to reduce the risks of the investors a well-regulated environment has to be developed. With markets in various countries, harmonizing their regulations, these financial intermediaries are now becoming global players.
Financial assets constitute an abstract but verifiable financial stake that maybe represented through a paper document or a computer system, but does not disappear just because something happens to the piece of paper (or the computer) on which it was recorded.
Financial assets can be broadly classified into Equities / Stocks, fixed income securities and derivatives. The financial stakes represented by securities are stakes in some business, government or other legal entity.
Buying equities of any company/corporation lead to investors becoming owners of the corporation. As a shareholder, investor has certain basic rights.
The liability of the investor/shareholder is limited to the proportion of the holdings of the investor in the corporation.
Preference shares are also shares with certain variations.
Preference shares may be cumulative or non-cumulative. If they are cumulative, they are entitled to a dividend whether or not the firm earns it. If during a particular year the company does not have adequate earnings to distribute as dividends, the dividends in arrears are accumulated and paid in a later year when earnings are sufficient. Some preference shares are convertible. This option permits the shareholders to exchange preference shares for equity shares of the same company.
The following types of securities are considered as fixed income securities.
Bonds are fixed income securities. The basic characteristics of the bonds are as follows:
Bonds are typically classified into fixed income securities with long term maturity (7 – 10 years), commercial paper with very short maturity term ( < 18 months) and treasury notes which fall in the intermediary range.
Bond Features
Bonds may be retired / redeemed by three methods:
Treasury bills are short-term instruments, with the longest maturity of one year. Bills are discounted instruments. Discounted instruments usually do not have a coupon, or fixed, interest rate. Instead, the bills are bought at say $8 amount and you receive a higher amount (the face value of say $10) at maturity. The difference between the two amounts is the discount. The rate of interest earned is ‘built into ‘ the discount.
Treasury bonds and notes are longer-term instruments. Notes are issued for one to ten years. Bonds are issued with maturities ranging from 10 to 30 years. Bonds and notes have fixed, or coupon, interest rates and pay interest on a semi-annual basis. The interest is computed on a 365-day basis, not 360 (as with bills and other instruments).
The Treasury also issues long-term discounted Treasury instruments known as strips. These instruments do not pay interest periodically. Instead, they pay ‘face’ at maturity. The difference between what is paid at the time of purchase and what is received at maturity represents the interest earned.
CDs are one of the major instruments of the money market sector, which includes T Bills, commercial paper, and banker’s acceptances. A certificate of deposit is a negotiable security issued by commercial banks against money deposited over a period of time. The value of CDs varies depending on the amount of deposit and maturity.
Included in the category of certificates of deposit are small issues that are not transferable and therefore non-negotiable. This form of CD, usually $ 10,000 in value and sometimes with a life of two years or more, is advertised by many banks to attract the retail investors. However, because these are not tradable, they are not part of the negotiable CD market.
Corporations raise long-term capital by issuing stocks and bonds. They raise short-term money by taking out loans from commercial banks and by issuing commercial paper to the investing public.
Commercial paper is a debt instrument that is offered sometimes as ‘discount instrument’ and sometimes as ‘principal plus interest’ For a plus interest instrument, the client pays the full face value to buy the paper and receives the face value plus the interest accrued at maturity.
Neither type of instrument has a fixed interest rate. Instead, the rate is negotiated at the time of purchase and the interest is calculated from face and full value. To receive the interest, the buyer must, for all practical purposes, hold the instrument until maturity. If the paper is sold during its life, its price is subject to market fluctuations. In the case of commercial paper, the secondary market is thin, almost non-existent.
Banker’s acceptances (BAs) are bills of exchange that are issued and guaranteed by a bank for payment within one to six months. The funds raised through their sale provide manufacturers and exporters with operating capital between the time of production or exporting and the time of payment y purchasers. I effect, the bank ‘accepts’ evidence of the value of goods being either manufactured or exported. For that evidence, it issues its ‘acceptance’ in the form of a certificate, which can then be bought and sold as security.
Municipal bonds or munis, are debt instruments issued by state and local governments to raise capital to finance their projects and other needs. Income (that is, interest) earned on municipal securities is free from federal income tax. For a resident of the issuing municipality, interest from the bonds is also free from state and local income taxes
From time to time a company may need to raise additional capital by issuing common stock. It may do so either through the usual underwriting methods or through the issuance of rights or warrants to current stockholders.
Rights and warrants are similar in that both permit their holders to subscribe to the new shares. They differ in that rights are generally short term whereas warrants have much longer lives. Also a corporation may have several warrant issues outstanding at one time, but it may offer only one rights issue at a time.
A right or subscription right, is a privilege granted by a corporation to its stockholders to purchase new securities in proportion to the number of shares they own. Usually right holders are entitled to a purchase, or subscription price that is lower than the stock’s current market price. Shareholders who choose not to subscribe may sell their rights.
A warrant, attached to another security, entitles the holder to convert the security into common stock or some other instrument at a set price during a specified period of time. The price set in the warrant is usually lower than the current market value of the common stock.
Warrants are longer- term issues than rights. They generally come to the marketplace as part of a unit, which is comprised of two or more issues. For example, a corporation may issue a combination of bonds and warrants. The bonds are in regular form, and the warrants are used to make the offering more attractive.
The ‘Certificate’ In the case of either a right or warrant, the certificate itself is referred to as a right or as a warrant. Actually, ‘a’ right certificate could represent 100 rights, and ‘a’ warrant certificate could represent 100 warrants. The term causes confusion and is a source of errors in the brokerage community. Operations personnel should always make certain whether the term means the right or warrant certificate or the quantity of rights or warrants represented thereon.
Selling stock to the public - When corporations issue stock (or other securities), they are referred to as Issuers. Stock can be issued for sale to the public or for private placement. When issuers prepare to sell securities to the public, they usually call upon investment bankers to act as underwriters.
Most corporations come out with the new issue of shares through Initial Public Offerings (IPO), which is called as the primary market offering. The equity shares then get listed on the stock exchange. Stock exchange is the market place for buying and selling of equity shares.
Stock exchange offers the common trading floor for trading on stocks. They offer liquidity to the investors. Every stock exchange has its own rules and regulations under which the securities get traded. Investors can offer to buy or offer to sell stocks of certain corporations through financial intermediaries on the stock exchange. The stock exchange publishes the various price quotes for stocks listed on their stock exchange on the daily basis. Stock exchanges also allow for settlement for trades.
Typical settlement periods that stock exchanges follow are:
The investors can hold securities in any of the following forms:
Bonds are traded on the stock exchanges. However, they are traded more in an Over The Counter (OTC) market scenario, wherein, most of the deals in the bonds lead to Delivery vs Settlement scenario. The deals done in such a manner normally get settled within few days. The quantity of bonds is generally quoted in the market in two forms:
In the ‘units’ scenario, bonds are bought in units and are quoted at a nominal price. Since fixed income securities usually mature at the face value, the prices of such securities are always quoted at discount. Years to maturity and interest rate of the fixed income security are the two primary factors, which determine the price of the security. Here again, the price at which it is quoted can be either Clean price or it can be Flat price. Clean price is the basic price of the security and flat price contains the basic price plus the accrued interest on the security from the last interest payment date. In the first case, the buyer will pay the seller the accrued interest from the last interest payment date separately. Even though, the outflow for the buyer is same in both the cases, the important thing is from the accounting point of view.
Accrued = [Face value of bond] x [rate of interest] x
Interest {[Number of days bond is owned /360]}
Days used for interest computation (the variables mentioned within {} in the above formula) can be done using any of the nine methods as mentioned below:
In the nominal value scenario, bonds are bought at face value. These bonds are normally traded at a discount on the face value. The investors then hold on these bonds to maturity at which time the face value of the security is recovered from the issuer.
In the bond market, three types of yield are typically encountered:
Nominal Yield - This is the percentage of interest paid on the face value of the instrument.
For instance, a $1000 bond with an interest obligation of 7% has a nominal yield of 7% (.07 x $1000). It pays $70 interest per year on each $1000 bond.
Current Yield - Bonds pay interest based on the face value. The interest or coupon rate remains the same regardless of fluctuations in the market price of the bond. The investor is concerned with the return or the amount of interest received on the amount of money paid. Current yield tells the investor what the return is, given the price of the bond.
For example, the bond in the previous example is selling for 120, that is, the bond costs the investor $1200 to acquire. It still pays only $70 in interest (7% on the face value of $1000). Although, as the bond’s owner, investor receives $70, the return is based on a cost of $1200. The current yield is therefore only 5.83%. ($70 / $1200)
Yield to Maturity: This type of yield takes into account the net dollar amount that an investor can expect if the bond is held to its maturity date.
For instance, a $1000 bond paying 7% interest will mature in 30 years. When the investor purchases it for $1200, the bond has twenty years of life left. At the end of the 20 years (at maturity), the corporation is obligated to retire the debt for $1000 (face value). If the investor paid $1200 today for the bond, he will receive only $1000 at maturity. Divide the $200 loss (or amortize it) over the 20 remaining years: $200 divided by 20 years equals $10 per year. The investor is losing $10 per year, which accumulates on this transaction. Yet the bond is going to pay him $70 per year in interest. So over 20 years, the investor actually earned an average of $60 per year every year he owns the bond. In dollars, this is the yield to maturity.
Yield to maturity = Interest received +/- amortized figure
(Face value + cost) / 2
For example,
$70 - $10 = 0.0545
($1000 + $1200) / 2
The yield to maturity is 5.45%
Certain bonds like Zero coupon bonds trade with the price being quoted as ‘Yield to Maturity’ (YTM). These securities carry a face value, but they are usually traded at a discount. The YTM for such securities would be quoted in the market. Yield to maturity in such scenario can be understood using the following formula:
YTM = (Face value – Purchase Price)* Days in a year
Current price * Days to maturity
Corporate actions are various events that happen on the different types of securities during the life cycle of the securities. Some of these actions can be directly correlated to the return, which the investors earn on these securities and others are relating to the various happenings on the securities during its life cycle.
Investors’ returns:
Corporate actions, which fall under this category, can be:
Corporate actions, which do not fall under this category are:
Corporations reward the investors by declaring cash dividends, which would normally be a small portion of the company’s earnings after interest payment and tax. Companies plough back the remaining portion of the earnings into its reserve, which can be re-used for funding the company’s growth in future. The dividend declared as explained above is paid to the investors in cash.
When voting on the amount and form of a dividend, the Board of Directors provides two dates: a record date and a pay date. The record date is the point of reference for determining shareholder eligibility for the dividend. The pay date is typically a couple of weeks after the record date.
Three days before the record date and about three weeks before the pay date, the stock goes ex-dividend. Investors who purchase shares between the ex-dividend date (sometimes just called the ex-date) and the pay date are not entitled to the dividend. Instead, it is paid to the previous shareholder. When a stock goes ex-dividend, its price usually drops by the (after tax) amount of the anticipated payment.
Corporation reward the investors by declaring additional free shares to the investors based upon the proportion of holdings of the investors as of the record date. Whenever the board of directors feels that the money lying in the Reserve account as explained above is more than adequate, they would convert a portion of the reserve into Capital by issuing stock dividends. Issuance of stock dividends does not entail any additional cost to the investor.
If the company issues a stock dividend of 1: 2 (Investors would get an additional share for every two shares held by them), the outstanding units of the company increase by 50% over the existing outstanding units. The market value of the stock usually comes down after a stock dividend.
The interest paid on the fixed income securities / bonds is same as the Nominal yield as explained above. Interest is normally paid on these securities on a pre-defined frequency. Companies pay interest on the earnings earned by them prior to payment of tax or cash dividend on both preference / equity stocks
Fixed income securities / bonds has a pre-defined life of 7 – 10 years. Conceptually, the company is indebted to all its borrowers who have funded the bonds. The companies would normally redeem its debts and thus there is a fixed maturity period for all the fixed income securities. The customers are usually paid back the face value of the bond or the face value and a small premium on the bond at the time of maturity.
For example, if the face value of the bond is $100, the company would repay $100 or $105 (Face value + premium of 5% ) at the time of redemption.
Rights offerings give existing shareholders an opportunity to purchase (or subscribe to) additional shares of stock at a discount from the public offering price when the company prepares to issue new shares. These shares, which are also called subscription rights, are transferable securities. The existing investors have the option to allow the rights to expire, renounce (where they sell the rights offer to another person) or exercise the options.
A warrant, attached to another security, entitles the holder to convert the security into common stock or some other instrument at a set price during a specified period of time. The price set in the warrant is usually lower than the current market value of the common stock. These offerings give existing shareholders another opportunity to purchase additional shares at a discount from the market price.
Stock split increases the total number of shares outstanding without changing the total market value of shares. The companies usually issue stock splits if the price of the stock is too high and is not affordable for the common investor. Essentially, stock split increases the liquidity of the stock among common investors.
For example, in a 2-for-1 stock split, a holder of 100 shares IJK Corporation common stock receives an additional 100 shares (usually in book entry form, although investors can request a stock certificate). If the price of IJK was $144 just before the split, it is $72 right after it. The nominal value of the stock comes down by half in the above example after the split.
Mergers combine two (or more) companies to form a larger company. Frequently, the acquiring company pays shareholders of the acquired company in shares. For example, company A may purchase all of company B’s shares on the basis of a pre determined ratio of shares, say, two shares of company A stock for every share of Company B stock outstanding. If an investor own 100 shares of Company B stock, after the acquisition is complete (and company B no longer exists as a separate entity) the investor will own 200 shares of Company A stock.
Spin–offs are like mergers in reverse. Company C decides to split off part of its operations into a separate organization. Let us say the new organization is called Company D. How are shareholders in Company C compensated for this splitting off of part of their ownership interest into a new enterprise? Usually, through issuance of stock at sum pre set ratio. Let us say an investor own 100 shares of Company C. After the spin - off of Company D, the investor still own 100 shares of C, but you also own, say, 50 shares of Company D.