NISM-Series-XA Investment Adviser (Level 1) Workbook PDF

NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Workbook for NISM-Series-X-A:...

NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Workbook for NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination National Institute of Securities Markets www.nism.ac.in 1 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Level 1 Certification Examination for Investment Advisers. Workbook Version: August 2014 Published by: National Institute of Securities Markets © National Institute of Securities Markets, 2014 Plot 82, Sector 17, Vashi Navi Mumbai – 400 703, India All rights reserved. Reproduction of this publication in any form without prior permission of the publishers is strictly prohibited. 2 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Disclaimer The contents of this publication do not necessarily constitute or imply its endorsement, recommendation, or favoring by the National Institute of Securities Market (NISM) or the Securities and Exchange Board of India (SEBI). This publication is meant for general reading and educational purpose only. The statements/explanations/concepts are of general nature and may not have taken into account the particular objective/ move/ aim/ need/ circumstances of individual user/ reader/ organization/ institute. Thus NISM and SEBI do not assume any responsibility for any wrong move or action taken based on the information available in this publication. Therefore before acting on or following the steps suggested on any theme or before following any recommendation given in this publication user/reader should consider/seek professional advice. The publication contains information, statements, opinions, statistics and materials that have been obtained from sources believed to be reliable and the publishers of this title have made best efforts to avoid any errors. However, publishers of this material offer no guarantees and warranties of any kind to the readers/users of the information contained in this publication. Since the work and research is still going on in all these knowledge streams, NISM and SEBI do not warrant the totality and absolute accuracy, adequacy or completeness of this information and material and expressly disclaim any liability for errors or omissions in this information and material herein. NISM and SEBI do not accept any legal liability what so ever based on any information contained herein. While the NISM Certification examination will be largely based on material in this workbook, NISM does not guarantee that all questions in the examination will be from material covered herein. 3 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination About NISM In pursuance of the announcement made by the Finance Minister in his Budget Speech in February 2005, Securities and Exchange Board of India (SEBI) has established the National Institute of Securities Markets (NISM) in Mumbai. SEBI, by establishing NISM, has articulated the desire expressed by the Indian government to promote securities market education and research. Towards accomplishing the desire of Government of India and vision of SEBI, NISM has launched an effort to deliver financial and securities education at various levels and across various segments in India and abroad. To implement its objectives, NISM has established six distinct schools to cater the educational needs of various constituencies such as investor, issuers, intermediaries, regulatory staff, policy makers, academia and future professionals of securities markets. NISM brings out various publications on securities markets with a view to enhance knowledge levels of participants in the securities industry. NISM is mandated to implement certification examinations for professionals employed in various segments of the Indian securities markets. 4 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Acknowledgement This workbook has been developed by NISM in consultation with the Examination Committee for NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination consisting of industry participants, educators, trainers and SEBI officials. NISM gratefully acknowledges the contribution of the committee members. About the Author This workbook has been developed by the Ms. Uma Shashikant of the Centre for Investment Education and Learning and has been reviewed by Ms. Sunita Abraham, Consultant in co- ordination with the Certification Team of NISM. 5 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination About the Level 1 Certification Examination for Investment Adviser The examination seeks to create a common minimum knowledge benchmark for all associated persons registered as an investment adviser and partners and representatives of investment advisers under SEBI (Investment Advisers) Regulations, 2013 and offering investment advisory services. NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination is the level 1 examination and NISM has also launched the NISM-Series-X-B: Investment Adviser (Level 2) Certification Examination. An associated person is required to pass both the levels (i.e. NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination and NISM-Series-X-B: Investment Adviser (Level 2) Certification Examination) to fulfill the requirements under Regulation 7(2) of the SEBI (Investment Advisers) Regulations, 2013. The certification aims to enhance the quality of investment advisory and related services in the financial services industry. Examination Objectives On successful completion of the examination, the candidate should: Know the basics of investment advisory, steps in the advisory process, making and implementation of financial plan. Understand how to evaluate different products, their suitability and how the recommendation of the same can impact investment risks, returns and strategies in a personal finance environment for investors and prospective investors in the market. Get oriented to the Income tax, Wealth tax and legalities of Estate planning in personal finance, and regulatory aspects underlying advisory. Get acquainted with financial planning as an approach to investing, insurance, retirement planning and an aid for advisers to develop long term relationships with their clients. Assessment Structure The examination consists of 100 questions of 1 mark each and should be completed in 2 hours. The passing score on the examination is 60%. There shall be negative marking of 25% of the marks assigned to a question. How to register and take the examination To find out more and register for the examination please visit www.nism.ac.in 6 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination CONTENTS CHAPTER 1: INTRODUCTION TO INDIAN FINANCIAL MARKET............................................... 11 1.1 The Indian Economy....................................................................................................... 11 1.2 The Indian Financial Markets......................................................................................... 11 1.3 Structure of Financial Markets in India.......................................................................... 13 1.4 Role of Participants in the Financial Markets................................................................ 20 1.5 Regulators of Financial Markets..................................................................................... 22 CHAPTER 2: SECURITIES MARKET SEGMENTS....................................................................... 31 2.1 Nature and Definition of Primary Markets.................................................................... 31 2.2 Role and Function of the Secondary Market................................................................. 45 2.3 Corporate Actions.......................................................................................................... 56 CHAPTER 3: MUTUAL FUNDS............................................................................................... 65 3.1 Meaning and features of Mutual Fund.......................................................................... 65 3.2 Concepts and Terms Related to Mutual Funds.............................................................. 66 3.3 Regulatory Framework of Mutual Funds....................................................................... 69 3.4 Mutual Fund Products.................................................................................................... 70 3.5 Taxation of Mutual Fund Products................................................................................. 81 3.6 Mutual Fund Investment Options.................................................................................. 83 3.7 Process associated with Investment in Mutual Funds................................................... 84 3.8 Systematic Transactions................................................................................................. 94 3.9 Benefits of Investing in Mutual Funds........................................................................... 98 CHAPTER 4: INVESTMENT PRODUCTS.................................................................................107 4.1. Small Saving Instruments............................................................................................. 107 4.2. Fixed Income Instruments............................................................................................ 112 4.3. Alternate Investments.................................................................................................. 117 4.4. Direct Equity................................................................................................................. 129 CHAPTER 5: MANAGING INVESTMENT RISK........................................................................141 5.1. Risk............................................................................................................................... 141 5.2. Common Types of Risk................................................................................................. 142 5.3. Measuring Risk............................................................................................................. 147 CHAPTER 6: MEASURING INVESTMENT RETURNS................................................................155 6.1. Understanding Return.................................................................................................. 155 6.2. Understanding Return Concepts.................................................................................. 156 6.3. The Concept of Compounding..................................................................................... 160 7 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination 6.4. Real Rate of Return vs. Nominal Rate of Return.......................................................... 174 6.5. Tax Adjusted Return..................................................................................................... 175 6.6. Risk Adjusted Returns.................................................................................................. 177 CHAPTER 7: CONCEPT OF FINANCIAL PLANNING.................................................................181 7.1. Financial Planning......................................................................................................... 181 7.2. Need for Financial Advisory Services........................................................................... 182 7.3. Scope of Financial Planning Services............................................................................ 183 7.4. Financial Advisory and Execution................................................................................. 186 7.5. Assets, Liabilities and Networth................................................................................... 188 7.6. Preparation of Budget.................................................................................................. 190 7.7. Financial Planning Delivery Process............................................................................. 191 CHAPTER 8: ASSET ALLOCATION AND INVESTMENT STRATEGIES.........................................205 8.1. Asset Classes................................................................................................................. 205 8.2. Portfolio Construction.................................................................................................. 208 8.3. Practical Asset Allocation and Rebalancing Strategies................................................ 213 8.4. Portfolio Monitoring and Re-balancing........................................................................ 217 CHAPTER 9: INSURANCE PLANNING....................................................................................223 9.1. Need for Insurance....................................................................................................... 223 9.2. Requirements of an Insurable risk............................................................................... 223 9.3. Role of Insurance in Personal Finance......................................................................... 224 9.4. Steps in Insurance Planning......................................................................................... 225 9.5. Insurance Products....................................................................................................... 226 9.6. Life Insurance Products................................................................................................ 227 9.7. Non- Life Insurance...................................................................................................... 233 9.8. Life Insurance Needs Analysis...................................................................................... 235 CHAPTER 10: RETIREMENT PLANNING................................................................................245 10.1. Introduction to retirement planning process.............................................................. 245 10.2. Estimating the Retirement Corpus............................................................................... 247 10.3. Determining the Retirement Corpus............................................................................ 250 10.4. Retirement Products.................................................................................................... 257 CHAPTER 11: TAX AND ESTATE PLANNING..........................................................................277 11.1. Understand Income tax principles............................................................................... 277 11.2. Tax aspects of investment products............................................................................ 287 11.3. Wealth Tax Act and its implication for clients............................................................. 295 11.4. Estate Planning............................................................................................................. 297 8 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination CHAPTER 12: REGULATORY ENVIRONMENT AND ETHICAL ISSUES.......................................309 12.1. Regulation for Investment Advisers............................................................................. 309 12.2. Regulatory System and Environment........................................................................... 316 12.3. Role of Regulators........................................................................................................ 317 12.4. Role of Self-Regulatory Organizations (SRO)............................................................... 323 12.5. Prevention of Money-Laundering Act, 2002................................................................ 323 12.6. Code of Conduct and Ethics......................................................................................... 325 12.7. Ethical Issues in providing Financial Advice................................................................. 330 12.8. Investor Complaint redressal systems......................................................................... 331 9 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination THIS PAGE HAS BEEN LEFT BLANK INTENTIONALLY 10 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination CHAPTER 1: INTRODUCTION TO INDIAN FINANCIAL MARKET 1.1 The Indian Economy The Indian economy has gone through phases of growth and change that has transformed it from being a primarily agriculture-oriented economy to one where services and manufacturing contribute to 3/4th of its gross domestic product. The economy requires the financial system to support growth by enabling access to resources, both financial as well as real resources. The banking sector provides credit at efficient costs, secure systems for transactions and transfer of funds and the means to channelize savings of the economy in productive ways. Securities markets allow wider access to investors for businesses seeking funds by issuing securities with features that cater to the risk and return requirements of different types of investors. The foreign exchange markets determine the costs of import of funds and commodities essential for production. A well- developed foreign exchange market helps to hedge the risks of price movements for companies dependent upon imports as well as the earnings of export-oriented organisation. Similarly, the commodity markets enable mitigating the risk of adverse price movements in commodities to producers and users. Ensuring adequate insurance cover for people will ensure that they are protected from emergencies of large expenses or loss of income. It will enable higher savings and investments. All these markets need to be well developed in systems and regulations to enable economic growth. 1.2 The Indian Financial Markets 1.2.1 Key Features The financial markets enable efficient transfer and allocation of resources for productive activities in the economy. Users of funds include businesses, governments and households who seek funds to run their activities. Households, businesses and governments also act as providers of surplus funds. Intermediaries such as banks, financial institutions, mutual funds and insurance companies, among others, channelize the available surplus funds from lenders to the users. The function of the financial markets is to ensure that economic activity is enabled by providing access of funds to those that need it for consumption or productive activity. They provide a way for aggregation of funds from a large number of investors and make it available for productive economic activity. In the absence of financial markets such aggregation may not be possible. An efficient financial market ensures that the transfer of funds happens at a cost that makes it attractive for savers to save and lend and for users to 11 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination borrow funds. The markets must enable the dissemination of relevant information to all the participants in the market so that the decision on price of funds is made after integrating all available information. It must also allow the participants to review their funding decisions given new information and to re-allocate the resources accordingly. Therefore, providing liquidity and exit options are an important function of financial markets. Financial market regulations and regulators focus on setting up systems and processes in place to streamline the activities associated with the transfer of funds. The Indian financial market can be illustrated in the figure below: The financial market comprises of the money markets that deal with the short-term lending and borrowing of funds and the securities or capital markets that enable longer term transfer of funds using debt and equity instruments. The allocation and re-allocation of resources may happen in the primary markets where securities are issued by the borrowing institutions directly to the lenders or investors or in the secondary markets which provides investors the options to exit or reallocate their resources by dealing amongst themselves. The activities in the financial markets are facilitated by the market participants such as banks, financial institutions, brokers and dealers, custodians, depositories and depository participants, among others. Institutions such as mutual funds, insurance companies and pension funds are large and informed investors who provide funds in the markets and 12 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination provide liquidity and stability. They also play an important role in the proper pricing of financial assets since they can source and evaluate information better. Banks and financial institutions aid the actual transfer of funds between the participants and may also be present in the markets to source funds for their activities or as investors of funds. Fund managers and financial advisors provide the service of advising and managing funds for investors so that their savings are invested in a way that suits their requirements the best. Apart from the financial markets, economic activity is supported by the development of other markets such as the commodities markets and foreign exchange markets that protect producers, consumers and businesses against adverse price movements. Similarly, a well- developed insurance and pension markets protect the personal financial situation of households apart from playing an important role as an institutional investor in the financial markets. 1.3 Structure of Financial Markets in India 1.3.1 Banking System The banking system is at the core of the financial structure of an economy and supports its growth. It enables capital growth and formation through financial intermediation by accumulating savings from households, governments and businesses and making credit available for productive activities. The Indian banking has a multi-tier structure. The Reserve Bank of India is the regulator of the banking system and the monetary authority. Its functions include licensing banks and putting in place regulations for a strong and stable banking system, be the note-issuing authority and banker to the government and act as a lender of last resort to the other banks by providing accommodation in the form of advances. It also acts as a controller of credit in the monetary system by effecting changes in the Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR) and other selective credit controls, transact and regulate the foreign exchange market. Other apex regulators in the banking system include specialist institutions that cater to the credit and financial needs of specific groups. For example, the EXIM bank fosters the growth of export and import activities. NABARD caters to the need of rural based development and the National Housing Bank (NHB) regulates the housing sector of the economy. Commercial banks may be scheduled commercial banks which include public sector banks, private sector banks, foreign banks and regional rural banks or non-scheduled commercial banks that include local area banks. Apart from commercial banks, there are co-operative credit institutions such as the urban co-operative banks and state and district level co- 13 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination operative banks that cover rural area needs. The capital requirements, functions and obligations and regulatory provisions of each category are defined by the RBI. The primary function of the banking system is to accept deposits and make credit available to those entities that qualify for it. The banks act as an intermediary between those that have excess funds to invest and those that need funds by undertaking the role of mobilizing these surplus funds by taking deposits and lending it on the basis of a credit evaluation done of the ability of the borrowers to pay interest and return the principal. The banks also provide a secure system for settling financial transactions of their customers through a system of cheques and electronic payment systems. Apart from these primary banking activities, banks also provide third-party products and services to their clients by offering advice on investments and insurance. Banks tie up with mutual funds, portfolio management service providers, insurance companies and others and offer their products and services. 1.3.2 Securities Market The securities market provides an institutional structure that enables a more efficient flow of capital in the system. If a household has some savings, such savings can be deployed to fund the capital requirement of a business enterprise, through the securities markets. The business issues securities, raises the money from the household through a regulated contract, lists the securities on a stock exchange to ensure that the security is liquid (can be sold when needed) and provides information about its activities and financial performance to the household. This basic arrangement in the securities markets enables flow of capital from households to business, in a regulated institutionalised framework. A security represents the terms of exchange of money between two parties. Securities are issued by companies, financial institutions or the government. They are purchased by investors who have money to invest. Security ownership allows investors to convert their savings into financial assets which provide a return. Security issuance allows borrowers to raise money at a reasonable cost. The broader universe of savers with surplus to invest is available to issuers of securities; a universe of wider options is available to savers to invest their money in. Thus the objectives of the issuer and the investor are complementary and the securities market provides a vehicle to mutually satisfy their goals. The issuer of the security provides the terms on which the capital is being raised. The investor in the security has a claim to the rights represented by the securities. These rights may involve ownership, participation in management or claims on assets. The specific terms of issue and their implications for the investor and the issuer are discussed in detail in the workbook of the NISM-Series-XII: Securities Market Foundation Certification Examination. 14 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination The market in which securities are issued, purchased by investors and subsequently transferred among investors is called the securities market. The securities market has two interdependent and inseparable segments, viz., the primary market and secondary market. The primary market, also called the new issue market, is where issuers raise capital by issuing securities to investors. The secondary market, also called the stock exchange, facilitates trade in already-issued securities, thereby enabling investors to exit from an investment or to accumulate more, if it meets their expectations. The risk in a security investment is transferred from one investor (seller) to another (buyer) in the secondary markets. The primary market creates financial assets and the secondary market makes them marketable. Investors and issuers are the primary participants in the securities market. Investors are individuals or organisations with surplus funds that can be used to purchase securities. The chief objective of investors is to convert their surpluses and savings into financial assets that earn a return. Investors are divided into two categories based on the size of their investment and sophistication of their investing strategies – retail investors and institutional investors. Retail investors are individual investors who invest money on their personal account. Institutional investors are organizations that invest large volumes and have specialized knowledge and skills in investing. Institutional investors are companies, banks, government organisations, mutual funds, insurance companies, pension trusts and funds, associations, endowments, societies and such organisations that may have surplus funds to invest. Issuers supply securities and create a demand for capital, whereas investors buy the securities and provide the supply of capital. Issuers may have short-term and long-term need for capital and they issue securities based on their need, their ability to service the securities and meet the obligations to investors, and the cost they are willing to pay for the use of funds. Interaction between investors and borrowers is facilitated through financial intermediaries; intermediaries form the third component of the market. The entire process of issuance, subscription and transaction in securities is subject to regulatory control and supervision. There are several major players in the primary market. These include the merchant bankers, mutual funds, financial institutions, foreign institutional investors (FIIs), individual investors; the issuers including companies, bodies corporate; bankers to the issue, brokers, and depository participants. The stock exchanges are involved to the extent of listing of the securities. In the secondary market, there are the stock exchanges, stock brokers (who are members of the stock exchanges), the mutual funds / asset management companies (AMCs), financial institutions, foreign institutional investors (FIIs), investment companies, individual investors, depository participants and banks. The Registrars and 15 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Transfer Agents, Custodians and Depositories are capital market intermediaries, which provide important infrastructure services to both the primary and secondary markets. 1.3.3 Commodities Market A commodity market facilitates transactions between buyers and sellers of commodities. These could be agriculture based commodities, commodities for industrial use such as metals and minerals, gas and oil for consumption or production and precious metals for investment or industrial use. Commodities can be traded in the cash market for immediate delivery and payment between the buyer and the seller. Or, transactions in commodities can be done in the forward or futures market for settlement at a future point in time at prices determined at the time of entering the contract. A forward transaction is one where the terms of the transaction, such as the quantity, quality, price and terms of delivery are customized to the requirements of the persons involved. In a futures contract, the terms of the contract are determined by the exchange which initiates the contract. The price is determined by the parties to the contract. A futures contract is standardized as to quantity, quality and delivery terms. An exchange traded commodity futures contract minimizes the counter-party risk of default that exists in forward contracts. The commodity exchanges adopt risk management measures such as margin system and settlement guarantee funds to protect the interest of the participants. Forwards and futures in commodities help producers and consumers of the commodity to hedge against the risk of adverse price movements in the future. It helps them streamline and accurately estimate the demand and supply of commodities. There are three national commodity exchanges for trading in commodity futures. They are the Multi Commodity Exchange of India Limited, the National Commodity and Derivative Exchange Limited and the National Multi Commodity Exchange of India Limited. These exchanges follow established practices in trading, clearing and settlement and processes and structure. Apart from these, there are commodity trading associations registered with the Forward Markets Commission (FMC) which can trade in commodities contracts approved by the FMC. The commodity exchanges designs or standardizes contracts and provides an electronic trading platform for the trades to be put through by members registered with the exchange. Investors who trade in commodity markets are entities who need to hedge their exposure to the commodity such as farmers, oil companies, manufacturers and others. Arbitrageurs, who try to exploit price differences in different markets, also participate in the markets as do speculators who expect to benefit from an anticipated price movement. The clearing house of the exchange determines the settlement obligations arising from trades conducted. The clearing house may also stand novation i.e. become the counter party to all trades done on the exchange so that investors are protected from the risk of 16 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination default. The clearing house collects margins such as initial and mark to market margins and trade and settlement guarantee funds contributed by the members to fulfil their guarantee obligations. Trades on commodity exchanges may be settled by cash or delivery of the commodity, depending upon the terms of the contract. If delivery is indicated, then the seller has to provide warehouse receipts of designated warehouses as well quality certificate for the assayer. Delivery is received at delivery centres designated by the exchange. The clearing banks empanelled by the exchange offers banking services to the members. The Forward Markets Commission (FMC) is the regulator of commodity futures and forward transactions in India. It is the registering and regulating authority of commodity exchanges in India. 1.3.4 Foreign Exchange Market The growth of international trade made it necessary to be able to determine the relative value of currencies given the differences in their purchasing power. The need for exchanging one currency to another for settling trades in goods and services brought about the term foreign exchange. Since the foreign exchange is the value of a currency relative to other currencies, its value will differ for each combination of currency, called a currency pair. For example, USDINR is the currency pair of US dollars and Indian rupee. The currency quoted first in the currency pair is called the base currency and the currency quoted next is called the quoting currency. The practice in the market is to quote the price of the base currency in terms of the quoting currency. If there is a PRICE quote for USDINR as 61, it means one unit of USD has a value of 61 INR. The Indian foreign exchange market has a spot market and a forward market. The spot market has an interbank segment and a merchant segment. In the interbank segment, banks make market by giving two-way quotes for buying and selling a currency. In the merchant segment, the merchants are price takers who buy or sell currency based on the price given by the banks. The participants in the spot markets are the banks, the dealers and brokers, businesses, government and retail customers. The quotes offered for different currencies will depend upon the interbank rate available to the bank for different currencies. For large value transactions a bank quotes a price that is close to the interbank rate available to it and this varies marginally among banks and also as the rates change during the day. Each bank also publishes standard rates called the card rate. This is the rate available for retail transactions and does not change during the day unless there is a significant movement in the exchange rates. The RBI publishes a reference rate for each currency pair based on the bid and offer rates of a set of banks. The reference rate is available for every week day. 17 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination The settlement of spot market trades happens with actual delivery and receipt of currency on gross settlement basis on the value date. The value date is the second business day after trade date i.e. T+2 day. The forward market in currency can be the OTC market or the exchange traded futures market. The forward market can give quotes for any maturity but maturity less than one year has higher liquidity. RBI rules require the existence of an underlying trade contract which creates exposure to foreign exchange before taking a position in the forward market. The exchange traded derivative market in currency consists of futures, options, and swaps. Hedgers, speculators and arbitrageurs trade in the derivatives market. Hedgers face risk associated with the price of an underlying asset and they use derivative markets to reduce or eliminate this risk. Speculators wish to bet on future movements in the price of an underlying asset. Derivatives give them an ability to buy the underlying without paying for it fully or to sell it without owning it or delivering it immediately. In the process, the potential gains and losses are amplified. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Trading systems are provided by the exchanges that allow currency derivative trading such as the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Settlement happens on the last working day (excluding Saturday) of the month and the settlement price for a contract is the RBI reference rate. 1.3.5 Insurance Market The Indian insurance market consists of the life insurance segment and the general insurance segment. The life insurance sector was opened to private providers in 2001. Currently, there is one public sector insurance provider, namely the Life Insurance Company and 24 private insurers. The life insurance products may be broadly categorized as the traditional products, variable insurance products and the unit linked products. Traditional life insurance products include term insurance, endowment policies, whole life policies and the like. Term insurance is a pure risk protection product with no benefit on maturity. If the insured event occurs, in this case loss of life insured, then the sum assured is paid to the beneficiaries. Other traditional products typically have maturity benefits and have a small savings component. Variable insurance products and unit linked products combine risk protection and investment. A portion of the premium is used for risk cover while the remaining portion of the premium is invested to provide returns linked to an index or based on the performance of the portfolio in which it is invested. On the occurrence of the event or maturity of the policy the sum assured and/or value of the fund created is returned to the policy holder or beneficiary. 18 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination The products are distributed through multiple channels such as agency, banc-assurance, direct agents, broking and corporate agency, among others. The non-life insurance or general insurance segment covers motor, health insurance, travel, fire and personal accident, among others. There are 28 insurers in this segment. The Insurance Regulatory and Development Authority, India (IRDA) regulates the insurance sector including registering insurance companies, clearing insurance products, licensing and establishing norms for the intermediaries and protecting policy holders’ interest. Other entities involved in the insurance sector include insurance brokers, who are licensed to offer policies from any insurance company and are paid a brokerage by the company whose policy is sold. Individual agents are certified and licensed by IRDA and can sell policies of life insurance and general insurance companies or both. Corporate agents include institutions such as banks, and they offer the insurance products to their clients. Agents typically represent one life insurer, one general insurer and one standalone health insurance company. Surveyors and loss assessors are used by general insurance companies to assess a claim and quantum of loss. Third party administrators are used to process health insurance claims. Insurance penetration in India continues to be much below that of comparable economies. Insurance continues to be taken for tax benefits, as in the case of life insurance, or for regulatory compliance, as in the case of motor insurance or on the insistence of financiers. Low financial awareness combined with inefficient distribution lines that are unable to convey the benefits of insurance have continued to keep much of the population without adequate insurance cover. 1.3.6 Pension Market A growing elderly population and a large unorganized employment market are two primary factors that define the pension industry in India. Much of the Indian population is still outside the formal retirement benefit cover provided by the government and its associated organisations, and companies covered under the Employees Provident Fund Organisation (EPFO) rules. The government’s pension plan has moved from defined benefit structure, where all retired employees of a particular rank get the same pension with no contributions by the employee, to a defined contribution structure, where the employee and the employer contribute to the pension fund and the pension received on retirement will depend upon the fund accumulated. The private sector is covered by the Employee Provident Fund and the Employee Pension scheme or funds managed by establishments allowed to do so by the EPFO. The National Pension System (NPS) is a defined contribution pension scheme now applicable to government employees, where the employee and the government make matching 19 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination contributions to a fund of the employee’s choice, managed by licensed fund managers. The NPS is also available for the general public to voluntarily contribute periodically and create a retirement corpus. Other voluntary retirement plans available include the Public Provident Fund and retirement plans offered by insurance companies and mutual funds. On retirement, the corpus accumulated in the NPS is used to buy an annuity offered by insurance companies. The annuity provides a pension to the annuity holder according to the terms of the annuity selected. The Pension Fund Regulatory and Development Authority (PFRDA) is the regulator of the pension market. 1.4 Role of Participants in the Financial Markets Intermediaries in the financial markets are responsible for coordinating between investors and borrowers, and organizing the transfer of funds between them. Without the services provided by intermediaries, it would be quite difficult for investors and issuers to locate each other and carry out transactions efficiently and cost-effectively. The role and responsibilities of intermediaries are laid down in the acts and regulations governing them. 1.4.1 Stock Exchanges provide the infrastructure for trading in securities that have been issued at prices that reflect its current value. The existence of the system allows the valuation of their investment and to realize its value when they require funds encourage investors to invest when issuers raise funds. Stock markets such as the NSE, BSE and the MCX Stock Exchange (MCX-SX) are national exchanges with provide nation-wide broker networks. Trading happens on electronic trading terminals which feature anonymous order matching. Stock exchanges also appoint clearing and settlement agencies and clearing banks that manage the funds and securities settlement that arise out of these trades. 1.4.2 Depository participants enable investors to hold and transact in securities in the dematerialised form. Demat securities are held by depositories, where they are admitted for dematerialisation after the issuer applies to the depository and pays a fee. Depository participants (DPs) open investor accounts, in which they hold the securities that they have bought in dematerialised form. Brokers and banks offer DP services to investors. DPs help investors receive and deliver securities when they trade in them. While the investor-level accounts in securities are held and maintained by the DP, the company level accounts of securities issued is held and maintained by the depository. In other words, DPs act as agents of the Depositories. 20 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination 1.4.3 Custodians typically work with institutional investors, holding securities and bank accounts on their behalf. They manage the transactions pertaining to delivery of securities and money after a trade is made through the broker, and also keeps the accounts of securities and money. They may also account for expenses and value the portfolio of institutional investors. Custodians are usually large banks. 1.4.4 Stock brokers are registered trading members of stock exchanges. They sell new issuance of securities to investors. They put through the buy and sell transactions of investors on stock exchanges. All secondary market transactions on stock exchanges have to be conducted through registered brokers. Sub-brokers help in reaching the services of brokers to a larger number of investors. Several brokers provide research, analysis and recommendations about securities to buy and sell, to their investors. Brokers may also enable screen-based electronic trading of securities for their investors, or support investor orders over phone. Brokers earn a commission for their services. 1.4.5 Investment Banks are financial entities that provide strategic advice to companies, governments and others on their capital requirements and investment decisions and arrange raising such funds on terms that are most suitable to the company. Their activities include advisory services for business expansions, project financing, mergers and acquisition, investment valuation, among others. They charge a fee for their services. Investment banks also deal with large investors and help them manage their portfolios across asset classes, products and geographies. 1.4.6 Commercial Banks provide banking services of taking deposits, providing credit and enable payment services. They provide efficient cash management for businesses and meet their short-term financing needs through facilities such as over drafts and bills discounting. They also provide term financing for projects. For individuals and households, banks provide a secure infrastructure for holding their excess funds, making payments, accessing credit and financing facilities. 1.4.7 Insurance Companies provide service of insuring life, property and income against unexpected and large charge. Life insurance companies deal with insuring the life of individuals while general insurance covers health, motor, travel and other areas, where a sudden large expense can derail the financial situation of a household or business. Insurance companies use channels such as individual and corporate agents, brokers and banks to sell their products. Given the large resources mobilized by insurance companies by way of premiums, they are an important source of long-term funding for governments and businesses. 1.4.8 Pension Funds are intermediaries who are authorized to take contributions from eligible individuals and invest these funds according to the directions of the contributors to create a retirement corpus. These funds provide different options for investment of the 21 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination contribution, such as debt, equity or a combination. Investors select the type of fund depending upon their ability to take risk and their requirement for returns. 1.4.9 Asset management companies and portfolio managers are investment specialists who offer their services in selecting and managing a portfolio of securities (‘Portfolio’ is the collective noun for securities. A portfolio holds multiple securities). Asset management companies are permitted to offer securities (called ‘units’) that represent participation in a pool of money, which is used to create the portfolio of a mutual fund. Portfolio managers do not offer any security and are not permitted to pool the money collected from investors. They act on behalf of the investor in creating and managing a portfolio. Both asset managers and portfolio managers charge the investor a fee for their services, and may engage other security market intermediaries such as brokers, registrars, and custodians in conducting their functions. 1.4.10 Investment advisers and distributors work with investors to help them make a choice of securities that they can buy, based on an assessment of their needs, time horizon return expectation and ability to bear risk. They may also be involved in creating financial plans for investors, where they define the goals for which investors need to save money and propose appropriate investment strategies to meet the defined goals. 1.5 Regulators of Financial Markets 1.5.1 Ministry of Finance The Ministry of Finance through its Department of Financial Services regulates and overseas the activities of the banking system, insurance and pension sectors. The Department of Economic Affairs regulates the capital markets and its participants. The ministry initiates discussions on reforms and overseas the implementation of law. 1.5.2 Ministry of Corporate Affairs The Ministry of Corporate Affairs regulates the functioning of the corporate sector. The Companies Act, 2013 is the primary regulation which defines the setting up of companies, their functioning and audit and control. The issuance of securities by companies is also subject to provisions of the Companies Act. 1.5.3 Registrar of Companies The Registrar of Companies (RoC) is the authority appointed under the Companies Act to register companies and to ensure that they comply with the provisions of the law. 22 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination 1.5.4 The Reserve Bank of India (RBI) The Reserve Bank of India regulates the money market segment of securities market. As the manager of the government’s borrowing program, RBI is the issue manager for the government. It controls and regulates the government securities market. RBI is also the regulator of the Indian banking system and ensures that banks follow prudential norms in their operations. RBI also conducts the monetary, forex and credit policies, and its actions in these markets influences the supply of money and credit in the system, which in turn impact the interest rates and borrowing costs of banks, government and other issuers of debt securities. 1.5.5 Securities and Exchange Board of India (SEBI) The Securities and Exchange Board of India (SEBI), a statutory body appointed by an Act of Parliament (SEBI Act, 1992), is the chief regulator of securities markets in India. The main objective of SEBI is to facilitate growth and development of the capital markets and to ensure that the interests of investors are protected. SEBI has codified and notified regulations that cover all activities and intermediaries in the securities markets including stock brokers and sub brokers, merchant bankers, registrars to an issue, share transfer agents, underwriters, portfolio managers, depository participants, custodians, investment advisers and others. SEBI also register and regulate the working of institutions such as depositories, credit rating agencies, foreign institutional investors, mutual funds, venture capital funds, self-regulatory organisations and others. The Securities Contracts Regulation Act, 1956 and the Depositories Act, 1996 is administered by SEBI. SEBI also oversees the functioning of primary markets. Eligibility norms and rules to be followed for a public issue of securities are detailed in the SEBI (Issuance of Capital Disclosures and Requirements) Regulations, 2009. The SEBI (ICDR) Regulations lays down general conditions for capital market issuances like public and rights issuances and private placement of securities. The Regulations define the eligibility requirements, general obligations of the issuer and intermediaries, nature and format of disclosures required and the process of making the issue, among others. The listing agreement that companies enter into with the stock exchange has clauses for continuous and timely flow of relevant information to the investors, corporate governance and investor protection. SEBI has been assigned the powers of recognizing and regulating the functions of stock exchanges. The requirements for granting recognition to a stock exchange include representation of SEBI on the board of the stock exchange and an undertaking to make and amend their rules only with the prior approval of SEBI. Stock exchanges have to furnish periodic reports to the regulator and submit bye-laws for SEBI’s approval. Stock exchanges are required to send monitoring reports daily and for every settlement. SEBI has set up surveillance mechanisms, both internal and at stock exchanges, to monitor the 23 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination activities of stock exchanges, brokers, depository, R&T agents, custodians and clearing agents and identify unfair trade practices. SEBI makes routine inspections of the intermediaries functioning in the securities markets to ensure that they comply with prescribed standards. It can also order investigations into the operations of any of the constituents of the securities market for activities such as price manipulation, artificial volume creation, insider trading, violation of the takeover code or any other regulation, public issue related malpractice or other unfair practices. SEBI has the powers to call for information, summon persons for interrogation and examine witnesses. If the investigations so require, SEBI is also empowered to penalize violators. The penalty could take the form of suspension, monetary penalties and prosecution. SEBI has laid down regulations to prohibit insider trading i.e. trading by persons connected with a company having material information that is not publicly available. SEBI Regulations require companies to have a comprehensive code of conduct to prevent insider trading. This includes appointing a compliance officer to enforce regulations, ensuring periodic disclosure of holding by all persons considered as insiders and ensuring data confidentiality and adherence to the requirements of the listing agreement on flow of price sensitive information. If an insider trading charge is proved through SEBI’s investigations, the penalties include monetary penalties, criminal prosecution, prohibiting persons from securities markets and declaring transactions as void. 1.5.6 Insurance Regulatory and Development Authority (IRDA) IRDA regulates the insurance sector in India in accordance with the terms of the IRDA Act of 1999. IRDA is the licensing authority for insurance companies and defines the capital and networth requirements for insurance companies. It ensure the adherence of insurance products to the rules laid down and defines the rules for the terms and conditions of insurance contracts such as sum assured, surrender value, settlement of claims, nomination and assignment, insurable interest and others. It regulates the distribution of insurance products by laying down the qualification and training requirements of intermediaries and the payment of commission to distributors. IRDA supervises the functioning of the Tariff Advisory Committee that determines the rates for general insurance products. It also lays down the modalities for investment of funds by insurance companies. 1.5.7 Pension Fund Regulatory and Development Authority (PFRDA) The PFRDA is the authority entrusted to act as a regulator of the pension sector in India under the PFRDA Act, 2013. The PFRDA has been assigned the responsibility of designing the structure of funds and constituents in the National Pension System (NPS). It is responsible for registering the various constituents such as the fund managers, custodians, Central 24 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination record keeping agency and trustee banks and to define the parameters of their roles and responsibilities. 1.5.8 Forward Markets Commission (FMC) The Forward Markets Commission is the regulatory body that oversees the futures and forward trading in commodities in India. It was set up by the Forward Contracts (Regulation) Act, 1952 and is responsible for regulating and promoting forward and futures trading in commodities. The FMC monitors the trading conditions in the forward markets, including demand and supply and prices, and takes necessary action to streamline the functioning of the market. It advises the government on granting and withdrawing recognition to associations and undertakes inspection of the associations. The FMC prescribes regulatory measures for limits on open positions of clients and members, circuit filters to control price volatility, managing risk through margins and specifying regulations for physical delivery of contracts and penalty for defaults. 25 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Summary The growth of the economy requires a well-developed financial market for access to resources and for wider participation in the benefits of growth. The function of the financial markets is to ensure that economic activity is enabled by providing access of funds to those that need it for consumption or productive activity. The financial market comprises of the money markets that deal with the short-term lending and borrowing of funds and the securities or capital markets that enable longer term transfer of funds using debt and equity instruments. The banking system acts as the intermediary to channel funds to economic enterprises. Banks also provide a secure system for settling financial transactions. RBI is the regulator of the banking sector. It is the bank licensing and note-issuing authority. It also controls the credit and monetary activities in the economy. The securities market provides the structure for businesses to raise funds through the issue of securities. The primary market, also called the new issue market, is where issuers raise capital by issuing securities to investors. The secondary market, also called the stock exchange, facilitates trade in already-issued securities. Commodity transactions can be done in the cash market for immediate payment and delivery, or in the forward and futures market for settlement at a future point in time. An exchange traded futures contract standardizes the quality, quantity and terms of settlement of the underlying and reduces counter-party risk in the trade. Investors in the commodity markets include producers and consumers who want to hedge their exposure, investors who want to take advantage of arbitrage opportunities and speculators who want to benefit from an expected price movement. The foreign exchange market determines the value of one currency relative to another (called ‘currency pairs’) to enable settling trades in goods and services. There is a spot market and forward market in currency. The forward market currency deals have to be supported by an exposure to currency from trade that requires hedging. Future trades in currency are done on the exchanges. Insurance products may provide pure risk cover (term insurance) or may combine insurance and investment on a traditional platform (endowment, whole life) or unit- linked platform. PFRDA regulates the pension market in India. NPS is a defined contribution pension schemes that covers government employees who joined service after a specified dates. It is also available for other citizens. 26 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Stock exchanges provide a regulated platform for trading in securities at current values so that investors have liquidity in the securities held by them. Depository participants are empanelled members of a depository who enable investors to hold and trade in securities in dematerialized form. Custodians hold and manage the operational aspects of trading in securities on behalf of institutional investors. Stock brokers are registered members of a stock exchange who enable investors to put through transactions on a stock exchange for a brokerage. Investment banks help issuers make decisions on capital structure and assist in fund raising activities. Commercial banks provide banking services of taking deposits, providing credit and enable payment services. Insurance companies provide service of insuring life, property and income against unexpected and large loss or expense. Pension Funds are intermediaries who are authorized to take contributions from eligible individuals and invest these funds to create a retirement corpus. Asset management companies and portfolio managers are investment specialists who offer their services in selecting and managing a portfolio of securities. Investment advisers and distributors work with investors to help them make a choice of securities that they can buy, based on an assessment of their needs, time horizon, return expectation and ability to bear risk. The Ministry of Finance through its departments regulates and overseas the activities of the banking system, insurance and pension sectors, the capital markets and its participants. The Registrar of Companies (RoC) is the authority appointed under the Companies Act to register companies and to ensure that they comply with the provisions of the law. The Reserve Bank of India regulates the money market segment of securities market and acts as the manager of the government’s borrowing program. RBI is also the regulator of the Indian banking system and conducts the monetary, forex and credit policies. The Securities and Exchange Board of India (SEBI) is the chief regulator of securities markets in India. It facilitates the growth and development of the capital markets and ensures that the interests of investors are protected. IRDA is the licensing authority for insurance companies. It ensures the adherence of insurance products to the rules laid down and regulates the distribution of insurance products. 27 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination The PFRDA has been assigned the responsibility of designing the structure of funds and constituents in the National Pension System (NPS). The Forward Markets Commission is the regulatory body that oversees the futures and forward trading in commodities in India. 28 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Sample Questions 1. Financial markets enable economic growth by a. Creating demand and supply for goods and services b. Providing access to funds for productive enterprise c. Enabling appreciation in the price of securities d. None of the above 2. Which of the following markets is directly influenced by the policies of the RBI? a. Forex markets b. Commodities markets c. Insurance market d. Pension market 3. The terms on which a security is issued is primarily decided by a. Regulators b. Government c. Investors d. Issuers 4. The market for trading in securities already issued is called a. Future market b. Follow on market c. Secondary market d. Forward market 29 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination THIS PAGE HAS BEEN LEFT BLANK INTENTIONALLY 30 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination CHAPTER 2: SECURITIES MARKET SEGMENTS 2.1 Nature and Definition of Primary Markets The capital of a company is brought in by the promoters and their associates in the initial stages. As the requirement for additional funds go up, it may be necessary to source funds from a wider group of investors. The primary market refers to the market where equity or debt funds are raised by companies from ‘outside’ investors through an offer of securities. ‘Outside’ investors refer to investors who are not associated with the promoters. They may be individual investors or institutional investors. It is called the primary market because investors purchase the security directly from the issuer. It is also called the “new issue market” since these securities are issued for the first time by the company. The process of expanding the ability of an issuer to raise capital from public investors, who may not have been associated with the initial stages of the business, is also known as “going public.” The issuance of securities in the primary markets expands the reach of an issuer and makes long-term capital available to the issuer from a larger number of investors. Raising capital for a company may also be conducted through a syndicate of institutional investors who buy equity or debt securities through a private placement. This is also a primary market activity but the investors in these securities are a few pre-identified institutional investors. These investors may also seek sale of their holdings, conversion of debt to equity, or may offload their holdings in a public issue on a later date. Private placement of debt is similar to private equity or venture capital deals, except that the security issued is debt in the former and equity in the latter case. The ability of a company to raise funds from external sources will depend upon the performance of the company in the past and the expected performance in the future. Outside investors will require protection against a possible default on getting their dues or their rights getting diluted. This protection is available to them when they fund the company through investing in securities rather than one-on one agreement with the promoters. This is because securities are issued under regulatory overview, which also imposes obligations on the issuer of securities, to honour the commitments made at the time of raising funds. Investors may also require the flexibility to review their investment and exit the investment if need be. A security provides this facility as it may be listed on the exchanges, where key information about the company has to be periodically disclosed. The expectation for its performance tends to reflect in the prices at which its securities trade. 2.1.1 Functions of the Primary Market 31 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination The primary markets serve the following functions: a. Wider Investor Participation: A primary market issue enables participation of a wider group of investors. Companies move away from known sources of funding that may be restrictive in terms of the amount available or the terms at which capital may be made available. They may be able to raise the funds they require at much more competitive terms. For example, when an Indian company issues a global depository receipt (GDR) in the Euro markets, it reaches out to institutional and retail investors in those markets who may find the investment in a growing Indian enterprise, attractive. b. Foster Competitive Processes Securities are issued for public subscription, at a price that is determined by the demand and supply conditions in the market and the perceived fundamental strengths of the issuer to honour their commitments. The rate of interest a debt instrument will have to offer and the price at which an equity share will be purchased are dependent on the pricing mechanisms operating in the primary market. For example, government securities, which are issued by RBI on behalf of the government, are priced through an auction process. Banks and institutional investors are the main buyers of government securities, and they bid the rates they are willing to accept and the final pricing of the instrument on offer depends on the outcome of the auction. This enables fair pricing of securities in the primary market. c. Diversify Ownership As new subscribers of equity capital come in, the stakes of existing shareholders reduces and the ownership of the business becomes more broad-based and diversified. This enables the separation of ownership and management of an enterprise, where professional managers will be brought in to work in the broad interest of a large group of diverse shareholders. The presence of independent directors on the boards of companies, representing public shareholders, enhances the governance standards of companies. d. Better Disclosures A business that seeks to raise capital from new investors, who may not be familiar with the history and working of the enterprise, has to meet higher standards of disclosure and transparency. Regulations that govern primary markets prescribe the nature and periodicity of disclosures that have to be made. Investors will need adequate, relevant, accurate and verifiable financial and other information about the business to be able to buy the securities being offered. e. Evaluation by Investors An issuer that raises money from outside investors will be open for evaluation by a large number of prospective investors, who would assess the information provided. This forms another layer of scrutiny of the operations and performance of the company, apart from 32 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination its auditors and regulators. Publicly disclosed financial statements, reports, prospectus and other information also come up for scrutiny and discussion by analysts, researchers, activists, and media apart from investors. f. Exit for Early Investors Primary markets provide an exit option for promoters, private and inside investors who subscribed to the initial capital and early requirements for capital of a business. Such investors will be able to realize the value of the investment made by offering their shares, fully or partly, when the company makes an issue in the primary market. It provides them the opportunity to exit their investments at a profit. A vibrant primary market is thus an incentive for such investors who invest in early-stage business with the intent to nurture the business to a level at which public and other investors would be interested. g. Liquidity for Securities When capital is held by a few inside investors, the equity and debt securities held are not liquid, unless sold in a chunk to another set of interested investors. A primary market issue distributes the securities to a large number of investors and it is mandatory to list a public issue of securities in the stock exchange. This opens up the secondary market where the securities can be bought and sold between investors, without impacting the capital raised and used by the business. h. Regulatory Supervision Inviting outside investors to subscribe to the capital or buy securities of an issuer comes under comprehensive regulatory supervision. The issue process, intermediaries involved, the disclosure norms, and every step of the primary issue process is subject to regulatory provisions and supervision. The objective is to protect the interest of investors who contributes capital to a business, which they may not directly control or manage. While there is no assurance of return, risk, safety or security, regulatory processes are designed to ensure that fair procedures are used to raise capital in the primary market, adequate and accurate information is provided, and rights of all parties is well defined, balanced and protected. 2.1.2 Types of Issues All primary market issues need not be public issues. A primary issue of securities is made to promoters when a company is set up and equity shares are issued to them; if bonds are issued to institutions that lend to a company, that is also a primary issue, but issued privately only to a select set of investors. It is not uncommon for companies in early stages to issue equity capital to venture capitalists and private equity investors, who help the business to grow in size and scale. When an issuer does not choose any specific group of investors, but offers securities inviting anyone interested in buying the securities of the business, we have a public issue. 33 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Issuance of capital in the primary market can be classified under four broad heads: a. Public issue Securities are issued to the members of the public, and anyone eligible to invest can participate in the issue. This is primarily retail issue of securities. b. Private placement Securities are issued to a select set of investors who can bid and purchase the securities on offer. This is primarily a wholesale issue of securities to institutional investors by an unlisted company. c. Preferential issue A private placement of securities by a listed company is called a preferential issue. Securities are issued to an identified set of investors, on preferential terms, along with or independent of a public issue. This may include promoters, strategic investors, employees and such specified preferential groups. d. Qualified Institutional Placement (QIP) A private placement of securities by a listed company to a set of institutional investors termed as qualified institutional buyers is a QIP. Qualified institutional buyers include institutions such as mutual funds. e. Rights and Bonus issues Securities are issued to existing investors as on a specific cut-off date, enabling them to buy more securities at a specific price (rights) or get an allotment of additional shares without any consideration (bonus). 2.1.3 Issuers An issuer in the primary market has to be eligible to raise capital under the provisions of the law that governs it. The issuer has to meet the eligibility conditions specified by the concerned regulator before making an issue. The primary responsibility to meet the obligations associated with the security being issued rests on the issuer. For example, an issuer of bonds is responsible for paying interest and returning the principal on maturity; an issuer of equity shares is responsible to pay dividends as and when declared and notify equity shareholders about resolutions being brought for their approval through voting in the annual general meeting. Issue of securities in the primary market may be made by the following entities: 34 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination a. Central, State and Local Governments They raise funds to meet their fiscal deficits by issuing bonds called government securities (G-secs) and treasury bills. The central government alone issue treasury bills for different maturities such as 91 days, 182 days and 364 days. G-secs have tenors ranging from one year to 30 years. Bonds issued by the government carry a government guarantee. These securities are issued only in the Indian markets. They are no equity issuances by the government. b. Public Sector Units These are companies registered under the Companies Act, 2013, in which the government is the majority shareholder. These companies may make an issue of shares where the government offers a portion of the shares held by them to the public. This is called a disinvestment. For example, in December 2013, Power Grid Corporation of India made a share issue which comprised of 13% fresh equity offer by the company and a 4% stake sale by the government. These companies also issue bonds to raise debt. Some of the bonds may provide tax benefits to investors in the form of exemption from tax for interest earned on them or to save on long-term capital gains. For example, the National Highway Authority of India (NHAI) made an issue of tax free bonds in January 2014. The interest earned by investors on these bonds is exempt from tax. c. Private Sector Companies They raise equity and debt funds from the markets by issuing securities. They may issue ordinary equity shares, preference shares and convertible instruments. Corporate bonds are issued to raise long-term debt while commercial papers and securitized papers are issued to raise funds for less than one year. For this category of issuers, the securities market is the principal source of funds. They can access funds from domestic and international markets. d. Banks, Financial Institutions and Non-banking Finance Companies They raise funds by issuing equity shares, preference shares, bonds, convertible bonds, commercial paper, certificates of deposits and securitized paper. Deposit taking institutions like banks have access to low cost funds from the public and therefore not dependent too much on the securities markets. However, financial institutions and NBFCs raise short term and long term capital through the issue of securities. They have access to domestic and international markets. e. Mutual Funds They make a new fund offer (NFO) of units in the domestic markets to raise funds for a defined scheme. The funds may be raised for a specific period after which the current 35 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination value of the units will be returned to the investors (Closed-end fund) or it may be for perpetuity with investors being given the option to exit at any time at the prevailing value of the units. The primary markets are regulated by the Companies Act, 2013, Securities and Contract Regulation Act, 1956, SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 for issue of equity and debt securities by companies. Government securities are issued by RBI on behalf of the government, and are subsequently listed on stock exchanges. The primary issue of government securities is governed by the Government Securities Act, 2000. Instruments such as certificates of deposit and commercial paper are money market securities, whose issuance is also governed by RBI. The provisions of these Acts regulate the following with respect to public issues: Eligibility to make public issue Information to be provided to the public and regulators Reservation for different categories of investors Methods of making the offer to investors Timelines for the issue process Usage of funds raised in issues Continued involvement and accountability of promoters and other inside investors in case of equity issuances Provision for investors to continuously evaluate the investment and execute investment and exit decisions. 2.1.4 Types of Investors Both retail and institutional investors participate in primary market issues. The following are the various categories of investors who buy securities in the primary markets: Resident individuals Hindu undivided family (HUF) Minors through guardians Registered societies and clubs Non-resident Indians (NRI) Persons of Indian Origin (PIO) Qualified Foreign investors (QFI) Banks Financial institutions Association of persons Companies Partnership firms 36 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination Trusts Foreign institutional investors (FIIs) Limited Liability Partnerships (LLP) Individual investors are further categorized based on the amount invested as retail, who invests less than Rs.2 lakhs in a single issue and non-institutional buyers (NIBs), who invest more than Rs. 2 lakhs in a single issue. The other categories of investors are classified as institutional investors and are also known as qualified institutional buyers (QIBs) Some securities may be available only to specific categories of investors. The information about who can purchase securities being offered is provided in the offer document. Investors require a PAN card issued by the Income Tax authorities to be able to apply in a primary market issue of securities. If the securities are to be issued in only dematerialized form, then the investor needs to mention the demat account details in the application form. 2.1.5 Types of Public Issue of Equity Shares Public issue of equity shares can be categorized as follows: a. Initial Public Offer (IPO) The first public offer of shares made by a company is called an Initial Public Offer (IPO). When a company makes an IPO the shares of the company becomes widely held and there is a change in the shareholding pattern. The shares which were privately held by promoters are now held by retail investors, institutions, promoters etc. An IPO can either be a fresh issue of shares by the company or it can be an offer for sale to the public by any of the existing shareholders, such as the promoters or financial institutions, or a combination of the two. Fresh Issue of Shares: New shares are issued by the company to public investors. The issued share capital of the company increases. The percentage holding of existing shareholders will come down due to the issuance of new shares. Offer for Sale: Existing shareholders such as promoters or financial institutions offer a part of their holding to the public investors. The share capital of the company does not change since the company is not making a new issue of shares. The proceeds from the IPO go to the existing shareholders who are selling the shares and not to the company. The holding of the existing shareholders in the share capital of the company will reduce. Example A company has an issued 1000 shares of a face value of Rs. 10 each. The shares are equally held by the two promoters P and Q. 37 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination A. The company decides to make a fresh issue of 500 shares. B. The company decides to offer 250 shares of each promoter to the public. The fresh issue of shares in the IPO (A) will result in the following post-IPO situation: The issued capital of the company will now be 1500 shares with a face value of Rs. 10 each. Promoters A and B continue to hold 500 shares each. The percentage holding of each of the promoters in the share capital of the company will change from 50% (500 shares out of 1000 shares issued by the company) to 33.33% (500 shares out of 1500 shares issued by the company). The offer for sale in the IPO (B) will result in the following post-IPO situation: The capital of the company will remain at 1000 shares with a face value of Rs.10 each. The holding of the promoters will decrease to 250 shares each from 500 shares each pre-issue. They now hold 25% each of the share capital; 50% is held by the public. The money raised in the IPO will go to the promoters who have sold the shares and not to the company. The disinvestment of shares by the government in PSUs is an example of an offer for sale. The government offers a portion of its shares to the public in an IPO. The proceeds collected go the government which is selling the shares and not to the company. There will be no change in the share capital of the company. However, there will be a change in the list of shareholders as new investors buy the shares and a reduction in the government’s holding in the company. An IPO may also be a combination of an offer for sale and a fresh issue of shares by the issuing company. b. Follow-on Public Offer A follow-on public offer is made by an issuer that has already made an IPO in the past and now makes a further issue of securities to the public. When a company wants additional capital for growth or to redo its capital structure by retiring debt, it raises equity capital through a fresh issue of capital in a follow-on public offer. A follow-on public offer may also be through an offer for sale. This usually happens when it is necessary to increase the public shareholding to meet the requirements laid down in the listing agreement between the company and the stock exchange. Or promoters may dilute their holdings in the company after the lock-in imposed at the time of the IPO is over. 38 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination 2.1.6 Pricing a Public Issue of Shares SEBI’s Regulations allow an issuer to decide the price at which the shares will be allotted to investors in a public issue. This can either be fixed by the issuer in consultation with the managers of the issue or it can be determined by a process of bidding by investors. Based on the method used to determine the price, a public issue can be categorized as: a. Fixed Price Issue In a fixed price issue of shares to the public, the company in consultation with the lead manager (who is the merchant banker in-charge of the issue) would decide on the price at which the shares will be issued. The company justifies the price based on the expected performance of the company and the price of shares of comparable companies in the market. This information is made available to the investors when the issue is announced so that investors know the price at which the shares will be allotted to them at the time of making the application. b. Book Built Issue The objective of a book building process is to identify the price that the market is willing to pay for the securities being issued by the company. The company and its issue managers will specify either a floor price or a price band within which investors can bid. When the issue opens, investors will put in bid applications specifying the price and the number of securities (or total amount) bid at that price. The price bid should be above the floor price or within the price band, as applicable. Retail investors can revise the bids in the period when the issue is open. The issuer, in consultation with the book running lead manager will decide on the cut-off price which is the price at which the issue gets subscribed. All allottees who bid at or above the cut-off price are successful bidders and are eligible for allotment in the respective categories. For example, a company wants to issue 5000 shares through a book built offer within a price band of Rs 120 to Rs 144. Bids are received as follows: Price No. of Shares Total Demand Rs 144 1000 1000 Rs 140 1500 2500 Rs 135 2500 5000 Rs 130 1000 6000 Rs 120 500 6500 39 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination The offer is filled up at the cut-off price of Rs 135. All investors who bid at this price and higher are eligible for allotment in their respective categories. The company may decide the cut-off piece at a price lower than the price at which the issue is subscribed for the benefit of the investors. Book built issues may also have a clause which allows allotment to retail investors at a price that is at a discount to the cut off price which cannot however exceed 10% of the price at which shares are allotted to the other category of investors. In a book built offer, not more than 50% shall be offered to the QIBs of which 5% shall be reserved for mutual funds, not less than 15% to non-institutional investors and not less than 35% to the retail investors. For fixed price offers, a minimum of 50% of the net offer of securities to the public shall be initially made for allotment to retail individual investors and the balance to HNIs and other investors. 2.1.7 Regulatory Norms for Public Issue of Shares A public issue will be open for a minimum of three working days and a maximum of 10 working days in the case of fixed price issues. For book built issues, the offer will be open for a period between 3 to 7 days extendable by 3 days in case of a revision in price band. Investors can make applications during this period. In a book built issue investors can also revise bids in this period. SEBI’s regulations requires a company making a public issue of shares to enter into an agreement with all the depositories to dematerialize its shares so that investors can be given the option of holding the shares in dematerialized form. If the issue size is equal to ten crores or more, then the securities will be issued only in dematerialized form. Companies making a public offer of shares are required to get the IPO graded by a credit rating agency registered with SEBI. The grading is done based on the prospects of the industry, the competitive strength of the company and risks in the business. The grade assigned based on the evaluation is an assessment of the fundamentals of the issuer and is not a commentary on the issue price or a recommendation to subscribe to the issue. The grade ranges from 1 to 5, with 5 indicating strong fundamentals and 1 poor fundamental. A company can get itself graded by multiple agencies but has to publish all the grading it has received. 2.1.8 Applying to a Public Issue The prospectus or offer document lays down the process of applying to a public issue of securities. Information of a forthcoming public issue is typically available from the mandatory advertisements that the company will have to issue and from the coverage that IPOs get in the press. The soft copies of the offer document are available on SEBI’s website and on the websites of the lead manager to the issue. 40 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination A public issue is open for subscription during a limited period as notified by the company. The date on which the issue will open for subscription and the earliest closing date are mentioned in the announcements about the issue. Investors have to make their application during this period. The application forms are available with the brokers and syndicate members and with collection banks appointed as constituents to the issue. The NSE, BSE and MCX-SX feature an online bidding network that enables conducting online bidding for IPOs offered using the book building route. It is a screen based system in which investors through the trading terminals of broker-members can enter bids. This is a lower cost option to reaching a large number of investors electronically. This segment is called the IPO market and is operated from 10 am to 5pm during the IPO period. The lead manager can seek an extension of bidding time on the closing date. From 2013, all public issues will provide the e-IPO facility under which investors can bid for IPOs using the electronic trading facility of any broker of the exchange, whether or not the broker is appointed as such for the issue. The price band is announced atleast 5 days before the issue opens. This enables investors to evaluate the issue and decide the price they are willing to bid for. In a book built offer investors must place bids for the minimum bid lot specified by the issuer so that the minimum application value adheres to the SEBI prescribed range of Rs. 10,000 to Rs. 15,000. Investors can either specify the bidding price or they may choose to bid at the cut-off. Bidding at the cut-off implies that the price they would accept is the price determined by the bidding process. Investors who bid a price can revise their bid at any time using the revision form attached to the application form. They can also modify their bids online. This has to be done before the issue closing date. Payment for applications made in a public issue must be made through a local cheque, demand draft or using the ASBA (application supported by blocked amount) facility. ASBA is an application for subscription to an issue containing an authorization to the investors’ bank to block the application money in the bank account and release funds only on allotment. Once the issue closes, the cut-off price is determined based on the bids received. All investors who bid at the cut-off price or higher are successful bidders and receive allotment at the cut-off price. Investors who bid lower than the cut-off price will receive the refund of their application amount. Bidding at the cut-off ensures that the investor’s application is always accepted. The issue may be over-subscribed, which means that the bids made at the cut-off price and higher were for a higher number of shares than what was offered. In an over- 41 NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination subscribed issue, the shares will be allotted to an investor on a proportionate basis. There will be a refund made to the extent that the shares allotted are lower than the shares applied for. If subscriptions are lower than the offered number of shares, it is undersubscribed and all applying investors, at or above the cut-off price will receive allotments. The issuer credits the shares to the beneficiary demat account of the successful applicants, and refunds for partial or non-allotment within 12 working days of the closing date of the issue. 2.1.9 Public Issue of Debt Securities A company can make a public issue of debt securities, such as, debentures by making an offer through a prospectus. The issue of debt securities is regulated by the provisions of the Companies Act and SEBI (Issue and Listing of Debt Securities) Regulations, 2008. The company will appoint a lead manager who will ensure compliance with all the regulatory requirements for the issue. A public issue of debt securities is possible by a company registered as a public limited company under the Companies Act, 2013. An unlisted company, in other words a company that has not made an initial public offer of its shares and listed the shares on a stock exchange, can still make a public issue of debentures and list them on a stock exchange. The company files an offer document with SEBI and the Registrar of Companies which gives all the material information of the issue. The final document will be available for download from the website of the stock exchange where the instrument is proposed to be listed prior to the issue opening. If there is a request for a physical copy of the offer document, the lead manager or issuer is required to make the same available. The debentures issued under a public offer have to mandatorily be listed on a stock exchange. The company has to obtain credit rating from at least one credit rating agency and the rating has to be disclosed in the offer document. If the rating has been obtained from more than one rating agency, all the ratings have to be disclosed. a. Dematerialization The issuer has to enter into an agreement with a depository for dematerialization of the securities p