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What is a financial market/system?
A market/system in which financial assets such as stocks and bonds can be purchased or sold.
Which of the following are participants in financial markets? (Select all that apply)
Secondary markets provide liquidity to investors.
True
What are debt markets primarily used for?
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What type of claim do equity capital claims represent?
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An example of a debt instrument issued by the government is a __________.
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What does the opportunity cost of debt refer to?
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Which of the following is a typical source of financing for early-stage capital? (Select all that apply)
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Employee Stock Ownership Plans (ESOPs) can help minimize agency conflict.
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The primary market involves the issuance of __________ to investors for the first time.
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What is an effect of new issue debt?
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What is a Red Herring Prospectus?
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Which of the following are steps in the IPO/FPO process? (Select all that apply)
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What does IPO stand for?
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What is the main purpose of the Registrar to the issue?
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The difference between public-offer price and the price paid by the underwriter is called the ______.
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FPO stands for Follow-up Public Offer.
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What is a major benefit of the secondary market?
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What does NPV stand for and what does it signify?
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Match the following financial terms with their definitions:
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Study Notes
Financial Markets/System
- A financial market/system is a platform for buying and selling financial assets, such as stocks and bonds.
- Facilitates the flow of funds among households, firms, and government agencies for financing and investment.
- Transfers funds from those with excess capital to those in need of financing.
Financial Market Participants
- Key participants include households, intermediaries, businesses, governments (central, state, local), regulators (such as RBI, SEBI, IRDA), and supranationals (e.g., IMF, WB, ADB).
Role of Financial Markets
- Determine pricing and required returns on assets.
- Provide liquidity to investors.
- Reduce transaction costs related to searches and information.
Classification of Financial Markets
- Debt vs. equity markets: Focus on types of financial claims.
- Money market vs. capital market: Differentiates short and long-term financing.
- Primary vs. secondary market: Primary for new issues; secondary for subsequent trading.
- Cash or spot market vs. derivatives market: Immediate transactions versus contracts based on future prices.
- Auction vs. over-the-counter vs. intermediated market: Different mechanisms for trading securities.
Primary and Secondary Markets
- Primary Market: Source of capital for firms through Initial Public Offerings (IPOs) and Follow-on Public Offers (FPOs).
- Secondary Market: Provides liquidity for investors through the trading of existing securities.
Debt, Equity, and Other Claims
- Debt: Provides fixed payments, preference in claims, and no ownership; includes secured/unsecured loans, treasury securities.
- Equity: Represents ownership; includes common shares and preferred stock.
- Hybrid options: Preference shares and convertible bonds.
- Derivatives: Financial contracts deriving their value from an underlying asset.
Role of Financial Assets
- Transfer funds from surplus to deficit units, redistributing risk among investors.
- Cash funds allocated to surplus and deficit units facilitate smoother financial transactions.
Types of Financial Intermediaries
- Include commercial banks, investment banks, mutual funds, pension funds, insurance firms, and hedge funds.
- Play critical roles in transforming and exchanging financial assets, managing portfolios, and providing investment advice.
Debt Markets
- Influence of interest rates based on credit ratings and demand-supply dynamics within the credit market.
- Interest costs are generally lower than equity costs; debt creates obligatory payments and financial distress risk.
Agency Problem
- Arises from conflicts of interest between managers (agents) and owners (principals).
- May lead to sub-optimal management decisions impacting firm value.
- Resolving the agency problem utilizes corporate governance and performance measurement mechanisms.
Primary and Non-primary Instruments
- Primary Instruments: Include debt (bonds, debentures) and equity (shares).
- Non-primary Instruments: Include mutual funds, ADRs, GDRs, and derivatives.
Startup Financing Stages
- FFF Stage: Friends, family, and fools; initial seed funding for product development.
- Startup Capital: Funding for recruitment and market research.
- Early Stage Capital: For established companies aiming for sales growth.
- Expansion Capital: To increase market presence and marketing efforts.
- Late Stage Capital: For established companies to enhance capabilities.
Private Placements
- Sale of securities privately to select investors without public offering requirements.
- Preferential issues enable listed companies to avoid public issues, governed by SEBI guidelines.
Rights and Employee Stock Ownership Plans (ESOPs)
- Rights Issues: Opportunity for existing shareholders to maintain ownership before going public.
- ESOPs: Align employee interests with those of the company, minimizing agency conflicts.
Public Issues Markets and Processes
- Primary Market: For first-time security issuance; includes IPOs and is a capital source.
- Secondary Market: Subsequent trading of securities among investors.
- Important documentation includes the Red Herring Prospectus with offer details and risk factors.
Key IPO Steps
- Preparing documentation, establishing pricing agreements, marketing, and stabilizing share prices post-issue.
- Involves regulatory compliance, shareholder approvals, and mechanisms for public trading.### Initial Public Offerings (IPOs) and Follow-on Public Offers (FPOs)
- IPO: The first sale of stock to the public, leading to listing on a stock exchange.
- FPO: Public stock offer from an already listed company.
- Underwriter: Firm that buys and resells securities.
- Book Runner: Lead underwriter responsible for managing the public issue.
- Underwriting Spread: Difference between public-offer price and underwriter's price.
- Red Herring Prospectus: Provides essential details about the security issue.
- IPO Grading: Mandatory rating by accredited agencies to guide investors.
- Registrar to the Issue: Manages share allotment and credits to investor accounts.
Pricing Mechanisms in Public Issues
- Fixed Price Issues: Issuer decides the issue price beforehand.
- Book-building: Lead book-runner assesses investor demand to determine price.
- Price Band: Range set for bids in book-building (floor and cap prices).
- Auction: Involves differential or equal pricing based on bids.
- Reverse Book Building: Collects bids for determining buy-back prices during voluntary delisting.
Fast Track Issues (FTIs)
- Tailored for well-established companies to quickly access the Indian primary market.
- Allows filing of a prospectus or Letter of Offer without extensive documentation.
Cost of Raising Capital
- Factors into the overall calculations for investment returns compared to expected cash flows.
Role and Importance of the Secondary Market
- Facilitates trade of primary issues.
- Aids in price discovery and liquidity.
- Ensures efficient distribution of capital and risk.
Concepts of Value and Opportunity Cost
- Current money value differs from future or past values due to time and opportunity cost.
- Opportunity Cost (r): Rate of return from similar risk investment opportunities.
Future Value (FV) and Present Value (PV) Calculations
- Future Value Formula: FV = C0 × (1 + r)^T, where C0 is cash flow today, r is interest rate, T is number of periods.
- Present Value Formula: PV = C1 / (1 + r), where C1 is cash flow at future date.
- NPV: Calculated by subtracting investment cost from present value of expected cash flows.
Invested Cash Flows Analysis
- Multi-period calculations for single or multiple cash flows involve steps to project future values and discount them to present value.
- Incremental cash flows can be modeled, aiding investor decision-making regarding purchases based on present value assessments.
Growth and Compounding in Investments
- Compounding effects impact investment growth, characterized by growth rates applied over multiple periods.
- Practical examples demonstrate the future value of increasing dividends or cash flows over time.
Summary of Practical Applications
- Investors need to evaluate potential investments through present value analysis and future growth projections, enabling informed choices on stock purchases and capital allocation.
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Description
This quiz covers the basic concepts of financial markets and systems, including their functions and participants. It explores how financial assets like stocks and bonds can be traded and the flow of funds within the economy. Test your understanding of crucial financial principles and market dynamics.
