TOPIC-5: CAPITAL MARKET-I:

BASICS
-by Jayant Parikshit

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 ECONOMICS HANDOUT (TOPIC NO. 5)
by Jayant Parikshit
MCQ FOR SELF PRACTICE
Question-1: Consider the following statements about “Financial Markets”:
1. A financial market is a market for the creation and exchange of financial assets.
2. The financial market deals with creation of new financial assets only like shares, bonds
etc.
Choose the correct option:
a. Only1
b. Only2
c. Both1&2
d. None of these

Question-2: Which of the following are the constituents of Financial Market in India?
1. Money market instruments
2. Capital Market Instruments
3. Derivative Instruments
Choose the correct option:
a. Only1
b. Only2
c. Both1&2
d. Both2&3
e. 1,2&3

Question-3: Consider the following statements regarding “Bonds”:

1. A bond is a debt instrument.
2. A bondholder gets fixed returns at fixed intervals.
3. A bondholder gets floating rate of interest at fixed intervals.

Choose the correct option:

a. Only1
b. Both1&2
c. Both1&3
d. 1,2&3

Question-4: Consider the following statements regarding “Zero” coupon bonds:

1. They carry very low rate of interest.
2. They are offered at large discount on the face value of the bond.
3. On maturity, bondholder gets face value of his investment.
4. They are available only for long run.
Choose the correct option:
a. Only1
b. Both1&2
c. Both3&4
d. 1,2&3

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e. 1,2,3,4&5

Question-5: Consider the following statements regarding “Foreign Currency Convertible

Bonds (FCCB)”
1. These are issued by Indian companies & expressed in rupee.
2. Both principal & interest are payable in rupee.
3. They are issued and traded in foreign stock exchange.
4. FCCB holder might convert it into shares to get the benefits of increase in share prices.

Choose the correct option:

a. Only1
b. Only2
c. Only4
d. Both1&2
e. 1,2&3
f. 1,2,3&4

Question-6: Consider the following Statements regarding “Debentures”:

1. A debenture is a medium to long-term debt that is used by large companies to borrow
money.
2. It is secured by physical assets or collateral.
3. It is required that the interest on debenture is paid only after dividends being paid to
shareholders.
4. Debenture holders (investors) have very limited rights to vote in the company's general
meetings of shareholders.
Choose the correct option:
a. Only1
b. Only2
c. Both1&2
d. 1,2&3
e. 1,2,3&4

Question-7: Consider the following statements regarding “Shares”

1. Equity shares are the ordinary shares of the company.
2. The holders of the preference shares are the real owners of the company.
3. Preference shareholder gets precedence over equity shares on the matters like
distribution of dividend at a fixed rate and repayment of capital in the event of liquidation
of the company.
4. Preference shareholders get exclusive voting rights in all matters of the company.

Choose the correct option:

a. Both1&2
b. Both1&3
c. 1,2&3
d. 1,2,3&4

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SYLLABUS:

FINANCIAL MARKET
§ A financial market is a market for the creation and exchange of financial assets.
§ Financial transactions could be in the form of creation of new financial assets such as the
initial issue of shares and debentures by a firm or the purchase and sale of existing
financial assets like equity shares, debentures and bonds.
§ Financial markets are classified on the basis of maturity of financial instruments:
1. Instruments with a maturity of less than one year are traded in the money market.
2. Instruments with longer maturity (greater than one year) are traded in the capital
market.
CAPITAL MARKET
§ Capital Market could be classified into:
1. Debt Market: Primary Debt Market & Secondary Debt Market
2. Equity Market: Primary Equity Market & Secondary Equity Market

DEBT MARKET
BONDS
A bond is a debt instrument in which an investor loans money to an entity (typically corporate
or government) which borrows the funds for a defined period of time at a variable or fixed
interest rate.

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Some examples of bonds:
1. Fixed Interest Bonds: These bonds promise fixed interest to the bondholder to be paid
periodically, while interest is returned upon maturity.

2. Floating Rate Bonds: Floating rate bonds are instruments where the interest rate is not
fixed, but re-set periodically with reference to a pre-decided benchmark rate.

3. Zero-Coupon Bonds: They are offered at large discount on the face value of the bond. On
maturity, bondholder gets face value of his investment. They are available for both short
run and long run.

4. Deep Discount Bond (DDB): A zero coupon bond with a long maturity is issued at a very
big discount to the face value. Such bonds are also known as deep discount bonds.

5. Foreign Currency Convertible Bonds (FCCB):

a. Definition: These are issued by Indian companies & expressed in foreign currency.
Both principal & interest are payable in foreign currency. They are issued and traded
abroad.
b. Features:
I. FCCB holder might convert it into certain number of ordinary shares at a preferred
price.
II. Generally, issued by the companies in currency of those countries where interest
rate is less than rate of interest in domestic economy.

6. Inflation Indexed Bonds:

§ Inflation risk has been a potential problem especially with the fixed maturity products
like bonds. If the inflation rate is higher than the interest rate being received on the
fixed income products, it diminishes the purchasing power of the consumer. Inflation
indexed bonds are an efficient way to counter the inflation risk.
How does it work?:
§ The amount you invest in a bond is called the ‘principal’ or ‘face value’. Each bond
promises a fixed rate of interest called coupon rate. This is used to calculate regular
interest payments. In a normal bond, the principal amount never changes, and the
returns are constant. In an IIB, the principal amount is adjusted every year according
to the inflation. This means, if the prices rise, the returns (in the form of interest
earnings) on the bonds too rise, and vice versa.

DEBENTURES
§ A debenture is a medium to long-term debt that is used by large companies to borrow
money.
§ In general, it is not secured by physical assets or collateral. Debentures are backed only
by general creditworthiness & reputation of the issuer.
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§ Most debentures pay a fixed rate of interest. It is required that this interest is paid prior
to dividends being paid to shareholders.
§ Debenture holders (investors) do not have any rights to vote in the company's general
meetings of shareholders.

Convertible Vs. Non-Convertible Debentures:

1. Convertible debentures can convert into equity shares of the issuing corporation after
a specific period of time.
2. Non-convertible debentures are regular debentures that cannot be converted into
equity of the issuing corporation.

EQUITY SECURITY
SHARES
§ Shares are the financial assets issued by the companies to raise capital from the general
public. When a company offers share, for sale, it sells the portion of its ownership for cash.
They are traded on stock exchange.
§ The shares are divided into two categories:
1. Equity shares
2. Preference shares

Equity Shares:
§ Equity shares are the ordinary shares of the company. The holder of the equity shares are
the real owners of the company.
§ Equity shareholders have some privileges like they get voting rights, can appoint or
remove the directors and auditors of the company, have the right to get the profits of the
company, i.e. dividend.

Preference Shares:
§ Preference Shares, as its name suggests, gets precedence over equity shares on the
matters like distribution of dividend at a fixed rate and repayment of capital in the event
of liquidation of the company.
§ The preference shareholders are also the part owners of the company like equity
shareholders.

BASIS FOR EQUITY SHARES PREFERENCE SHARES

COMPARISON
Meaning Ordinary shares of the company They carry preferential rights on the
representing the part ownership matters of payment of dividend and
of the shareholder in the repayment of capital.
company.

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 Payment of The dividend is paid after the Priority in payment of dividend over
dividend payment of all liabilities. equity shareholders.
Repayment of In the event of winding up of In the event of winding up of the
capital the company, equity shares are company, preference shares are
repaid at the end. repaid before equity shares.
Convertibility They can never be converted. They can be converted into equity
shares.
Voting rights Equity shares carry voting rights. Normally, PS don’t carry VR. But, in
special circumstances, they might get
voting rights.

PRIMARY MARKET
§ It deals with new securities being issued for the first time. The essential function of a
primary market is to facilitate the transfer of investible funds from savers to
entrepreneurs.
§ The investors in this market are banks, financial institutions, insurance companies, mutual
funds and individuals.
§ Typically, a company will hire an investment banker to underwrite the offering and a
corporate lawyer to assist in the drafting of the prospectus.

INITIAL PUBLIC OFFERING (IPO)

§ It is the first sale of shares by the UNDERWRITER:

company to public. When a § Any company when decides to go public
company makes an IPO the shares generally prefers the IPO route, which it does
of the company becomes widely with the help of big investment bankers also
called underwriters.
held. Companies offering an IPO
§ These underwriters are responsible for
are sometimes new, young making the public issue successful and find
companies, or companies which the buyers for company’s shares. They are
have been around for many years paid a certain amount of commission to do
and have finally decided to go this work.
public.
§ The money paid by investor goes directly to the company in contrast to the shares at stock
exchange where money passes between investors.

Fresh Issue of Shares

§ New shares are issued by the company to public investors. The issued share capital of the
company increases. The percentage holding of existing shareholders will come down due
to the issuance of new shares.

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Offer for Sale
§ Existing shareholders such as financial institutions offer a part of their holding to the
public investors. The share capital of the company does not change since the company is
not making a new issue of shares. The proceeds from the IPO go to the existing
shareholders who are selling the shares and not to the company.

FURTHER PUBLIC OFFER (FPO)

§ A follow-on public offer is made by an issuer that has already made an IPO in the past
and now makes a further issue of securities to the public.

RIGHTS ISSUE
§ This is a privilege given to existing shareholders to subscribe to a new issue of shares
according to the terms and conditions of the company.

PRIVATE PLACEMENT
§ Private placement (or non-public offering) is a funding round of securities which are sold
not through a public offering, but rather through a private offering, mostly to a small
number of chosen investors like financial institutions and banks.
GREENSHOE OPTION
§ The issuer company uses green shoe option during IPO to ensure that the shares price on
the stock exchanges does not fall below the issue price after issue of shares. Any company
when decides to go public generally prefers the IPO route, which it does with the help of
big investment bankers also called underwriters. The green shoe option is also often
referred to as an over-allotment provision.

§ For instance, a company plans to issue 100 shares, but to use the greenshoe option; it
actually issues 115 shares, in which case the over-allotment would be 15 shares. The
money received from the over-allotment is required to be kept in a separate bank account
(i.e. escrow account).

Role of the stabilising agent:

§ In case the shares are trading at a price lower than the offer price, the stabilising agent
starts buying the shares by using the money lying in the separate bank account. In this
manner, by buying the shares when others are selling, the stabilising agent tries to put the
brakes on falling prices. The shares so bought from the market are handed over to the
promoters from whom they were borrowed.
§ In case the newly listed shares start trading at a price higher than the offer price, the
stabilising agent does not buy any shares.

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e-INITIAL PUBLIC OFFER (e-IPOs)
§ A company proposing to go public through the on-line system of the stock exchange has
to enter into an agreement with the stock exchange. This is called an e-Initial Public Offer
(e-IPO).

SECONDARY MARKET
§ It is a market for the purchase and sale of existing securities- shares, debentures, bonds.
§ A secondary offering is not dilutive to existing shareholders, since no new shares are
created. The proceeds from the sale of the securities do not benefit the issuing company.

Stock Exchanges of India:

§ Indian secondary market consists of stock exchanges where securities issues by central
government, state government, public bodies and other companies are traded.
§ To trade in a stock exchange, the companies must be listed there. The exchange imposes
rules and regulations on the firms & brokers for efficient trading and provides the facility
for the issue and redemption of securities.
§ Those companies which are not listed on the stock exchanges are traded Over the Counter
(OTC). These are the smaller, riskier, and less liquid companies. Generally, they do not
meet the requirements of getting listed on the stock exchanges and hence trade over the
counter.
§ Timeline:
v Real beginning was with the Companies Act 1850 which generated interest in
corporate securities.
v BSE started in 1875.
v Stock Exchange in Ahmedabad, Kolkata & Madras followed.
v NSE was setup in 1992 and started operations from 1994.

§ Regulation:
v Stock Market in India is regulated by central government under Securities Contract
(Regulation) Act 1956.
v Securities and Exchange Board of India (SEBI) Act 1992 established SEBI to protect
investors and promote securities market. They supervise the securities market.

SOME PROMINENT STOCK EXCHANGES IN INDIA

BOMBAY STOCK EXCHANGE (BSE)

§ Established in 1875, BSE (formerly known as Bombay Stock Exchange Ltd.), is Asia's first &
the fastest Stock Exchange in world with the speed of 6 micro seconds and one of India's
leading exchange groups.
§ In 1956, the government recognized BSE as the first national stock exchange under the
Securities Contracts (Regulation) Act.

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§ BSE provides an efficient and transparent market for trading in equity, debt instruments,
derivatives, mutual funds. It also has a platform for trading in equities of small-and-
medium enterprises (SME).

§ More than 5,500 companies are publicly listed on the BSE.

§ The BSE is the world’s 10th largest stock exchange with an overall market capitalization of
$2.29 Trillion as of April 2018.
§ As of Feb 2021, 4,722 companies trading on the BSE were worth over Rs 200 Lakh Crore
(Rs 2,00,47,191.31 Cr), as per data available on the exchange.

NATIONAL STOCK EXCHANGE (NSE)

§ The National Stock Exchange (NSE) is India's leading stock exchange covering various cities
and towns across India.
§ It was setup in 1992 and started operations from 1994.

§ Overtime, the NSE cornered almost the complete market share in equity derivatives
trading, putting BSE firmly into a distant second place.

§ It was the first exchange in the country to provide a modern, fully automated screen-
based electronic trading system that offered an easy trading facility to the investors
spread across the length and breadth of the country.

§ NSE has a total market capitalization of more than US$ 2.27 trillion, making it the
world’s 11th-largest stock exchange as of April 2018.

STOCK MARKET INDEX (SMI)

§ They reflect the performance of selected companies in a stock exchange. It helps us to
understand the level of prices & trend of price movements. The companies are selected
on the basis of Mcap & other factors like its history of trading, the type of industry etc.

v Market Capitalisation = Total worth of all outstanding shares of a company. It

represents the total worth of a company.
v MC = No. of shares outstanding x Market Price of Shares

v Free-float methodology market capitalization = Price x Number of shares readily

available in the market.

Some important SMIs in Indian capital market are:

1. BSE SENSEX: is the oldest for equities, includes 30 firms listed on the BSE that represent
about 45% of the index’s free float market capitalization.

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2. NSE NIFTY: has 50 shares listed on the NSE, representing about 62% of its free-float
market capitalization.
CLEARING HOUSE:
§ Clearing houses are associated with an exchange to handle the confirmation, settlement
and delivery of transactions, fulfilling the main obligation of ensuring transactions in a
prompt and efficient manner.
§ So, all buyers pay funds to clearing house, and all sellers deliver securities to the clearing
house.
§ They settle deals in derivative market too & guarantee settlement.
§ They facilitate deals between buyer and seller and guarantee performance of contracts.
§ Example: Metropolitan Clearing Corporation of India Ltd., Multi Commodity Exchange
Clearing Corporation Ltd. etc.

SEBI REFORMS (IMPORTANT FOR UPSC):

§ IPO share allotments: Investors are classified into different categories. Each category has
to follow its own set of rules while investing in Initial Public Offerings (IPOs). Non-banking
financial institutions (NBFCs) will now be classified as ‘Qualified Institutional Buyers’
(QIBs). Until now, banks and insurance companies were classified as QIBs. Not all NBFCs
will be classified as QIBs, though. Only those registered with the RBI and with a net worth
of over Rs 500 crore can be classified as QIBs.

§ Usage of IPO proceeds: The market regulator will now regulate how companies use the
money they raise through IPO over Rs 100 crore. Earlier, it used to regulate any proceeds
over Rs 500 crore.
Why does this matters? When companies list shares in the stock market, they issue shares
through the IPO. After selling these shares to the public, the company raises money. It
then uses this money for business purposes. However, companies may not use the money
for the purpose stated in the documents. This could be problematic for investors. This is
why SEBI wants to regulate companies more.

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