Primary and Secondary Markets

Agenda

Capital Market Primary Market Features of Primary market Secondary Market Features of Secondary Market Conclusion

CAPITAL MARKET The market where investment

instruments like bonds, equities and mortgages are traded is known as the capital market.

The primal role of this market is to make investment from investors who have surplus funds to the ones who are running a deficit.

The capital market offers both long term and overnight funds.

The different types of financial instruments that are traded in the capital markets are:

> equity instruments > credit market instruments, > insurance instruments, > foreign exchange

instruments, > hybrid instruments and > derivative instruments.

Importance of Capital Markets

Help firms and governments raise cash by selling securities

Allow investors with excess funds to invest and earn a return

Channel funds from savers to borrowers Allocate resources optimally (i.e.,

provide funds to those who can make the best use of them)

Help allocate cash to where it is most productive

Help lower the cost of exchange Secondary markets, where investors

trade existing securities, assures investors that they can quickly sell their securities if the need arises

Types of capital marketThere are two types of capital

market: Primary market, Secondary market

Primary Market It is that market in which

shares, debentures and other securities are sold for the first time for collecting long-term capital.

This market is concerned with new issues. Therefore, the primary market is also called NEW ISSUE MARKET.

In this market, the flow of funds is from savers to borrowers (industries), hence, it helps directly in the capital formation of the country.

The money collected from this market is generally used by the companies to modernize the plant, machinery and buildings, for extending business, and for setting up new business unit.

Features of Primary Market It Is Related With New Issues

It Has No Particular Place It Has Various Methods Of Float

Capital: Following are the methods of raising capital in the primary market:

i) Public Issue ii) Offer For Sale iii) Private Placement iv) Right Issue v) Electronic-Initial Public

Offer It comes before Secondary Market

Initial public offering (IPO) The first sale of a company’s stock to the general public.

Investment bankers Financial specialists who handle the sales of most corporate and municipal securities.

Underwriting Process of purchasing an issue from a firm or government and then reselling the issue to investors.

Factors to be considered by Investors

Promoters Credibility Project Details Product Financial data Risk factors Auditors report

Secondary Market The secondary market

is that market in which the buying and selling of the previously issued securities is done.

The transactions of the secondary market are generally done through the medium of stock exchange.

The chief purpose of the secondary market is to create liquidity in securities.

If an individual has bought some security and he now wants to sell it, he can do so through the medium of stock exchange to sell or purchase through the medium of stock exchange requires the services of the broker presently, their are 24 stock exchange in India.

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Features of Secondary Market

It Creates Liquidity It Comes After Primary Market It Has A Particular Place It Encourage New Investments Aids in financing the industry Ensures safe & fair Dealing( MEDIA

BROADCASTING)

Functions of Secondary Markets

Provides regular information about the value of security.

Helps to observe prices of bonds and their interest rates.

Offers to investors liquidity for their assets.

Secondary markets bring together many interested parties.

It keeps the cost of transactions low.

Meaning of Lease and Leasing

• A lease is a contractual arrangement calling for the lessee (user) to pay the lessor (owner) for use of an asset

• Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments.

Important Terms:

• Lessee is the receiver of the services or the assets under the lease contract.

• Lessor is the owner of the assets.• Tenancy is the relationship between the tenant and

the landlord.• Term is the fixed or an indefinite period of time

involved in the lease contract.• Rent is the consideration for the lease.

Types Of Lease

Operating

lease

Capital lease

Leveraged

lease

Sale and lease back

Direct lease

1. 100% Financing at Fixed Rates.

2. Protection Against Obsolescence.

3. Flexibility.

4. Less Costly Financing.

5. Tax Advantages.

6. Off-Balance-Sheet Financing.

Advantages of Leasing

Disadvantages of Leasing:

• If the business is successful, lessors may demand higher rental payments when leases come up for renewal.

• A net lease may shift some or all of the maintenance costs onto the tenant.

1 Usually lease terms are rigid and

difficult to navigate in circumstances

where the business has tochange its operations

substantially.2Tactical legal

considerations usually make it expedient for lessees to default on their leases

Meaning Venture capital means funds made available

for startup firms and small businesses with exceptional growth potential.

Venture capital is money provided by professionals who alongside management invest in young, rapidly growing companies that have the potential to develop into significant economic contributors.

Venture Capitalists generally:

• Finance new and rapidly growing companies

• Purchase equity securities

• Assist in the development of new products or services

• Add value to the company through active participation.

The SEBI has defined Venture Capital Fund in its Regulation 1996 as ‘a fund established in the form of a company or trust which raises money through loans, donations, issue of securities or units as the case may be and makes or proposes to make investments in accordance with the regulations’.

Characteristics

• Long time horizon

• Lack of liquidity

• High risk

• Equity participation

• Participation in management

Stages of financing

1. Seed Money: Low level financing needed to prove a new idea.2. Start-up: Early stage firms that need funding for expenses

associated with marketing and product development. 3. First-Round: Early sales and manufacturing funds. 4. Second-Round: Working capital for early stage companies that are selling

product, but not yet turning a profit .

5. Third-Round: Also called Mezzanine financing, this is

expansion money for a newly profitable company

6. Fourth-Round: Also called bridge financing, it is intended to

finance the "going public" process

Methods of Venture Financing

The financing pattern of the deal is the most important element. Following are the various methods of venture financing:

• Equity• Conditional loan• Income note• Participating debentures• Quasi equity

MEANING A credit rating evaluates the credit worthiness of

a debtor, especially a business (company) or a government. It is an evaluation made by a credit rating agency of the debtor's ability to pay back the debt and the likelihood of default.

Credit ratings are determined by credit ratings agencies. The credit rating represents the credit rating agency's evaluation of qualitative and quantitative information for a company or government; including non-public information obtained by the credit rating agencies analysts.

MEANING Credit ratings are not based on mathematical formulas.

Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government.

The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations.

A poor credit rating indicates a credit rating agency's opinion that the company or government has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of long term economic prospects.

OBJECTIVES OF CREDIT RATINGThe main objective is to provide superior and low cost info to investors fortaking a decision regarding risk return trade off, but it also helps to marketparticipants in the following ways:

improves a healthy discipline on borrowers,

Lends greater credence to financial and other representations,

Facilitates formulation of public guidelines on institutional investments,

Helps merchant bankers, brokers, regulatory authorities, etc., in discharging their functions related to debt issues,

Encourages greater information disclosure, better accounting standards and improved financial information (helps in investors protection),

May reduce interest costs for highly rated companies,

Acts as a marketing tool

BENEFITS OF CREDIT RATINGEasy Understandability of Investment Proposal : The rating agencies gives rating symbols to the instrument, which can be easily understood by investors. This helps them to understand the investment proposal of an issuer company. For e.g. AAA (Triple A), given by CRISIL for debentures ensures highest safety, whereas debentures rated D are in default or expect to default on maturity

Choice of Instruments : Credit rating enables an investor to select a particular instrument from many alternatives available. This choice depends upon the safety or risk of the instrument.

Saves Investor's Time and Effort : Credit ratings enable an investor to his save time and effort in analyzing the financial strength of an issuer company. This is because the investor can depend on the rating done by professional rating agency, in order to take an investment decision. He need not waste his time and effort to collect and analyse the financial

information about the credit standing of the issuer company.

BENEFITS OF CREDIT RATING Wider Audience for Borrowing : A company with high rating for its

instruments can get a wider audience for borrowing. It can approach financial institutions, banks, investing companies. This is because the credit ratings are easily understood not only by the financial institutions and banks, but also by the general public.

Good for Non-Popular Companies : Credit rating is beneficial to the non-popular companies, such as closely-held companies. If the credit rating is good, the public will invest in these companies, even if they do not know these companies.

Act as a Marketing Tool : Credit rating not only helps to develop a good image of the company among the investors, but also among the customers, dealers, suppliers, etc. High credit rating can act as a marketing tool to develop confidence in the minds of customers, dealer, suppliers, etc.

Helps in Growth and Expansion : Credit rating enables a company to grow and expand. This is because better credit rating will enable a company to get finance easily for growth and expansion

DEMERITS OF CREDIT RATING

Problems for New Companies : There may be problems for new companies to collect funds from the market. This is because, a new company may not be in a position to prove its financial soundness. Therefore, it may receive lower credit ratings. This will make it difficult to collect funds from the market.

Downgrading by Rating Agency : The credit-rating agencies periodically review the ratings given to a particular instrument. If the performance of a company is not as expected, then the rating agency will downgrade the instrument. This will affect the image of the company.

Difference in Rating : There are cases, where different ratings are provided by various rating agencies for the same instrument. These differences may be due to many reasons. This will create confusion in the minds of the investor.

DEMERITS OF CREDIT RATING

Possibility of Bias Exist : The information collected by the rating agency may be subject to personal bias of the rating team. However, rating agencies try their best to praovide an unbiased opinion of the credit quality of the company and/or instrument. If not, they will not be trusted.

Improper Disclosure May Happen : The company being rated may not disclose certain material facts to the investigating team of the rating agency. This can affect the quality of credit rating.

Impact of Changing Environment : Rating is done based on present and past data of the company. So, it will be difficult to predict the future financial position of the company. Many changes take place due to changes in economic, political, social, technological, legal and other environments. All this will affect the working of the company being rated. Therefore, rating is not a guarantee for financial soundness of the company.

WHAT IS FACTORING ?Factoring is the Sale of Book Debts by a firm (Client) to a financial

institution(Factor) on the understanding that the Factor will pay for the Book Debts

asand when they are collected or on a guaranteed payment date.

Normally, theFactor makes a part payment (usually upto 80%) immediately after the

debts are purchased thereby providing immediate liquidity to the Client.

PROCESS OF FACTORINGCLIENT CUSTOMER

FACTOR

So, a Factor is,

a) A Financial Intermediaryb) That buys invoices of a manufacturer or a trader, at a

discount, andc) Takes responsibility for collection of payments.

The parties involved in the factoring transaction are:-

d) Supplier or Seller (Client)e) Buyer or Debtor (Customer)f) Financial Intermediary (Factor)

PROCESS INVOLVED IN FACTORING

Client concludes a credit sale with a customer.

Client sells the customer’s account to the Factor and notifies the customer.

Factor makes part payment (advance) against account purchased, after adjusting for commission and interest on the advance.

Factor maintains the customer’s account and follows up for payment.

Customer remits the amount due to the Factor.

Factor makes the final payment to the Client when the account is collected or on the guaranteed payment date.

CHARGES FOR FACTORING SERVICES

Factor charges Commission (as a flat percentage of value of Debts purchased) (0.50% to 1.50%)

Commission is collected up-front.

For making immediate part payment, interest charged. Interest is higher than rate of interest charged on Working Capital Finance by Banks.

If interest is charged up-front, it is called discount.

TYPES OF FACTORING

Recourse Factoring

Non-recourse Factoring

Maturity Factoring

Cross-border Factoring

RECOURSE FACTORING

Upto 75% to 85% of the Invoice Receivable is factored.

Interest is charged from the date of advance to the date of collection.

Factor purchases Receivables on the condition that loss arising on account of non-recovery will be borne by the Client.

Credit Risk is with the Client.

Factor does not participate in the credit sanction process.

In India, factoring is done with recourse.

NON-RECOURSE FACTORING

Factor purchases Receivables on the condition that the Factor has no recourse to the Client, if the debt turns out to be non-recoverable.

Credit risk is with the Factor.

Higher commission is charged.

Factor participates in credit sanction process and approves credit limit given by the Client to the Customer.

In USA/UK, factoring is commonly done without recourse.

MATURITY FACTORING

Factor does not make any advance payment to the Client.

Pays on guaranteed payment date or on collection of Receivables.

Guaranteed payment date is usually fixed taking into account previous collection experience of the Client.

Nominal Commission is charged.

No risk to Factor.

CROSS - BORDER FACTORING It is similar to domestic factoring except that there are four parties,

viz., a) Exporter, b) Export Factor, c) Import Factor, and d) Importer.

It is also called two-factor system of factoring. Exporter (Client) enters into factoring arrangement with Export Factor

in his country and assigns to him export receivables. Export Factor enters into arrangement with Import Factor and has

arrangement for credit evaluation & collection of payment for an agreed fee.

Notation is made on the invoice that importer has to make payment to the Import Factor.

Import Factor collects payment and remits to Export Factor who passes on the proceeds to the Exporter after adjusting his advance, if any.

Where foreign currency is involved, Factor covers exchange risk also.

FACTORING vs

BILLS DISCOUNTING

BILL DISCOUNTING1. Bill is separately examined and discounted.

2. Financial Institution does not have responsibility of Sales Ledger Administration and collection of Debts.

3. No notice of assignment provided to customers of the Client.

FACTORING1. Pre-payment made against all unpaid and not due invoices

purchased by Factor.

2. Factor has responsibility of Sales Ledger Administration and collection of Debts.

3. Notice of assignment is provided to customers of the Client.

FACTORING vs

BILLS DISCOUNTING (contd…)

BILLS DISCOUNTING4. Bills discounting is usually

done with recourse.

5. Financial Institution can get the bills re-discounted before they mature for payment.

FACTORING4. Factoring can be done

without or without recourse to client. In India, it is done with recourse.

5. Factor cannot re-discount the receivable purchased under advanced factoring arrangement.

STATUTES APPLICABLE TO FACTORING

Factoring transactions in India are governed by the following Acts:-

a) Indian Contract Act

b) Sale of Goods Act

c) Transfer of Property Act

d) Banking Regulation Act.

e) Foreign Exchange Regulation Act.

WHY FACTORING HAS NOT BECOME POPULAR IN INDIA

Banks’ reluctance to provide factoring services

Bank’s resistance to issue Letter of Disclaimer (Letter of Disclaimer is mandatory as per RBI Guidelines).

Problems in recovery.

Factoring requires assignment of debt which attracts Stamp Duty.

Cost of transaction becomes high.

FORFAITING

“Forfait” is derived from French word ‘A Forfait’ which means surrender of fights.

Forefaiting is a mechanism by which the right for export receivables of an exporter (Client) is purchased by a Financial Intermediary (Forfaiter) without recourse to him.

It is different from International Factoring in as much as it deals with receivables relating to deferred payment exports, while Factoring deals with short term receivables.

FORFAITING (contd…)

Exporter under Forfaiting surrenders his right for claiming payment for services rendered or goods supplied to Importer in favour of Forefaiter.

Bank (Forefaiter) assumes default risk possessed by the Importer.

Credit Sale gets converted as Cash Sale.

Forfaiting is arrangement without recourse to the Exporter (seller)

Operated on fixed rate basis (discount)

Finance available upto 100% of value (unlike in Factoring)

Introduced in the country in 1992.

MECHANICS OF FORFAITING

EXPORTER IMPORTER

FORFAITER AVALLING BANK

HELD TILL MATURITY

SELL TO GROUPS OF INVESTORS

TRADE IN SECONDARY MARKET

ESSENTIAL REQUISITES OF FORFAITING TRANSACTIONS

Exporter to extend credit to Customers for periods above 6 months.

Exporter to raise Bill of Exchange covering deferred receivables from 6 months to 5 years.

Repayment of debts will have to be avallised or guaranteed by another Bank, unless the Exporter is a Government Agency or a Multi National Company.

Co-acceptance acts as the yard stick for the Forefaiter to credit quality and marketability of instruments accepted.

IN FORFAITING:-

Promissory notes are sent for avalling to the Importer’s Bank.

Avalled notes are returned to the Importer.

Avalled notes sent to Exporter.

Avalled notes sold at a discount to a Forefaiter on a NON-RECOURSE basis.

Exporter obtains finance.

Forfaiter holds the notes till maturity or securitises these notes and sells the Short Term Paper either to a group of investors or to investors at large in the secondary market.

CHARACTERISTICS OF FORFAITING (contd….)

Exporter is freed from credit administration.

Provides long term credit unlike other forms of bank credit.

Saves on cost as ECGC Cover is eliminated.

Simple Documentation as finance is available against bills.

Forfait financer is responsible for each of the Exporter’s trade transactions. Hence, no need to commit all of his business or significant part of business.

Forfait transactions are confidential.

COSTS INVOLVED IN FORFAITING

Commitment Fee:- Payable to Forfaiter by Exporter in consideration of forefaiting services.

Commission:- Ranges from 0.5% to 1.5% per annum.

Discount Fee:- Discount rate based on LIBOR for the period concerned.

Documentation Fee:- where elaborate legal formalities are involved.

Service Charges:- payable to Exim Bank.

FACTORING vs. FORFAITING

POINTS OF DIFFERENCE

FACTORING FORFAITING

Extent of Finance

Usually 75 – 80% of the value of the invoice

100% of Invoice value

Credit Worthiness

Factor does the credit rating in case of non-recourse factoring transaction

The Forfaiting Bank relies on the creditability of the Avalling Bank.

Services provided

Day-to-day administration of sales and other allied services

No services are provided

Recourse With or without recourse Always without recourse

Sales By Turnover By Bills

COMPARATIVE ANALYSIS

BILLS DISCOUNTED

FACTORING FORFAITING

1. Scrutiny Individual Sale Transaction

Service of Sale Transaction

Individual Sale Transaction

2. Extent of Finance

Upto 75 – 80% Upto 80% Upto 100%

3. Recourse With Recourse With or Without Recourse

Without Recourse

4. Sales Administration

Not Done Done Not Done

5. Term Short Term Short Term Medium Term

6. Charge Creation

Hypothecation Assignment Assignment

WHY FORFAITING HAS NOT DEVELOPED

Relatively new concept in India.Depreciating RupeeNo ECGC CoverHigh cost of fundsHigh minimum cost of transactions (USD 250,000/-)RBI Guidelines are vague.Very few institutions offer the services in India. Exim Bank alone does.Long term advances are not favoured by Banks as hedging becomes difficult.Lack of awareness.

STAGES INVOLVED IN FORFAITING:-

Exporter approaches the Facilitator (Bank) for obtaining Indicative Forfaiting Quote.

Facilitator obtains quote from Forfaiting Agencies abroad and communicates to Exporter.

Exporter approaches importer for finalising contract duly loading the discount and other charges in the price.

If terms are acceptable, Exporter approaches the Bank (Facilitator) for obtaining quote from Forfaiting Agencies.

Exporter has to confirm the Firm Quote.

Exporter has to enter into commercial contract.

Execution of Forfaiting Agreement with Forefaiting Agency.

Export Contract to provide for Importer to furnish avalled BoE/DPN.

STAGES INVOLVED IN FORFAITING:- (contd…..)

Forfaiter commits to forefait the BoE/DPN, only against Importer Bank’s Co-acceptance. Otherwise, LC would be required to be established.

Export Documents are submitted to Bank duly assigned in favour of Forfaiter.

Bank sends document to Importer's Bank and confirms assignment and copies of documents to Forefaiter.

Importer’s Bank confirms their acceptance of BoE/DPN to Forfaiter.

Forfaiter remits the amount after deducting charges.

On maturity of BoE/DPN, Forfaiter presents the instrument to the Bank and receives payment.

Forfaiter commits to forefait the BoE/DPN only against Importer Bank’s Co-acceptance. Otherwise, LC would be required to be established.

STAGES INVOLVED IN FORFAITING:- (contd…..)

Export Documents are submitted to Bank duly assigned in favour of Forfaiter

Importer’s Bank confirms their acceptance of BoE/DPN to Forfaiter.

Forfaiter remits the amount after deducting charges.

On maturity of BoE/DPN, Forfaiting Agency presents the instruments to the Bank and receives payment

STAGES INVOLVED IN EXPORT FACTORING

Exporter (Client) gives his name, address and credit limit required to the Export Factor.

Export Factor submits the details of Buyer to the Import Factor.

Import Factor decides on the credit cover and communicates decision to Export Factor.

Export Factor enters into Factoring Agreement with Exporter.

Overseas Buyer is notified of this arrangement.

Exporter is then free to ship the goods to Buyers directly.

Exporter submits original documents, viz., invoice and shipping documents duly assigned and receives advance there-against (upto 80%).

STAGES INVOLVED IN EXPORT FACTORING

Exporter (Client) gives his name, address and credit limit required to the Export Factor.

Export Factor submits the details of Buyer to the Import Factor.

Import Factor decides on the credit cover and communicates decision to Export Factor.

Export Factor enters into Factoring Agreement with Exporter.

Overseas Buyer is notified of this arrangement.

Exporter is then free to ship the goods to Buyers directly.

Exporter submits original documents, viz., invoice and shipping documents duly assigned and receives advance there-against (upto 80%).

STAGES INVOLVED IN EXPORT FACTORING (contd…..)

Export Factor despatches all the original documents to Importer/Buyer after duly affixing “Assignment Clause” in favour of the Import Factor.

Export Factor sends copy of invoice to Import Factor in the Debtor’s country.

Import Factor follows up and receives payment on due date and remits to Export Factor.

Export Factor, on receipt of payment, releases the balance of proceeds to Exporter.

Hire purchase

Hire purchase is an option for those buyers who cannot pay the whole amount of his or her purchase. Hire purchase refers to an agreement where the buyer of a good can take goods on a monthly rental basis and once the rent equals original price of a good in addition to the interest then the buyer may exercise his or her option to buy the goods at a predetermined price or return the goods to the owner. Given below are some of the features of hire purchase -1. The person who has hire the goods will give regular installment or rent to the owner of the good which will include some portion of principal amount and some portion of interest as agreed by both the parties.2. The ownership of good passes only when the person has paid the last installment of the goods which he or she has hired.3. Under hire purchase system the buyer can return the goods to the seller if he or she does not want to continue with the agreement.4. In case of hire purchase the person who has taken the good on hire cannot transfer the goods to a third party as he or she does not have the ownership of the goods.

Hire purchase

Hire purchase can be defined as a contract in which the buyer acquires the possession of the goods immediately and agrees to pay the total cost in installment where each installment is treated as hire charges. The ownership of goods is transferred to the buyer from seller only when the last Installment is paid. Here is the list of features of hire purchases -

1. Under hire purchase agreement the hire seller transfers possession of goods immediately to the purchaser.

2. The Buyer agrees to make payment in Installment over a period of time.

3. The Ownership of the goods will remain with the seller until the payment of the last Installment.

4. The hire purchaser generally makes a down payment on signing the agreement.

5. If the purchaser of the goods default even the last Installment, the hire seller has the right to takes the goods back without making any compensation to the buyer of goods