Indian Capital and Stock Market - Copy.docx

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Indian Capital and Stock Market -

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Indian Capital and Stock Market INTRODUCTION Capital markets are a sub-part of the financial system. Conceptually, the financial system includes a complex of institutions and mechanisms which affects the generation of savings and their transfer to those who will invest. It may be said to be made of all those channels through which savings become available for investments. The main elements of the financial system are a variety of (i) financial instruments/assets/securities, (ii) financial intermediaries/institutions and (iii) financial markets. Financial Assets A financial asset/Instrument/security is a claim against another economic unit and is held as a store of value and for the return that is expected. While the value of a tangible/physical asset depends on its physical properties such as buildings, machines, furniture vehicles and so on, a financial asset represents a claim to future cash flows in the form of interest, dividends and so on. They are a claim on a stream of income and/or particular assets. The entity/economic unit that offers the future cash flows is the issuer of the financial instrument and the owner of the security is the investor. Depending upon the nature of claim/return, an instrument may be (i) debt (security) such as bonds, debentures, term loans, (ii) equity (security) shares and (iii) hybrid security such as preference shares and convertibles, Based on the type of issuer, the security may be (1) direct (2) indirect and (3) derivative. The securities issued by manufacturing companies are direct assets (e.g. shares/debentures). Indirect assets are claims against financial intermediaries (e.g. units of mutual funds). The derivative instruments include options and futures. The prevalence of a variety of securities to suit the investment requirements of heterogeneous investors, offers differentiated investment choice to them and is an important element in the maturity and sophistication of the financial system. Financial Intermediaries Financial Intermediaries are institutions that channelise the savings of investors into investments/loans. As institutional source of finance, they act as a link between the savers and the investors, which results in institutionalisation of personal savings. Their main

function is to convert direct financial assets into indirect securities. The indirect securities offer to the individual investor better investment alternative than the direct/primary security by pooling which it is created, for example, units of mutual funds. The main consideration underlying the attractiveness of indirect securities is that the pooling of funds by the financial intermediary leads to a number of benefits to the investors. The services/benefits that tailor indirect financial assets to the requirements of the investors are (i) convenience, (ii) lower risk, (iii) expert management and (iv) lower cost. Convenience Financial intermediaries convert direct/primary securities into a more convenient vehicle of investment. They divide primary securities of higher denomination into indirect securities of lower denomination. They also transform a primary security of certain maturity into an, indirect security of a different maturity. For instance, as a result of the redemption/repurchase facility available to unitholders of mutual funds, maturities on units would conform more with the desires of the investors than those on primary securities. Lower Risk The lower risk associated with indirect securities results from the benefits of diversification of investments. In effect, the financial intermediaries transform the small investors in matters of diversification into large institutional investors as the former shares proportionate beneficiary interest in the total portfolio of the latter. Expert Management Indirect securities give to the investors the benefits of trained, experienced and specialised management together with continuous supervision. In effect, financial intermediaries place the individual investors in the same position in the matter of expert management as large institutional investors. Low Cost Low cost is the benefits of investment through financial intermediaries are available to the individual investors at relatively lower cost due to the economies of scale.

The major financial intermediaries are banks, insurance organisations, both life and non-life/ general, mutual funds, non-banking financial companies and so on. Financial Markets Financial markets perform a crucial function in the financial system as facilitating organisations. Unlike financial intermediaries, they are not a source of funds but are a link and provide a forum in which suppliers of funds and demanders of loans/investments can transact business directly. While the loans and investments of financial intermediaries are made without the direct knowledge of the suppliers of funds (i.e. investors), suppliers in the financial market know where their funds are being lent/invested. The two key financial markets are the money market and the capital market. Money Market The money market is created by a financial relationship between suppliers and demanders of short-term funds which have maturities of one year or less. It exists because investors (i.e. individuals, business entities, government and financial institutions) have temporarily idle funds that they wish to place in some type of liquid asset or short-term interest-earning instrument. At the same time, other entities/ organisations find themselves in need of seasonal/ temporary financing. The money market brings together these suppliers and demanders of short- term liquid funds. The broad objectives of money market are three-fold: An equilibrating mechanism for evening out short-term surplus and deficiencies in the financial system; A focal point of intervention by the central bank (e.g. Reserve Bank of India) intervention for influencing liquidity in the economy; and A reasonable access to the users of short-term funds to meet their requirements at realistic/ reasonable cost and temporary deployment of funds for earning returns to the suppliers of funds. Capital Market The capital market is a financial relationship created by a number of institutions and arrangements that allows suppliers and demanders of long-term funds (i.e. funds with maturities exceeding one year) to make transactions. It is a market for long-term funds.

Included among long-term funds are securities issues of business and Government. The backbone of the capital market is formed by the various securities exchanges that provide a forum for equity (equity market) and debt (debt market) transactions. Mechanisms for efficiently offering and trading securities contribute to the functioning of capital markets which is important to the long-term growth of business. Thus, the capital market comprises of (I) stock/security exchanges/markets (secondary markets) and (2) new issue/primary market [initial public offering (IPO) market]. Relationship between New Issue Market (NIM) and Stock Exchange The industrial securities market is divided into two parts, namely, NIM and stock market. The relationship between these parts of the market provides an insight into its organisation. One aspect of their relationship is that they differ from each other organisationally as well as in the nature of functions performed by them. They have some similarities also. Differences The differences between NIM and stock exchanges pertain to (i) Types of securities dealt, (ii) Nature of financing and (iii) Organisation. New vs Old Securities The NIM deals with new securities, that is, securities which were not previously available and are, therefore, offered to the investing public for the first time. The market, therefore, derives its name from the fact that it makes available a new block of securities for public subscription. The stock market, on the other hand, is a market for old securities which may be defined as securities which have been issued already and granted stock exchange quotation. The stock exchanges, therefore, provide a regular and continuous market for buying and selling of securities. The usual procedure is that when an enterprise is in need of funds, it approaches the investing public, both individuals and institutions, to subscribe to its issue of capital. The securities thus floated are subsequently purchased and sold among the individual and institutional investors. There are, in other words, two stages involved in the purchase and sale of securities. In the first stage, the securities are acquired from the issuing companies themselves and these are, in the second stage, purchased and sold continuously among the investors without any involvement of the companies whose securities constitute the stock-

intrude except in the strictly limited sense of registering the transfer of ownership of the securities. The section of the industrial securities market dealing with the first stage is referred to as the NIM, while secondary market covers the second stage of the dealings in securities. Nature of Financing Another aspect related to the separate functions of these two parts of the securities market is the nature of their contribution to industrial financing. Since the primary market is concerned with new securities, it provides additional funds to the issuing companies either for starting a new enterprise or for the expansion or diversification of the existing one and, therefore, its contribution to company financing is direct. In contrast, the secondary markets can in no circumstance supply additional funds since the company is not involved in the transaction. This, however, does not mean that the stock markets have no relevance in the process of transfer of resources from savers to investors. Their role regarding the supply of capital is indirect. The usual course in the development of industrial enterprise seems to be that those who bar the initial burden of financing a new enterprise, pass it on to others when the enterprise becomes well established. The existence of secondary markets which provide, institutional facilities for the continuous purchase and sale of securities and, to that extent, lend liquidity and marketability, play an important part in the process. Organisational Differences The two parts of the market have organisational differences also. The stock exchanges have, organisationally speaking, physical existence and are located in a particular geographical area. The NIM is not rooted in any particular spot and has no geographical existence. The NIM has neither any tangible form any administrative organisational set up like that of stock exchanges, nor is it subjected to any centralised control and administration for the consummation of its business. It is recognised only by the services that it renders to the lenders and borrowers of capital funds at the time of any particular operation. The precise nature of the specialised institutional facilities provided by the NIM is described in a subsequent section. Similarities

Nevertheless, in spite of organisational and functional differences, the NIM and the stock exchanges are inseparably connected. Stock Exchange Listing One aspect of this inseparable connection between them is that the securities issued in the NIM are invariably listed on a recognised stock exchange for dealings in them. In India, for instance, one of the conditions to which a prospectus is to conform is that it should contain a stipulation that the application has been made, or will be made in due course for admitting the securities to dealings on the stock exchange. The practice of listing of new issues on the stock market is of immense utility to the potential investors who can be sure that should they receive an allotment of new issues, they will subsequently be able to dispose them off any time. The absence of such facilities would act as some sort of psychological barrier to investments in new securities. The facilities provided by the secondary markets, therefore, encourage holdings of new securities and, thus, widen the initial/primary market for them. Control The stock exchanges exercise considerable control over the organisation of new issues. In terms of regulatory framework related to dealings in securities, the new issues of securities which seek stock quotation/listing have to comply with statutory rules as well as regulations framed by the stock exchanges with the object of ensuring fair dealings in them. If the new issues do not conform to the prescribed stipulations, the stock exchanges would refuse listing facilities to them. This requirement obviously enables the stock exchange to exercise considerable control over the new issues market and is indicative of close relationship between the two. Economic Interdependence The markets for new and old securities are, economically, an integral part of a single marketthe industrial securities market. Their mutual interdependence from the economic point of view has two dimensions. One, the behavior of the stock exchanges has a significant bearing on the level of activity in the NIM and, therefore, its responses to capital issues: Activity in the new issues market and the movement in the prices of stock exchange securities are broadly related: new Issues increase when share values are rising and vice

versa.1 This is because the two parts of the industrial securities market are susceptible to common influences and they act and react upon each other. The stock exchanges are usually the first to feel a change in the economic outlook and the effect is quickly transmitted to the new issue section of the market. The second dimension of the mutual interdependence of the two parts of the market is that the prices of new issues are influenced by the price movements on the stock market. The securities market represents an important case where the stock-demand-and-supply curves, as distinguished from flow-demand-and-supply curves, exert a dominant influence on price determination. The quantitative predominance of old securities in the market usually ensures that it is these which set the tone of the market as a whole and govern the prices and acceptability of the new issues. Thus, the flow of new savings into new securities is profoundly influenced by the conditions prevailing in the old securities marketthe stock exchange. Functions of Stock Exchanges (Secondary Markets Stock exchanges discharge three vital functions in the orderly growth of capital formation: (i) Nexus between savings and investments, (ii) Market place and (iii) Continuous price formation. Nexus between Savings and Investment First and foremost, they are the nexus between the savings and the investments of the community. The savings of the community are mobilised and channelled by stock exchanges for investment into those sectors and units which are favoured by the community at large, on the basis of such criteria as good return,...

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