primary and secondary markets

Primary and Secondary Markets Part-2

Syllabus section: RBI Grade B – Phase 2- Finance and Management- Primary and Secondary Markets

EQUITY MARKET

It is the market where equity instruments are traded.

Features of Equity Capital

  1. Nature: Equity capital is permanent capital that is provided by the owners/shareholders of the company. The profits or returns received by shareholders depends on the performance of the company.
  2. Denomination: Equity capital is denominated in equity shares, with a face value..
  3. Inside and outside Shareholders: Equity Capital can be provided by two types of shareholders. The first are the inside shareholders or promoters who start the company with their funds and entrepreneurial skills. These include large institutions with huge funds that invest in early stages of the company and become inside shareholders. Outside shareholders include the general public that invest during later stages when the company has expanded.
  4. Part ownershipEquity shareholders are part owners of the company. This implies that their ownership is only limited to the number of shares they have invested in the company.
  5. Variable return and residual claim: Equity capital is permanent and it is not returned during the life of the business. Equity investors receive periodic returns in the form of dividend. The rate of dividend depends on the profitability of the business and the availability of surplus for paying dividends after meeting all costs. If the company were to shut down due to losses, all the proceeds from selling assets would be paid to first to all other claimants and any residual amount, if at all, is paid to equity shareholders. Thus equity shareholders are residual claimants.
  6. Net worth: Companies are not forced to distribute their profits in form of dividends every year. They may retain these profits within the company, called retained earnings. This form part of company’s reserves. Reserves enhance the net worth of the company.
  7. Management and Control:  When company seeks capital from the public,ownership and management get separated, It is not feasible for thousands of shareholders holding a small proportion of capital each, to be involved in managing the company. Hence the shareholders appoint a group of people as the Board of Directors who will help in management of the company. Shareholders receive voting rights and several important decisions require shareholder approval.

Who regulates Equity Markets?

The Securities and Exchange Board of India (SEBI) is the regulatory authority established under the SEBI Act 1992 and is the principal regulator for Stock Exchanges in India.

Primary Markets

Primary capital markets are those security market where the equity and debt securities offered to the investors for the first time.

  • Also called new issues market
  • Origination Function: In a primary market, the securities are issued for the first time by the company to investors
  • Distribution Function:In primary market securities are issued by the company directly to the investors.
  • Underwriting: It is a very common practice to get the securities underwritten by various investment banks.
  • Primary market does not include loans from commercial banks and other financial institutions .

Equity Market Instruments

Public Issue

  • Method for issuing new issues in the primary capital market
  • Whencompany offers its shares in the primary market, it is called public issue.
  • It involves direct sale of securities to the public.
  • SEBI defined public issue as ―an invitation by a company to public to subscribe to the securities offered through a prospectus
  • As perCompanies Act of 2013, an issue becomes public if it is allotted to more than 50 persons.

Public issue can be further classified into two:

1. Initial Public Offer (IPO)

2. Further Public Offer (FPO).

Initial Public Offer (IPO)

  • An IPO is an issue of shares to the public for the first time.
  • Initial Public Offer is the selling of securities to the public in the primary market.
  • Initial public offering is the process by which a private company can go public by sale of its stocks to general public. It could be a new, young company or an old company which decides to be listed on an exchange and hence goes public.
  • Public share issuance allows a company to raise capital from public investors.
  • The sale of securities can either be through book building or through normal public issue.
  • IPO can be underwritten by investment banks. Underwriting refers to the process which helps the company to get an assurance that the company will be able to sell its shares in the market. Underwriting services are provided in return for some commission charges.

Further Public Offer (FPO)

  • When an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public it is called FPO Further Public Offer (FPO)
  • Also called Follow on Offer.

In a follow-on public offer (FPO), an already listed company issues fresh shares to new investors or existing shareholders. Companies take the FPO route after they have been through the IPO process. But OFS, is for diluting promoter stake in a listed company. No new shares are created.

Rights Issue

  • When a listed company proposes to issues fresh securities to its existing shareholders as on a particular dated fixed by the issuer (i.e. record date), it is called as rights issue.
  • The rights are offered in proportion ratio to the number of securities held as on the record date.
  • It does not dilute stake of existing shareholders.

Bonus Issue

  • When a company issues shares to its existing shareholders as on a record date, without any considerationin return, it is called  a bonus issue.
  • The shares are issued to the existing shareholders out of company’s  reserves in a particular ratio to the number of securities held on a record date.

Private Placement

  • Under Companies Act, 2013, “Private Placement” shall be made only to such persons whose names are recorded by the company prior to the invitation to subscribe.  Further, in case of private placements, the company shall not release any public advertisements or utilise any media, marketing or distribution channels or agents to inform the public at large about such an offer. Further, such offer or invitation shall not be made to more than 200 persons in the aggregate in a financial year.
  • It is neither a rights issue nor a public issue
  • Generally issued to qualified institutional investors.
  • It is the b way for a company to raise equity capital.
  • Private placement can of two types – preferential allotment and qualified institutional placement.

Preference Shares Issue:

  • The stocks are issued to parties who are given some preference over common shareholders
  • Preferred shareholders are usually guaranteed a fixed dividend.
  • In the event of liquidation, preferred shareholders are paid off before the
  • common shareholder

Secondary markets

The secondary market is where investors buy and sell securities they already own. It is what most people typically think of as the “stock market.

Functions of Secondary markets:

  1. Growth of Primary Market: They help in growth of primary market by providing liquidity. Primary markets can not flourish without secondary markets.
  2. Economic indicator: They act as an economic indicator for the economy. Bearish and bullish sentiments are used to assess the general level of business optimism in the economy.
  3. Price Determination: Secondary markets help in real time price determination of the securities.
  4. Mobilization of funds: Funds are mobilized from savers to useful investment avenues through stock exchanges.

Some important points:

Clearing Corporation: Clearing corporationsare also known as clearing houses. The National SecuritiesClearing Corporation Ltd. (NSCCL) is the clearing corporation for trades done on the NSE; theIndian Clearing Corporation Ltd. (ICCL) is the clearinghouse for BSE trades.

Depositories: For a security to be eligible to trade in the secondary markets, it should be heldin electronic or dematerialized form. National Securities Depository Ltd (NSDL) and CentralDepository Services Ltd (CDSL)are the 2 depositories in India.

Demutualization: Demutualization is a process by which a private, member-owned company, such as a co-op, or a stock exchange, legally changes its structure, in order to become a public-traded company owned by shareholders.

Depository Receipt: A depositary receipt (DR) is a negotiable certificateissued by a bank representing shares in a foreign company traded on a local stock exchange. The depositary receipt gives investors the opportunity to hold shares in the equity of foreign countries and gives them an alternative to trading on an international market.

American Depository Receipts (ADRs):These are listed on a stock exchange in the USAGlobal Depository Receipts (GDRs):These are listed on a stock exchange outside the US

Indian Depository Receipts (IDRs):These are issued in India and listed on Indian stock exchanges with foreign stocks as underlying shares

Greenshoe Option: A greenshoe option is an over-allotment option. In the context of an initial public offering (IPO), it is a provision in an underwriting agreement that grants the underwriter the right to sell investors more shares than initially planned by the issuer if the demand for a security issue proves higher than expected.

Book building: It is the process by which an underwriter attempts to determine the price at which an initial public offering (IPO) will be offered. The process of price discovery involves generating and recording investor demand for shares before arriving at an issue price.

Red Herring Prospectus : It is a prospectus, which does not have details of either price or number of shares being offered, or the amount of issue.

Shelf Prospectus

It is a type of public offering where issuers are allowed to offer and sell securities to the public without a separate prospectus for each offeringand without the issue of further prospectus. Instead, there is a single prospectus for multiple future offerings.

FOREIGN EXCHANGE MARKET

What is Foreign Exchange Market?

  • Foreign exchange market or Forex-market facilities the trading of foreign exchange. RBI is the regulatory authority for foreign exchange business in India.
  • The foreign exchange market in India prior to the 1990s was characterized by strict regulations, restrictions on external transactions, barriers to entry, low liquidity and high transaction costs. Foreign exchange transactions were strictly regulated and controlled by the Foreign Exchange Regulations Act (FERA), 1973. With the rupee becoming fully convertible on all current account transactions in August 1994, foreign exchange trading volumes started rising. This was supplemented by reforms undertaken by the Reserve Bank of India.
  • Foreign Exchange Regulation Act (FERA) was replaced by the Foreign Exchange Management Act (FEMA), 1999, in which the Reserve Bank of India delegated its powers to authorized dealers to release foreign exchange for a variety of purposes. Capital account transactions were also liberalized in a systematic manner.

Type of Persons

Applicability of FEMA is generally dependent upon the residential statusof a person and the nature of the transaction undertaken. A ‘person’ can be an individual, a HUF, a company, a firm, an association of persons etc.

A “person” under FEMA is either a “person resident in India” or a “person resident outside India”. The residential status of a person is not only basedon the period of stay in India but also the intent to stay for a long/uncertain period.

Authorised Persons (APs)

The regulatory framework providedunder FEMA casts a great responsibility on the “Authorised Persons” who are the immediate and necessary counterparty to every participant for any foreign exchange transaction.

Reserve Bank issues licences to Authorised Dealers (banks authorised to deal in foreign exchange) and Full Fledged Money Changers. Licences are also granted to financial and other institutions to carry out specific foreign exchange transactions related to their business / activities.

Authorised Persons can be classified into

  • Authorised Dealer Category I (AD Cat I) – This category of Authorised Persons can undertake all types of current and capital account transactions. Generally, Commercial Banks, Urban and State CooperativeBanks are authorised by Reserve Bank to function as AD Cat I.
  • Authorised Dealer Category II (AD Cat II) – This category of Authorised Persons can undertake specified non-trade related current accounttransactions. Cooperative Banks, Regional Rural Banks and various other entities based on the eligibility criteria decided by Reserve Bank function as AD Cat II.
  • Authorised Dealer Category III (AD Cat III) – This category of Authorised Persons can undertake transactions incidental to the foreign exchange activities undertaken by these institutions. Select Financial and otherInstitutions are authorised by Reserve Bank to function as AD Cat III.
  • Full Fledged Money Changers (FFMCs) – This category of AuthorisedPersons can undertake purchase of foreign exchange and sale for private and business visits abroad.

Non-Resident Deposits –Deposit accounts for non-resident Indians was one of the earliest measures to strengthen capital inflows. The various accounts that can be opened by non-residents are:

  • NRE account – NRE or Non-Resident (External) Rupee Account can be opened by NRIs and PIOs. This account can be opened as savings, current, recurring and fixed deposit and is denominated in Indian Rupees.
  • FCNR(B) Account – FCNR(B) or Foreign Currency (Non-Resident) Account (Banks) Scheme can be opened by NRIs and PIOs. This account can be opened as a term deposit and can be opened in any freely convertible foreign currency.
  • NRO Account – NRO or Non-Resident Ordinary Rupee Account can be opened by any non-resident. This account can be opened as savings, current, recurring and fixed deposit and is denominated in Indian Rupees.
  • SNRR Account – Special Non-Resident Rupee (SNRR) Account can be opened by any non-resident having a business interest in India for the purpose of putting through bona fide transactions in Rupees. The account can be opened as a current accountand does not bear any interest.

Derivatives Market

What is futures market?

A futures market is a market in which participants buy and sell commodity and futures contracts for delivery on a specified future date. Futures are exchange-traded derivatives contracts that lock in future delivery of a commodity or security at a price set today.

Futures markets help businesses to manage price risks.Thus, helping in hedging risk.

A futures contract is an agreement that requires a party to the agreement to either buy or sell something at a designated future date at a predetermined price.

Futures contract can be either commodity futures or financial futures.

Some examples of futures contract are:

1. Stock index futures

 2. Interest rate futures

3. Currency futures

4. Commodity futures etc.

Other kinds of derivates traded in the market are:

  1. Forward contracts
  2. Futures Contracts
  3. Options
  4. Swaps