Stock Market

Stock Markets Overview

Stockholders are the legal owners of a corporation
they have a residual claim to all earnings and assets after debt and tax claims are satisfied voting rights (e.g., to elect board of directors) shareholders do not exercise control (elected board chooses CEO, etc.)

Primary and Secondary Markets Overview

Primary Market
firm can raise equity capital in its initial public offering (IPO) firm can raise equity capital in a subsequent seasoned equity offering (SEO)

Secondary Markets
trading of shares among investors

Stock Market Securities

Two types of corporate stock exist
Common stock
the fundamental ownership claim in a public

corporation

Preferred stock
a hybrid security that has characteristics of both bonds and common stock

Calculating Stock Returns

R1 = P1 - Pt-1 + D1 Pt-1 P t-1
Where: P1 = Stock price at time t D1 = Dividends paid over time t - 1 to t P1 - Pt-1 = Capital gain over time t - 1 to t, and Pt-1

R1 = $45 - $40 + $4 $40 $40 = 12.5% + 10.0% = 22.5%

Characteristics of Common Stock

Dividends
payment and size of dividends is determined by the board of directors of the issuing firm

Residual Claim
in the event of liquidation, common stockholders have the lowest priority in terms of any cash distribution

Limited Liability
common stockholders losses are limited to the amount of their original investment in the firm

Voting Rights

Characteristics of Preferred Stock

Similar to common stock in that it represents an ownership interest but, like bonds, pays a fixed periodic dividend Senior to common stock but junior to bonds Generally do not have voting rights Nonparticipating preferred stock
dividend is fixed regardless of any increase or decrease in the firms value

Cumulative preferred stock

missed dividend payments go into arrears and must be made up before common stock dividends can be paid

Issuance of Stock in the Primary Market

Stocks Stocks

Issuing Corporation
Funds

Investment Bank
Funds

Investors

Investment bank conducts primary market sale of stock using firm commitment underwriting (guarantees corporation a fixed price for newly issued securities) or best efforts underwriting (no guarantee to issuer and acts more as a placing or distribution agent)
(continued)

 Net proceeds - the guaranteed price at which the investment bank purchases the stock from the issuer Gross proceeds - the price at which the investment bank resells the stock to investors Underwriters spread - the difference between the gross proceeds and the net proceeds Syndicate - the process of distributing securities through a group of investment banks Originating house - the lead bank in the syndicate negotiates with the issuing company on behalf of the syndicate Red herring proxy - a preliminary version of the prospectus describing a new security

Evolution of regulation
Abolition of Controller of Capital Issues in 1992 Constitution of Securities and Exchange Board of India (SEBI) as the apex regulator for capital markets Free pricing of equity Introduction of book building for raising capital Relaxation in equity dilution norms allowing large unlisted firms esp. in the technology sector to list in Indian markets Progressive changes in the entry norms enabling all companies to access markets but subject to high disclosure norms and QIB participation

Capital market
Efficient capital markets are a critical component for any developed economy The key to developing effective capital markets as an engine of growth is to design facilitating regulatory structures Indian capital markets today are amongst the best regulated markets providing efficient trading and settlement infrastructure, high levels of disclosure and fostering an environment for innovation The regulatory framework has kept pace with the significant growth in the securities markets and can be benchmarked with markets in developed nations Increasing integration with global markets will be the key agenda going forward as Indian corporates expand their presence across the globe and companies in the region look at listing in India While events during the past decade have resulted in strengthening of the regulatory framework, the environment is proactive and continues to develop with a strong industry interface and open minded approach

Secondary Market-Transaction Cycle

Trading & Settlement Process

Depository Investor

Clearing House

Broker

Exchange

Contd..

Market Participants
Exchange NSE/BSE Depository NSDL/CDSL Custodian Depository Participants Clearing Corporation NSCCL/BOI share Holding Stock Broker A broker is an intermediary who arranges to buy and sell securities on behalf of clients (the buyer and the seller) also known as CM Clearing Member Sub Broker

Trading At NSE
The trading on stock exchanges in India used to take place through open outcry NSE introduced a nation-wide on-line fullyautomated screen based trading system NEAT SBTS electronically matches orders on a strict price/time priority

Order Placement
NSE has main computer which is connected through Very Small Aperture Terminal (VSAT) installed at its office. Brokers have terminals (identified as the PCs in the Figure 1) installed at their premises which are connected through VSATs/leased lines/modems. An investor informs a broker to place an order on his behalf. The broker enters the order through his PC, which runs under Windows NT and sends signal to the Satellite via VSAT/leased line/modem. The signal is directed to mainframe

Contd ..
The order confirmation message is immediately displayed on the PC of the broker. This order matches with the existing passive order(s), otherwise it waits for the active orders to enter the system. On order matching, a message is broadcast to the respective member.

Contd .
All orders received on the system are sorted with the best priced order getting the first priority for matching i.e., the best buy orders match with the best sell order. Similar priced orders are sorted on time priority basis, i.e. the one that came in early gets priority over the later one. Orders are matched automatically by the computer keeping the system transparent, objective and fair. Where an order does not find a match, it remains in the system and is displayed to the whole market, till a fresh order comes in or the earlier order is cancelled or modified.

Clearing & Settlement

The clearing and settlement mechanism in Indian securities market has witnessed significant changes and several innovations during the last decade. T+2 rolling settlement has now been introduced for all securities. The members receive the funds/securities in accordance with the pay-in/pay-out schedules notified by the respective exchanges.

Contd ..
The obligations of members are downloaded to members/custodians by the clearing agency The members/custodians make available the required securities in their pool accounts with depository participants (DPs) by the prescribed pay-in time for securities.

Contd
The depository transfers the securities from the pool accounts of members/custodians to the settlement account of the clearing agency. The securities are transferred on the pay-out day by the depository from the settlement account of the clearing agency to the pool accounts of members/custodians.

Settlement Process in CM segment of NSE

Process
(1) Trade details from Exchange to NSCCL (real-time and end of day trade file).
(2) NSCCL notifies the consummated trade details to CMs/custodians who affirm back. Based on the affirmation, NSCCL applies multilateral netting and determines obligations. (3) Download of obligation and pay-in advice of funds/securities. (4) Instructions to clearing banks to make funds available by pay-in time. (5) Instructions to depositories to make securities available by pay-in-time. (6) Pay-in of securities (NSCCL advises depository to debit pool account of custodians/CMs and credit its account and depository does it). (7) Pay-in of funds (NSCCL advises Clearing Banks to debit account of custodians/CMs and credit its account and clearing bank does it). (8) Pay-out of securities (NSCCL advises depository to credit pool account of custodians/CMs and debit its account and depository does it). (9) Pay-out of funds (NSCCL advises Clearing Banks to credit account of custodians/CMs and debit its account and clearing bank does it). (10) Depository informs custodians/CMs through DPs. (11) Clearing Banks inform custodians/CMs.

Flow: Trade Processing

Order confirm Trade Details

Exchange Customer Place order

Enters order

Clearing Corporation

Clearing Banks

Depository

DP

Broker

Trading Terminal
Security Transfer Funds Availability Security Availability

Obligation report Security transfer CC a/c

Security transfer To CM pool acct

Auctions
Initiated by Exchange on behalf of trading members for settlement related reasons. On the securities pay-in day, NSCCL identifies short deliveries and the respective clearing member is debited by an amount equivalent to the securities not delivered by him and valued at a valuation price NSCCL conducts a buying-in auction for security shortages on the day after the pay-out day through the NSE trading system. If the buy-in auction price is more than the valuation price, the member is required to make good the difference. Close Out all shortages not bought are deemed closed at highest price of the trading period or closing price on auction day plus 20%

Order Management
NSE is Order driven market Order management consists of Entering orders Order modification Order cancellation Order matching

Entering Order
Active vs. Passive Order (price, time stamping) Order Book Regular lot, Stop loss, special terms, retail debt order, auction orders Symbol and Series Quantity Price Principal or Client Order types/conditions

Order modification

Modify during market hours Change unexecuted quantity, price Cannot change client code Cannot exceed price limits

Order Types/Conditions

Time Day, GTC Price Market, Stop loss, Limit Other conditions Pro, Client, Warehouse

Order Matching
Touch Line Best buy order, Best sell order By Price By Time

SHORT SALES
WHAT IS A SHORT SALE?
a sale which involves the investor borrowing stock from his/her broker to sell at a higher price and repurchase at a later time at a lower price

SHORT SALES
SHORT-SALE MARGINS
Initial margin

SHORT SALES
SHORT-SALE MARGINS
Actual margin
= (Short Sales Proceeds + Initial Margin) - Loan Loan

SHORT SALES
SHORT-SALE MARGINS
Maintenance margin
equal to the current dollar value of the loan.

Evolution of regulation
Electronic trading - Setting up of National Stock Exchange (NSE) in 1992 Demutualization of stock exchanges - Corporatization - Separation of clearing and trading functions - Broad basing of the governing bodies Dematerialization of securities - Safe and speedy settlement systems Introduction of Rolling Settlement System - Progressed from T + 5 days to T + 2 days; India is the only major market to have achieved this milestone in such a short span of time - Despite high volatility resulting from global events, natural disasters etc. markets have continued to operate without any disruption Derivative trading - Introduction of futures and options on both indices and individual stocks

Objective of regulation
The importance of securities markets in the economic development of a country cannot be overemphasized Well regulated markets provide an efficient mechanism for corporates to raise capital from a wide base of investors Countries with regulatory barriers and inadequate regulatory environment face higher cost of capital

Trends in regulatory policy

Why Self Regulation?

SROs can enforce ethical standards beyond the requirements of government regulations SROs may have considerable depth and expertise regarding market operations and practices Can respond more quickly and flexibly to changes in market conditions SROs in India
Association of Mutual Funds in India (AMFI) - Apex body of asset management companies - Aims to define, maintain high professional and ethical standards in mutual fund industry

SROs in India
Association of Merchant Bankers of India (AMBI) - Aims to recommend and regulate healthy business practices among merchant bankers Fixed Income Money Market and Derivatives Association of India (FIMMDA) - Interacts with regulators and undertakes development activities in the fixed income money markets and derivatives arena Central Listing Authority - Conceptualized to act as the agency for processing applications for listing and give recommendations Steps that need to be taken - Regulatory regime to make appropriate use of existing SelfRegulatory Organizations (SROs) - SROs to exercise direct oversight and responsibility for their area of competence - SROs subject to regulation and should observe standards of fairness and confidentiality when exercising powers and delegated responsibilities

Corporate Governance
Corporate governance norms have been strengthened and globally benchmarked for auditing and disclosure of financial information and have been extended to: - Ownership structure - Investor rights - Board/management structures and processes - Management compensation and ESOPs SEBI implemented the corporate governance code by introducing it as a part of the listing agreement of stock exchanges Guidelines impact the following areas for Indian corporates: - Composition of Board of Directors - Improved accounting standards and financial reporting - Formation of management committees for audit, managerial remuneration etc. - Defining role of management, shareholders rights - Strengthening disclosure norms

Way Ahead.. Restricted Offerings and IDRs

Indian Depository Receipts - Companies (Issue of Indian Depository Receipt) Rules, 2004 were notified by the Government of India on February 20, 2004 to enable foreign issuers to raise funds from the Indian Financial Markets in the form of Indian Depository Receipts (IDRs) - The IDR route shall invite small and mid-cap foreign companies which are familiar with Indian markets

Way Ahead .. Takeover guidelines

Changes in SEBI Take Over Code - Harmonization of DIP Guidelines, Takeover Regulations and Delisting guidelines so that takeovers become more smooth - Hostile takeovers should not be discouraged in case of underperforming companies - Norms relating to inter-se transfer among Indian and foreign promoter should be eased by relaxing the pricing norms Clarity with regards to Promoter/Public Shareholding - SEBI take over code defines Public Shareholding as shares held by persons other than Promoters - Recent amendment to clause 40A of the listing agreement defines Public Shareholding as excluding the promoters shareholding and shares underlying ADRs/GDRs - Clear guidance required as regards to entry/exit of a person as Promoter

Way Ahead.. New financial instruments

Securitization - Pass Through Certificates (PTCs) should be allowed for listing to create liquidity for securitized instruments - Disclosure requirements to be eased for listing of privately placed PTCs and role of SEBI has to be limited to public issue of PTCs Shares with differential voting rights - Concept of shares with differential voting rights including non-voting shares can be introduced in the Indian Securities Market which can be synchronised with relevant provisions of the Companies Act and Listing Guidelines - Mature companies can deliver value to shareholders through issue of tracking stock and passing on benefits of a growing business unit - Non-voting shares can act as a defense mechanism against a hostile takeover

Other Issues Pertaining to Stock Markets

Does the stock market forecast the economy?
Some evidence suggests that the stock market forecasts the economy but evidence is not reliable

Market efficiency
the speed with which financial security prices adjust to unexpected news pertaining to interest rates or a stockspecific characteristic

Random walk hypothesis

The theory that historical prices on a financial claim cannot help in predicting future prices