NISM-Series-XII Securities Markets Foundation Certification Examination PDF

NISM-Series-XII: Securities Markets Foundation Certification Examination Workbook for NISM-Series-XII: Securities Markets Foundation Certification Examination National Institute of Securities Markets www.nism.ac.in 1 NISM-Series-XII: Securities Markets Foundation Certification Examination This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Certification Examination for Securities Markets Foundation. Workbook Version: May 2019 Published by: National Institute of Securities Markets © National Institute of Securities Markets, 2019 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-XII: Securities Markets Foundation Certification Examination Foreword NISM is a leading provider of high end professional education, certifications, training and research in financial markets. NISM engages in capacity building among stakeholders in the securities markets through professional education, financial literacy, enhancing governance standards and fostering policy research. NISM works closely with all financial sector regulators in the area of financial education. NISM Certification programs aim to enhance the quality and standards of professionals employed in various segments of the financial services sector. NISM’s School for Certification of Intermediaries (SCI) develops and conducts certification examinations and Continuing Professional Education (CPE) programs that aim to ensure that professionals meet the defined minimum common knowledge benchmark for various critical market functions. NISM certification examinations and educational programs cater to different segments of intermediaries focusing on varied product lines and functional areas. NISM Certifications have established knowledge benchmarks for various market products and functions such as Equities, Mutual Funds, Derivatives, Compliance, Operations, Advisory and Research. NISM certification examinations and training programs provide a structured learning plan and career path to students and job aspirants who wish to make a professional career in the Securities markets. Till March 2019, NISM has certified nearly 8 lakh individuals through its Certification Examinations and CPE Programs. NISM supports candidates by providing lucid and focused workbooks that assist them in understanding the subject and preparing for NISM Examinations. The book covers all important topics to impart basic knowledge of the Indian securities markets to the participants and the related rules and regulations. These include the basics of the Indian Securities Markets, processes involved in Primary and Secondary Markets and the schemes and products in Mutual Funds and Derivatives Markets in India. The book also covers the essential steps in financial planning process. It will be immensely useful to all those who want to learn about the various aspects of securities markets. Dr. M. Thenmozhi Director 3 NISM-Series-XII: Securities Markets Foundation 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 Markets (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. Acknowledgement This workbook has been jointly developed by the Certification Team of National Institute of Securities Markets in co-ordination with Ms. Uma Shashikant of the Centre for Investment Education and Learning and Ms. Sunita Abraham, empanelled Resource Person of NISM. NISM gratefully acknowledges the contribution of the Examination Committee for NISM-Series- XII: Securities Markets Foundation Certification Examination consisting of industry representatives. 4 NISM-Series-XII: Securities Markets Foundation Certification Examination About NISM National Institute of Securities Markets (NISM) was established by the Securities and Exchange Board of India (SEBI), in pursuance of the announcement made by the Finance Minister in his Budget Speech in February 2005. SEBI, by establishing NISM, articulated the desire expressed by the Government of India to promote securities market education and research. Towards accomplishing the desire of Government of India and vision of SEBI, NISM delivers 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 to the educational needs of various constituencies such as investors, issuers, intermediaries, regulatory staff, policy makers, academia and future professionals of securities markets. NISM is mandated to implement Certification Examinations for professionals employed in various segments of the Indian securities markets. NISM also conducts numerous training programs and brings out various publications on securities markets with a view to enhance knowledge levels of participants in the securities industry. About NISM Certifications The School for Certification of Intermediaries (SCI) at NISM is engaged in developing and administering Certification Examinations and CPE Programs for professionals employed in various segments of the Indian securities markets. These Certifications and CPE Programs are being developed and administered by NISM as mandated under Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007. The skills, expertise and ethics of professionals in the securities markets are crucial in providing effective intermediation to investors and in increasing the investor confidence in market systems and processes. The School for Certification of Intermediaries (SCI) seeks to ensure that market intermediaries meet defined minimum common benchmark of required functional knowledge through Certification Examinations and Continuing Professional Education Programmes on Mutual Funds, Equities, Derivatives Securities Operations, Compliance, Research Analysis, Investment Advice and many more. Certification creates quality market professionals and catalyzes greater investor participation in the markets. Certification also provides structured career paths to students and job aspirants in the securities markets. 5 NISM-Series-XII: Securities Markets Foundation Certification Examination About the Workbook This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Certification Examination for Securities Markets Foundation. NISM-Series-XII: Securities Markets Foundation Certification Examination is for entry level professionals, who wish to make a career in the securities markets. The book covers all important topics to impart basic knowledge of the Indian securities markets to the participants and the related rules and regulations. These include the basics of the Indian Securities Markets, processes involved in Primary and Secondary Markets and the schemes and products in Mutual Funds and Derivatives Markets in India. The book also covers the essential steps in financial planning process. 6 NISM-Series-XII: Securities Markets Foundation Certification Examination About the Certification Examination for Securities Markets Foundation This examination is a voluntary examination. The NISM-Series-XII: Securities Markets Foundation Certification Examination is for entry level professionals, who wish to make a career in the securities markets. This certification examination will also be useful to all those individuals who are interested in acquiring a basic knowledge of the Indian Securities markets, including: Entry level professionals in the securities markets Employees of intermediaries functioning in the securities industry Professionals in other industries interested in gaining knowledge of the securities markets Students Homemakers Teachers The purpose of this exam is to impart basic knowledge of the Indian securities markets to the participants and related rules and regulations. Examination Objectives On successful completion of the examination, the candidate should: Know the basics of the Indian Securities Markets. Know the various processes involved in Primary and Secondary Markets Understand the schemes and products in Mutual Funds and Derivatives Markets in India. Know the steps in financial planning process. 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 no negative marking. How to register and take the examination To find out more and register for the examination please visit www.nism.ac.in 7 NISM-Series-XII: Securities Markets Foundation Certification Examination CONTENTS CHAPTER 1: UNDERSTANDING SECURITIES MARKETS AND PERFORMANCE.......................... 11 1.1. Securities Markets and Securities: Definition and Features....................................................... 11 1.2. Securities Markets: Structure and Participants.......................................................................... 14 1.3. Role of Securities Markets as Allocator of Capital...................................................................... 22 CHAPTER 2: SECURITIES: TYPES, FEATURES AND CONCEPTS.................................................. 28 2.1. Equity and Debt Securities.......................................................................................................... 28 2.2. Features of Equity Capital........................................................................................................... 29 2.3. Features of Debt Capital............................................................................................................. 31 2.4. Choice between Equity and Debt Financing............................................................................... 32 2.5. Investing in Equity...................................................................................................................... 33 2.6. Equity Analysis and Valuation..................................................................................................... 35 2.7. Commonly Used Terms in Equity Investing................................................................................ 37 2.8. Risk and Return from Investing in Equity................................................................................... 39 2.9. Basic Features of a Debt Instrument.......................................................................................... 40 2.10. Types and Structures of Debt Instruments................................................................................. 41 2.11. Concepts and Terms Relating to Debt Securities....................................................................... 48 2.12. Benefits and Risks of Investing in Debt Securities...................................................................... 51 2.13. Choosing between Debt and Equity Investment Avenues......................................................... 53 2.14. Hybrid Instruments..................................................................................................................... 54 CHAPTER 3: PRIMARY MARKETS.......................................................................................... 63 3.1. Primary Market: Definition and Functions................................................................................. 63 3.2. Types of Issues............................................................................................................................ 66 3.3. Issuers......................................................................................................................................... 67 3.4. Regulatory Framework for Primary Markets.............................................................................. 69 3.5. Types of Investors....................................................................................................................... 74 3.6. Types of Public Issue of Equity Shares........................................................................................ 75 3.7. Pricing a Public Issue of Shares................................................................................................... 77 3.8. Public Issue Process.................................................................................................................... 79 3.9. Prospectus.................................................................................................................................. 81 3.10. Applying to a Public Issue........................................................................................................... 83 8 NISM-Series-XII: Securities Markets Foundation Certification Examination 3.11. Listing of Shares.......................................................................................................................... 85 3.12. Rights Issue of Shares................................................................................................................. 86 3.13. Public Issue of Debt Securities.................................................................................................... 87 3.14. Private Placements in Equity and Debt...................................................................................... 89 CHAPTER 4: SECONDARY MARKETS...................................................................................... 94 4.1. Role and Function of the Secondary Market.............................................................................. 94 4.2. Market Structure and Participants............................................................................................. 96 4.3. Brokers and Client Acquisition.................................................................................................... 99 4.4. Trade Execution........................................................................................................................ 103 4.5. Settlement of Trades................................................................................................................ 115 4.6. Market Information and Regulation......................................................................................... 122 4.7. Risk Management Systems....................................................................................................... 125 4.8. Rights, Obligations and Grievance Redressal........................................................................... 127 CHAPTER 5: MUTUAL FUNDS..............................................................................................132 5.1. Meaning and Description of a Mutual Fund............................................................................. 132 5.2. Terms and Concepts Related to Mutual Funds........................................................................ 134 5.3. Working of a Mutual Fund........................................................................................................ 140 5.4. Regulation of Mutual Funds..................................................................................................... 142 5.5. Types of Mutual Fund Products................................................................................................ 143 5.6. Processes for Investing in Mutual Funds.................................................................................. 152 5.7. Systematic Transactions........................................................................................................... 157 5.8. Reading Mutual Fund Information........................................................................................... 159 5.9. Benefits and Costs of Investing in Mutual Funds..................................................................... 159 CHAPTER 6: DERIVATIVE MARKETS.....................................................................................165 6.1. Definition of Derivatives........................................................................................................... 165 6.2. Underlying concepts in Derivatives.......................................................................................... 168 6.3. Types of Derivative Products.................................................................................................... 169 6.4. Structure of Derivative Markets............................................................................................... 172 6.5. Trading and Settlement Process: Equity Futures..................................................................... 174 6.6. Risk Management in Derivative Markets................................................................................. 178 6.7. Costs, Benefits and Risks of Derivatives................................................................................... 181 6.8. Market Indicators..................................................................................................................... 182 9 NISM-Series-XII: Securities Markets Foundation Certification Examination CHAPTER 7: FINANCIAL PLANNING AND SECURITIES MARKETS............................................188 7.1. Overview of Financial Planning................................................................................................. 188 7.2. Steps in Financial Planning....................................................................................................... 191 7.3. Asset Allocation and Diversification......................................................................................... 196 7.4. Investing for Financial Planning................................................................................................ 198 Glossary of Financial Terms................................................................................................202 10 NISM-Series-XII: Securities Markets Foundation Certification Examination CHAPTER 1: UNDERSTANDING SECURITIES MARKETS AND PERFORMANCE LEARNING OBJECTIVES: After studying this chapter, you should know about:  Securities markets and the definition of securities  Structure of securities markets and its participants  Role of securities markets in allocation of capital 1.1. Securities Markets and Securities: Definition and Features Financial market consists of various types of markets (money market, debt market, securities market); investors (buyers of securities), issuers of securities (users of funds), intermediaries and regulatory bodies (SEBI, RBI etc.). The components of the Indian financial market can be illustrated through Figure 1. In this book, the focus will be on the securities markets. Figure: 1 Component of Indian Financial Markets The securities markets provide a regulated institutional framework for an efficient flow of capital (equity and debt) from investors to businesses in the financial market system. It 11 NISM-Series-XII: Securities Markets Foundation Certification Examination provides a channel for allocation of savings to investments. Thus, the savings of households, business firms and government can be channelized through the medium of securities market to fund the capital requirements of a business enterprise and government. Savings are linked to investments by a variety of intermediaries through a range of complex financial products called “securities”. Securities are financial instruments issued by companies, financial institutions or the government to raise funds. These securities are purchased by investors who in turn convert their savings into financial assets. The term “securities” has been defined in Section 2 (h) of the Securities Contracts (Regulation) Act 1956. The Act defines securities to include: a) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; b) derivative 1; c) units or any other instrument issued by any collective investment scheme to the investors in such schemes; d) security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002; e) units or any other such instrument issued to the investors under any mutual fund scheme (securities do not include any unit linked insurance policy or scrips or any such instrument or unit, by whatever name called which provides a combined benefit risk on the life of the persons and investment by such persons and issued by an insurer refer to in clause (9) of section 2 of the Insurance Act, 1938 (4 of 1938)); f) any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be; g) government securities; h) such other instruments as may be declared by the Central Government to be securities (including onshore rupee bonds issued by multilateral institutions like the Asian Development Bank and the International Finance Corporation); i) rights or interest in securities. 1 As per SCRA, derivatives includes (i) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; (ii) a contract which derives its value from the prices, or index of prices, of underlying securities; (iii) commodity derivatives; and (iv) such other instruments as may be declared by the Central Government to be derivatives. 12 NISM-Series-XII: Securities Markets Foundation Certification Examination Features of Securities:  A security represents the terms of exchange of money between two parties. Securities are issued by companies, financial institutions or the government and are purchased by investors who have the money to invest. The broader universe of savers with surplus to invest is available to the issuers of securities; a universe of wider options is available to savers to invest their money in.  Security issuance allows borrowers to raise money at a reasonable cost while security ownership allows investors to convert their savings into financial assets which provide a return. Thus, the objectives of the issuer and the investor are complementary, and the securities market provides a platform to mutually satisfy their goals.  The business enterprises issue securities to raise money from the entity with surplus funds through a regulated contract. The enterprise list these 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 investing entity.  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.  Securities can be broadly classified into equity and debt. The terms of issue, rights of investors, risk and return for these two classes of securities varies widely. Return refers to the benefits that the investor will receive from investing in the security. Risk refers to the possibility that the expected returns may not materialise. For example, a company may seek capital from an investor by issuing a bond. A bond is a debt security, which means it represents a borrowing of the company. The security will be issued for a specific period, at the end of which the amount borrowed will be repaid to the investor. The return will be in the form of interest, paid periodically to the investor, at a rate and frequency specified in the security. The risk is that the company may fall into bad times and default on the payment of interest or return of principal.  An investor has the right to seek information about the securities in which he invests. For example, when investors buy the bond, they can seek information about the company, ask for evaluation of its ability to repay the borrowed amount, seek the rights to claim their dues if the company shuts down, and also have the benefit of a liquid market in which they can sell off the security if they do not like to bear the risks. Thus, the institutional structure of securities markets enables assuming risks in exchange for returns, evaluating the risks and return based on information available about the security, and transferring of risk when the investor sells the security to another investor who may be willing to bear the risk, for the expected return. Those who need money can source it from those who have it primarily through two means: 13 NISM-Series-XII: Securities Markets Foundation Certification Examination a. A one-to-one transaction, whose terms are determined and agreed to mutually b. A standard security, whose terms are accepted by both parties What is the difference between these two choices? Assume that a bank accepts a 3-year deposit from a customer. This is a transaction between the bank and its customer. The bank has borrowed the money; the customer has lent the money. The bank will repay the deposit only to the customer. The interest rate is fixed when the deposit is accepted. The deposit has to be kept for a 3-year period. If the customer needs money earlier than that, the deposit can be broken but may be subject to penalties. The bank may issue a fixed deposit receipt to the customer, but that receipt is not transferable. Assume instead that the bank issues a certificate of deposit (CD), which is a security. The CD is also for 3-years and carries the same interest rate as the deposit. But the similarities end there. The customer can either hold the CD till its maturity or can transfer it to another customer before the maturity date. The investor who holds the CD on the date of its maturity submits it to the bank and collects the maturity value. When the CD transfers from one investor to another, the price is determined based on what both agree as the market rate at that time. When a monetary transaction between two parties is structured using a security, the flexibility to both parties is higher. Bank deposits, inter-corporate deposits, company fixed deposits, deposits with housing finance and other finance companies, chit funds and benefit funds are all not securities. Insurance policies are also contracts and are not securities. Investment in provident funds or pension funds is also not investment in securities. All these are financial arrangements between two parties that are not in the form of transferable securities. 1.2. Securities Markets: Structure and Participants Structure 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 the 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/securities exchange, facilitates trade in already-issued securities, thereby enabling investors to exit from an investment. The risk in a security investment is transferred from one investor (seller) to another (buyer) in the secondary markets. Thus, the primary market creates financial assets, and the secondary market makes them marketable. 14 NISM-Series-XII: Securities Markets Foundation Certification Examination Participants Investors and issuers are the main building blocks of a securities market. Issuers supply securities and create a demand for capital; and investors buy the securities and thereby provide the supply of capital. Interaction between investors and borrowers is facilitated through financial intermediaries who are 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 portfolio investors (FPIs), individual investors; the issuers include companies, bodies corporate; lawyers, bankers to the issue, brokers, and depository participants. The role of stock exchanges in the primary market is limited to the extent of listing of the securities. The constituents of secondary market are stock exchanges, stock brokers (who are members of the stock exchanges), asset management companies (AMCs), financial institutions, foreign portfolio investors (FPIs), investment companies, individual investors, depository participants and banks. The Registrars and Transfer Agents (RTAs), custodians and depositories are capital market intermediaries, which provide important infrastructure services to both the primary and secondary markets. 1.2.1 Investors Investors are individuals or organisations with surplus funds which can be used to purchase securities. The chief objective of investors is to convert their surplus and savings into financial assets that earn a return. Based on the size of the investment and sophistication of investment strategies, investors are divided into two categories--retail investors and institutional investors. Retail investors are individual investors who invest money on their personal account. Institutional investors are organizations that invest large sum of money and employ specialised knowledge and investment skills. For instance, if A saves Rs. 5000 from her salary every month and uses it to buy mutual fund units, she is a retail investor, whereas an institution like ICICI Mutual Fund which buys 50,000 shares of Reliance Industries Ltd., is an institutional investor. Institutional investors are companies, banks, government organisations, mutual funds, insurance companies, pension trusts and funds, associations, endowments, societies and other such organisations that may have surplus funds to invest. Some of the institutions such as mutual funds are institutional investors by objective i.e. their primary business is to invest in securities. Other institutions may be into some other primary 15 NISM-Series-XII: Securities Markets Foundation Certification Examination business activities, but may have surplus funds to be invested in securities markets. Some other institutions such as banks and financial institutions may operate in the financial markets in various capacities, but also have an actively managed treasury department that efficiently deploys money in the securities markets to earn a return. Institutional investors manage their returns and risk through formal processes for (a) evaluating and selecting the securities they buy; (b) reviewing and monitoring what they hold, and (c) formally managing the risk, return and holding periods of the securities they hold. 1.2.2 Issuers Issuers are organizations that raise money by issuing securities. They may have short-term and long-term need for capital, and they issue securities based on their need, their ability to meet the obligations to the investors, and the cost they are willing to pay for the use of funds. Issuers of securities have to be authorised by appropriate regulatory authorities to raise money in the securities markets. The following are common issuers in the securities markets: a. Companies issue securities to raise short and long term capital for conducting their business operations. b. Central and State Governments issue debt securities to meet their requirements for short term and long term to finance their deficits. (Deficit is the extent to which the expenses of the government are not met by its income from taxes and other sources). c. Local governments and municipalities may also issue debt securities to meet their development needs. Government agencies do not issue equity securities. d. Financial institutions and Banks may issue equity or debt securities for their capital needs beyond their normal sources of funding from deposits and government grants. e. Public Sector Companies which are owned by the government may issue securities to public investors as a part of the disinvestment program of the government i.e. when the government decides to offer its holding of these securities to public investors. f. Mutual Funds issue units of a scheme to investors to mobilise money and invest them on behalf of investors in securities. The securities are issued in the name and under the common seal of the issuer and the primary responsibility of meeting the obligations are with the issuer. Earlier securities were issued in the paper form as certificates. Since the mid-1990s securities are issued in electronic form. Previously issued share certificates also were converted into electronic form by the issuers. This process is called dematerialisation. 1.2.3 Intermediaries Intermediaries in the securities markets are agents responsible for coordinating between investors (lenders) and issuers (borrowers), and organising the transfer of funds and securities 16 NISM-Series-XII: Securities Markets Foundation Certification Examination 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. According to the SEBI (Intermediaries) Regulations, 2008, following are the intermediaries of securities markets:  Asset Management Companies  Portfolio managers  Merchant bankers  Underwriters  Stock brokers  Authorized Persons  Clearing members of a clearing corporation or house  Trading members of the derivative segment of a stock exchange  Bankers to an issue  Registrars of an issue  Share transfer agents  Depository participants  Custodians of securities  Trustees of trust deeds  Credit rating agencies  Investment advisers Asset management companies and portfolio managers are investment specialists who offer their services in selecting and managing a portfolio2 of 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. 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. Merchant bankers, also called as issue managers, investment bankers, or lead managers, engage in the business of issue management either by making arrangements regarding the selling, buying or subscribing to securities or acting as manager, consultant, adviser or corporate advisory service in relation to such issue management. They evaluate the capital needs, structure an appropriate instrument, get involved in pricing the instrument, and manage the entire issue process until the securities are issued and listed on a stock exchange. They 2 Portfolio is the term used to describe a group of securities 17 NISM-Series-XII: Securities Markets Foundation Certification Examination engage other intermediaries such as registrars, brokers, bankers, underwriters and credit rating agencies in managing the issue process. Underwriters are primary market specialists who promise to pick up that portion of an offer of securities which may not be bought by investors. They serve an important function in the primary market, providing the issuer the comfort that if the securities being offered do not elicit the desired demand, the underwriters will step in and buy the securities. The specialist underwriters in the government bond market are called primary dealers. Stock brokers are registered trading members of stock exchanges. They facilitate 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. Authorized persons (AP) are agents of the brokers (previously referred to as sub-brokers) and are registered with the respective stock exchanges.3 APs help in reaching the services of brokers to a larger number of investors. Several brokers provide various services such as 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. Clearing members and trading members are members of the stock exchange where securities are listed and traded. Trading members put through the trades for buying and selling, either on their own behalf, or on behalf of customers. Clearing members receive funds and securities for completed transactions and settle the payment of money and delivery of securities. Bankers to an issue are selected bankers who are appointed during a new issue of securities, to collect application forms and money from investors who are interested in buying the securities being offered. They report the collections to the lead managers, send the applications and investor details to the registrars and transfer the funds mobilised to the bank accounts of the issuer. Registrars & Share Transfer Agents maintain the record of investors for the issuer. Every time the owner of a security sells it to another, the records maintained by the issuer needs to incorporate this change. Only then the benefits such as dividends and interest will flow to the new owners. In the modern securities markets, the securities are held in a dematerialised form in the depository. The changes to beneficiary names are made automatically when a security is sold and delivered to the buyer. Investor records are maintained for legal purposes such as 3 Vide SEBI Circular: SEBI/HO/MIRSD/DoP/CIR/P/2018/117 dated August 3, 2018, all the registered Sub-Brokers need to migrate to act as an AP and/ or Trading Member (TM). The Sub-Brokers, who do not choose to migrate into AP and/or TM shall deemed to have surrendered their registration with SEBI as Sub-Broker, w.e.f. March 31, 2019. No fresh registration shall be granted to any person as Sub-Broker. 18 NISM-Series-XII: Securities Markets Foundation Certification Examination determining the first holder and the joint holders of the security, their address, bank account details and signatures, and any nominations they may have made about who should be receiving the benefits from a security after their death. 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. 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. Trustees are appointed when the beneficiaries may not be able to directly supervise if the money they have invested is being managed in their best interest. Mutual fund trustees are appointed to supervise the asset managers; debenture trustees are appointed to ensure that the lenders interests are protected. Credit rating agencies evaluate a debt security to provide a professional opinion about the ability of the issuer to meet the obligations for payment of interest and return of principal as indicated in the security. They use rating symbols to rank debt issues, which enable investors to assess the default risk in a security. 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 expectations and their ability to bear risk. They also create 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. The role and responsibilities of intermediaries are laid down in Securities and Exchange Board of India (Intermediaries) Regulations, 2008. In addition, specific guidelines have been prescribed for each intermediary. All intermediaries operating in the securities market are required to be registered with SEBI. Registration has to be renewed periodically; this ensures continuous monitoring of intermediaries’ net worth, facilities and operating history. In providing services to investors and issuers, intermediaries are required to follow a SEBI- mandated code of conduct. The key points of this code are protection of investor interests, 19 NISM-Series-XII: Securities Markets Foundation Certification Examination providing fair, professional and skilled services, avoiding collusion with other intermediaries to the detriment of investors, providing adequate and timely information to clients, and maintaining appropriate financial and physical infrastructure to ensure sound service. 1.2.4 Regulators of Securities Markets The responsibility for regulating the securities market is shared by the Securities and Exchange Board of India (SEBI), the Reserve Bank of India (RBI), the Department of Economic Affairs (DEA) of the Ministry of Finance and Ministry of Corporate Affairs (MCA). 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. SEBI functions under the Ministry of Finance. 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. Some of the functions of SEBI have been explained in detail:  SEBI has been assigned the powers of recognising and regulating the functions of stock exchanges. The Securities Contracts Regulation Act, 1956 is administered by SEBI. This Act provides for the direct and indirect control of virtually all aspects of securities trading and the running of stock exchanges. The requirements for granting recognition to a stock exchange include representation of the Central Government on each of the stock exchange by such number of persons not exceeding three as the Central Government may nominate on this behalf. Stock exchanges have to furnish periodic reports to the regulator and submit bye-laws for SEBI’s approval. Stock exchanges are required to send daily monitoring reports.  SEBI has codified and notified regulations that cover all activities and intermediaries in the securities markets.  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 and Disclosures Requirements) Regulation, 2018. The SEBI (ICDR) Regulation lays down general conditions for capital market issuances like public and rights issuances, Institutional Placement Programme (IPP), Qualified Institutions Placement (QIP) etc; eligibility requirements; general obligations of the issuer and intermediaries in public and rights issuances; regulations governing preferential issues, qualified institutional placements and bonus issues by listed companies; Issue of Indian Depository Receipts (IDRs). SEBI (ICDR) also has detailed requirements pertaining to disclosures and process requirements for capital market transactions by listed and unlisted companies which are in the process of listing. The listing agreement that companies enter into with the stock exchange has clauses 20 NISM-Series-XII: Securities Markets Foundation Certification Examination for continuous and timely flow of relevant information to the investors, corporate governance and investor protection.  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 set up surveillance mechanisms internally as well as prescribed certain surveillance standards at stock exchanges, to monitor the activities of stock exchanges, brokers, depository, R&T agents, custodians and clearing agents and identify unfair trade practices.  SEBI has the powers to call for information, summon persons for interrogation, examine witnesses and conduct search and seizure. 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, or trading by persons connected with a company having material information that is not publicly available. SEBI regulations require companies to have 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 transaction(s) as void. The Reserve Bank of India (RBI) The Reserve Bank of India regulates the money market segment. 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. Ministry of Corporate Affairs (MCA) The Ministry of Corporate Affairs regulates the functioning of the corporate sector. The Companies Act is the primary regulation which defines the setting up of companies, their 21 NISM-Series-XII: Securities Markets Foundation Certification Examination functioning and audit and control. The issuance of securities by companies is also subject to provisions of the Companies Act. Ministry of Finance (MoF) 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. 1.3. Role of Securities Markets as Allocator of Capital Securities markets enable efficient allocation of financial capital. Well developed securities markets are usually associated with strong economic growth. The important links between market segments and their role as allocator of capital are as follows: Orderly channel for transfer of funds The primary markets channelize savings from millions of investors to borrowers in an organised and regulated manner. The system allows borrowers to raise capital at an efficient price, and investors to minimize the risk of being defrauded. It is an orderly platform for transfer of capital to earn a return. Generate productive investments Through securities investment, individual savings of many households can be mobilised into generating productive capacity for the country. This facilitates long-term growth, income and employment. For e.g. consider the setting up of a large steel plant that is expected to generate jobs and growth for many years. An individual or a single household would not be able to set up the plant, but a company that issues securities to raise funds from many investors would be able to do so. By investing in the plant, investors would benefit from the growth and revenue created by it. Liquidity Secondary markets provide liquidity to securities, by allowing them to be sold and converted to cash. The ability to buy and sell securities is a big advantage because not only does it permit investors to invest and disinvest as necessary, but also allows them to profit from price movements. For e.g. suppose an investor has purchased 100 shares of XYZ Ltd. at Rs.25 per share. After one year the price of the share is quoting at Rs.45 in the market. The investor can opt to sell his shares and earn Rs.20 per share, or a total of Rs.2000 from the sale. 22 NISM-Series-XII: Securities Markets Foundation Certification Examination Information signaling through prices Information about the issuer of the security or its assets is reflected quickly in secondary market prices. This is particularly useful for small investors who tend to have limited access to company or industry information. For example, a poor monsoon has a negative impact on agricultural inputs such as fertilizers and seeds, so prices of securities issued by fertilizer manufacturing companies may go down if rains are expected to be inadequate. The declining prices signal that sales and profits of the issuing company are likely to decline. 23 NISM-Series-XII: Securities Markets Foundation Certification Examination Summary  Securities are financial instruments issued by companies, financial institutions or the government to raise funds.  Securities can be broadly classified into equity and debt. The terms of issue, rights of investors, risk and return for these two classes of securities varies widely.  The market in which securities are issued, purchased by investors, and subsequently transferred among investors is called the securities market. The two main market segments are the primary market and the 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.  The main function of the securities markets is to enable flow of capital from households to business in a regulated institutionalised framework.  Investors and issuers are the building blocks of securities markets.  Investors are those who purchase securities in order to convert their savings into financial assets that earn a return.  Investors can be retail investors or 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, and usually incur lower investment costs.  Investors are chiefly concerned about investment safety and adequate returns.  A sound regulatory system is necessary to handle investor grievances and protect against market malpractices.  Issuers are organizations that raise money by issuing 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.  Intermediaries are agents responsible for coordinating between investors and borrowers and organizing the transfer of funds between them.  The following entities are considered to be intermediaries: stock brokers, authorized persons, share transfer agents, bankers to an issue, registrars of an issue, trustees of trust deeds, merchant bankers, underwriters, portfolio managers, credit rating agencies, 24 NISM-Series-XII: Securities Markets Foundation Certification Examination investment advisers, depository participants, custodians of securities, clearing member of a clearing corporation or house, asset management company, trading members of the derivative segment.  The Securities and Exchange Board of India (SEBI), a statutory body appointed by an Act of the Parliament, is the chief regulator of securities markets in India. 25 NISM-Series-XII: Securities Markets Foundation Certification Examination Sample Questions 1. A mutual fund that collects money from investors and invests in the market is an example of a/an _________. a. Issuer b. Intermediary c. Regulator d. Institutional Investor 2. The group of market participants that collectively facilitate interaction between investors and issuers is known as _______. a. Regulators b. Custodians c. Bankers d. Intermediaries 3. The financial results of a company show that it has suffered losses due to declining market share. The price of its equity share drops in the market. This is an example of the role of the market as: _________. a. Provider of liquidity b. Orderly channel for transfer of funds from investors to issuers c. Generator of productive investments d. Information Signalling through prices 4. The securities that are already issued are available for subsequent purchases and sales at: ________. a. Office of the registrar and transfer agent b. Follow on public offer of the issuer c. Stock exchanges where they are listed d. Depositories where they are held 26 NISM-Series-XII: Securities Markets Foundation Certification Examination This page has been intentionally left blank 27 NISM-Series-XII: Securities Markets Foundation Certification Examination CHAPTER 2: SECURITIES: TYPES, FEATURES AND CONCEPTS LEARNING OBJECTIVES: After studying this chapter, you should know about:  Different types of equity and debt securities and its features  Difference between equity and debt financing  Equity Investing: meaning, equity analysis and valuation; risk and return  Debt Investing: meaning, instruments, terminology and risk and return  Hybrid Instruments 2.1. Equity and Debt Securities Securities markets enable investors to deploy their surplus funds in investment instruments that are pre-defined for their features, are issued under regulatory supervision, and in most cases are liquid in the secondary markets. There are two broad types of securities that are issued by seekers of capital from investors:  Equity  Debt When a business needs capital to fund its operations and expansion, it makes a choice between these two types of securities. Equity capital is available for the company to use as long as it is needed; debt capital will have to be returned after the specified time. Equity investors do not enjoy any fixed return or return of principal invested; debt investors earn a fixed rate of interest and return of principal at maturity. Equity investors are owners of the business; debt investors are lenders to the business. Equity investors participate in the management of the business; debt investors do not. Due to these fundamental differences in equity and debt securities, they are seen as two distinct asset classes from which investors make a choice. Equity represents a risky, long-term, growth oriented investment that can show a high volatility in performance, depending on how the underlying business is performing. There is no assurance of return to the equity investor, since the value of the investment is bound to fluctuate. Debt represents a relatively lower risk, steady, short-term, income-oriented investment. It generates a steady rate of return, provided the business remains profitable and does not default on its payments. Since all residual benefits 28 NISM-Series-XII: Securities Markets Foundation Certification Examination of deploying capital in a profitable business go to the equity investor, the return to equity investor is likely to be higher than that of the debt investor. For example, if a business borrows funds at 12% and is able to earn a return of 14% on the assets created by such borrowing, the debt investor receives only 12% as promised. But the excess 2% earned by the assets, benefits the equity investor. The downside also hurts the equity investor, who may not earn anything if the return is lower than the borrowing cost and if the business is failing. Choosing between equity and debt is a trade-off. Investors desiring lower risk, and willing to accept a lower stable return choose debt; if they seek a higher return, they may not be able to earn it without taking on the additional risk of the equity investment. Most investors tend to allocate their capital between these two choices, depending on their expected return, their investing time period, their risk appetite and their needs. This process of distributing their investible surplus between equity and debt is called asset allocation. 2.2. Features of Equity Capital Nature Equity capital refers to the capital provided by owners of the business, who are willing to take the risk that the business may take time to generate profits. They also accept that these profits may not be fixed or remain unchanged over time. Denomination Equity capital is denominated in equity shares, with a face value. Face value in India is typically Re. 1, Rs. 2, Rs. 5 or Rs. 10 per share. Investors buy equity shares (also called stocks) issued by the company to become shareholders that jointly own the company. This is also why companies that are funded by equity are known as “joint stock companies.” Inside and Outside Shareholders Equity capital can be provided by two types of shareholders. The first are the inside- shareholders or promoters who start the company with their funds and entrepreneurial skills. Large institutional investors such as venture capitalists may subscribe to equity in early stages and become inside investors. The second set of owners are outside-shareholders, or members of the public, who invest in the company’s equity shares at a later stage in order to fund its subsequent expansions and operations. 29 NISM-Series-XII: Securities Markets Foundation Certification Examination Part Ownership If a company issues 10,000 equity shares of face value Rs. 10 each, then its equity capital is worth Rs. 100,000 (10,000 multiplied by 10). If the face value of the same equity share was Rs. 2, then the company’s equity capital would be worth Rs. 20,000 (10,000 multiplied by 2). An equity share grants ownership of the company to the shareholders in proportion to the extent of their holding. This proportionate share is also called a stake. For example, if promoters own 5100 of the 10000 shares issued by a company, they are said to have a 51% stake, or a majority stake. Some companies offer employee stock option programs (ESOPs) that enable employees to own a small stake in the share capital of the company, as an incentive to participate in making the business successful. Variable return and residual claim Equity capital is raised for perpetuity and not returned during the life of the business. Equity investors are paid a periodic dividend, which is not pre-determined. The rate of dividend depends on the profitability of the business and the availability of surplus for paying dividends after meeting all costs, including interest on borrowings and tax. Shareholders are ranked last both for profit sharing as well as for claiming a share of the company’s assets (residual claim). If a business were to fail, the proceeds from liquidation of assets are first paid to other claimants such as government, lenders and employees, and any residual amount, if at all, is paid to equity shareholders, after paying out preference shareholders, if any. Net Worth Companies are not obliged to payout dividends every year, nor are dividen d rates fixed or pre-determined. If companies are growing rapidly and have large investment needs, they may choose to forego dividend and instead retain their profits within the company. The share of profits that is not distributed to shareholders is known as retained profits. Retained profits become part of the company’s reserve funds. Reserves also belong to the shareholders, though it remains with the company until it is distributed as dividend. Reserves represent retained profits that have not been distributed to the rightful owners of the same, namely the equity investors. They enhance the net worth of a company and the value of the equity shares. Equity capital is also called risk capital because these investors are willing to take the risk that the business may succeed or fail, without expecting a fixed rate of regular return. They invest with the view to participate in the success of the business resulting in a higher value for the equity shares that they hold. 30 NISM-Series-XII: Securities Markets Foundation Certification Examination Management and Control Promoters of a business are the initial shareholders of a company. They may directly control the management of the company. As the company expands and seeks capital from the public, ownership and management get separated. It is not feasible for thousands of shareholders holding a small proportion of capital each, to be involved in managing the company. Large publicly held companies are managed by their board of directors and the management teams report to the board. Large shareholders with a significant shareholding may be represented in the board. Publicly held companies also have professional independent directors who represent the interest of common small shareholders. All shareholders however get voting rights. Each share has a vote, and several important decisions require shareholder approval expressed through their vote in a general meeting or through a postal ballot. 2.3. Features of Debt Capital Debt capital refers to the capital provided by the lenders who are keen to be compensated regularly in the form of a pre-specified fixed rate of interest. They also expect the money they have lent to be returned to them after an agreed period of time. Instrument types Debt capital may be raised by issuing various types of debt instruments such as debentures, bonds, commercial papers, certificates of deposit or pass-through certificates. Each of these instruments is defined for its tenor (the time period to maturity) and the rate of interest it would pay. As a practice, the rate of interest on debt instruments is represented as percent per annum on the face value of a debt security. Floating rate of interest Some debt instruments may pay a floating rate of interest. This means, the amount of periodic interest payment will vary, depending on the level of a pre-decided interest rate benchmark. The benchmark is usually a market interest rate such as the MIBOR (Mumbai Interbank Offer Rate). The lender and borrower agree to refer to the benchmark at a specific reset frequency, say once in six months, and set the rate until the next reset date, based on the level of the benchmark. Credit rating Lenders may not have access to complete information about how a business is performing, since they are outsiders to the company. The company appoints a credit rating agency to evaluate its ability to service a debt security being offered, for its ability to meet interest and principal repayment obligations. The rating agency assigns a credit rating for the debt 31 NISM-Series-XII: Securities Markets Foundation Certification Examination instrument, indicating the ability to service debt. This rating is used in the borrowing program to assure lenders that an external professional evaluation has been completed. Priority Interest to lenders is paid before taxes and before any distribution to equity investors. Interest payment is an obligation, which if not met will be seen as a default. A default in payment of interest and/or principal will hurt the credit rating of the borrower and make it tough for them to raise further capital. If there is a failure of the business, lenders will receive their settlement before other stakeholders such as employees and equity investors. Security Lenders to a business do not participate in the management of the company, nor do they get directly involved with the decisions of the company. They however like to protect their rights to receive a regular interest and timely return of the principal amount. For this the lenders may ask for security before lending. Several borrowings are secured by a mortgage on the assets of the business. These are called secured borrowings, where the lenders can press for sale of the asset to recover their dues, if the business is unable to pay them. Control Though lenders do not directly control the management of a company, they may place certain restrictions on the Board of the Company, with respect to the decisions that may harm their interests as lenders. They may prevent a company from unrelated diversification or expansion; they may require restrictions on further borrowings; they may prevent a second-charge on assets; or they may ask the owners to bring more equity capital as a cushion against losses. Conversion Lenders may seek a conversion of their debt into equity. This can be done either through the issue of convertible debentures by means of which the outstanding debt will be converted into equity at a specific date, price and time. It should be noted that interest payments are made to the lenders till the date of conversion, after which the holdings are treated as equity shares with all rights associated with them, and there are no more rights as lenders. 2.4. Choice between Equity and Debt Financing The implications of raising equity or debt capital are evaluated by a business before the decision is made. The following are the key factors to consider: a. Ability to pay periodic interest: If a business generates stable profit, such that it is able to pay interest on a regular basis then in such cases, the businesses can consider raising debt capital. Banks fund most of 32 NISM-Series-XII: Securities Markets Foundation Certification Examination their loans with deposits, which are borrowed funds. Depositors are willing to lend to the bank based on its ability to grow a steady loan book that earns higher interest than deposit rates. Business that does not generate steady and regular profits may choose equity over debt capital. b. Willingness to dilute ownership in the company: Equity capital represents ownership and confers voting rights to holders. Raising fresh equity capital reduces the proportion of the business holding and therefore the profits that accrue to the existing equity holders. If existing equity holders do not want a reduced stake in the business then they may consider raising debt capital to equity capital. c. Ability to give collateral as security: Lenders or debt financers prefer secured borrowings and the ability to access the assets of the business in case of its failure. If a business is services-based and not asset-based then it may not have adequate assets to offer as collateral to borrow debt capital. In such cases, equity financing is preferred to debt financing. d. Time period for which capital is required: If capital is required to tide over short-term capital requirements, a firm may choose debt capital for such needs. It is common for businesses to borrow from banks or issue debt instruments to fund working capital. If there is a long-term need and if debt investors are unwilling to take the risk, a firm issues equity capital. 2.5. Investing in Equity 2.5.1 Price and Value The price of the equity share in the secondary markets, where it is listed and traded, primarily reflects the prospects of the business. Many people engage in active day trading in stocks, purely led by the price movements. What differentiates equity investing from gambling is the fact that stock prices are anchored in their intrinsic value and it may not be possible for prices to mindlessly deviate from fair value for long periods of time. In finance terminology, the intrinsic value of an equity share is the discounted value of its future benefits to the investor. Investing in equity is about estimating this intrinsic value, and paying a price to earn the future value. The intrinsic value of an equity share is the estimate of the future earnings that it is expected to generate for the owner of the share. In equity investing therefore, there are two distinct notions of value and price. Intrinsic value is the estimated value per equity share, based on the future earning potentials of a company. 33 NISM-Series-XII: Securities Markets Foundation Certification Examination Market price is the price at which the share trades in the stock market, taking into account several factors including various estimates of intrinsic value. This value may be equal to, less than or more than the market price at any point in time. Equity markets help in gathering intrinsic value estimates of all the investors about a company to arrive at an equilibrium market price. The market price reflects all the information related to the company. In this price discovery process, estimates of value are tested, rewarded and penalized by the market forces of demand and supply. Equity is priced in the market with episodes of inefficiency. Equity prices reflect underlying information through a chaotic process. As a result equity markets are not perfectly efficient, so prices may not always reflect the underlying intrinsic value of the share. If the intrinsic value is perceived to be more than market value, the scrip is said to be undervalued. If intrinsic value is perceived to be less than market value, the scrip is said to be overvalued. The goal of investment strategies is to buy undervalued shares, and sell overvalued ones. But it remains tough to make these evaluations correctly and consistently, as what is being priced is the unknown future of the company. Equity investing requires identifying and exploiting inefficiencies and is not amenable to mathematical formulation. 2.5.2 Equity Investing Process Investing in equity involves the following: a. Security selection Several businesses compete for investor attention. They either issue equity shares in the primary markets, or are available for buying at the secondary markets. Selecting the right stock to invest in, requires understanding the business, its future prospects, its profit forecasts, expansion plans and several factors that impact the future value of the stock. b. Market timing All equity shares may not be attractive at all times. Investing in equity requires periodic reviewing for selling the low-return stocks and buying shares with potential higher returns. All firms undergo economic cycles (based on the macroeconomic environment) that impact their profits. For example, in a slowing economy, steel and construction sectors may relatively slow down more than businesses which are into FMCG products. Items of regular consumption may be bought even if the economy is slowing down, while consumption of non-regular items may be reduced. Businesses also have multiple growth phases, in which their earnings and revenues may grow at different rates. An early stage business may enjoy a high growth in revenue and 34 NISM-Series-XII: Securities Markets Foundation Certification Examination profits, from its innovative and near monopoly position. As it grows, it may attract competition; give up some of the early advantages, and settle down to a long term stable, but lower rate of growth. c. Sector and segment weighting The choice of which group of shares to invest in, i.e. large or small, new or established, growth-oriented or dividend-paying stocks, determines how the equity portfolio may perform in terms of risk and return. Combining various segments of the equity market into a portfolio requires careful consideration of how these components come together in terms of risk and return. Equity Research Equity research is a specialized pursuit that requires skills in financial analysis and valuation. Investors use equity research reports to select stocks to invest in. There are two types of equity research. Buy-side research is done by institutional investors, who manage portfolios with the objective of generating active returns that are higher than benchmarks. Buy side research analysts tend to be generalists than specialists, covering more sectors and stocks. They focus on questioning the model and business case to understand downside risks and work closely with sell-side analysts Sell side research is done by broking houses, who engage specialists to track sectors and stocks. Analysts create earning models for companies and sectors and track them to generate sector and stock reports and dynamically update them. They also interact with management, peers, suppliers and customers of businesses. They may arrange analyst and management meetings for buy-side clients and create special event-based reports and analysis. 2.6. Equity Analysis and Valuation There are two parts to evaluating a stock for investment:  Equity analysis to establish the fundamental reasons for investing in a particular stock.  Equity valuation and assessment of market price, to determine whether to buy or sell a stock at a given price. There are two approaches to such evaluation: a. Fundamental analysis is a study of the financial statements and information pertaining to a stock, to estimate the future potential. Fundamentals of a stock refer to the information that is relevant to estimate the earning potential and therefore the intrinsic value. 35 NISM-Series-XII: Securities Markets Foundation Certification Examination b. Technical analysis involves studying the price and volume patterns to understand how buyers and sellers are acting on existing price information. Technical analysis integrates the historical price and volume data of traded stocks into price charts, points of support and resistance and price trends. Technical indicators are constructed with price data and used to judge the buying and selling interest in the markets. Technical analysis views price as an aggregate indicator of all information about a stock. Equity analysis requires an understanding of the fundamental factors that affect the earnings of the company such as current trends and future potential trends in business, financial analysis, industry features, and estimation of the company’s revenue, costs and earnings and comparison with other companies in the same peer group. Financial analysis is done using the published financial statements. Ratio analysis, cash flow analysis, profitability and revenue estimates are all done for a company, using its historical data and estimates and forecasts for the future. Comparisons within the same industry, analysis of industry and management factors and analysis of the macro-economic framework are done, to sharpen the outputs of financial analysis. Equity analysis involves studying a range of variables, factors and numbers and their implications for the future potential of a stock. The economy-industry-company (EIC) framework is a simple description of the process of analysis. It is done in two principal ways:  Top down approach begins at macro factors and identifies sectors and stocks based on the identification of macro trends.  Bottom up approach begins at stock selection based on the business potential and its ratification by examining industry and macro indicators. Information for equity analysis is gathered from the following sources:  Audited financial statements  Analyst meetings, plant visits and interactions with the management  Industry reports, analytics and representations  Government and regulatory publications Valuation of equity shares involves using extensive information that enables estimating future cash flows, modeling these variables into a logical valuation framework, and understanding the sources of risk to the estimates of valuation. There are several sophisticated models for equity valuation, many of them are commercially available, easing the complex mathematical calculations involved. There are two broad approaches to valuation: 36 NISM-Series-XII: Securities Markets Foundation Certification Examination  Discounted cash flow models  Relative valuation models Discounted cash flow models are theoretical constructs that are based on the understanding that value can be estimated by looking into information about the business itself, its earnings, growth and dividends. Relative valuation models try and find the pricing of something similar to the asset being valued. Using the peer group averages, sector averages of and other such commonalities that enable one to compare an equity with another, or a group, relative valuation models make an assessment of fair value of an equity share. Relative valuation models help in identifying both undervalued and overvalued stocks since it include market variables, more importantly the price of a stock. The relative valuation model is easier to understand and tweak. At the same time, this is also a limitation as they may include valuation errors that may be included in market prices. While the use of relative valuation model is widespread, some of the assumptions regarding comparable stocks, peer groups or averages may be generalized and prone to error. Discounted cash flow (DCF) models are rigorous models requiring clearly specified assumptions and a focus on the core factors that drive the valuation of a stock. One set of assumption is about the cash flow estimates; the others are about the discounting rate, the proxy for risk. There can be differences in DCF valuation estimates depending on the above two factors, which tend to vary quite significantly across analysts who value stocks. 2.7. Commonly Used Terms in Equity Investing 2.7.1 Price Earning Multiple The price-earnings ratio or the PE multiple is a valuation measure that indicates how much the market values per rupee of earning of a company. It is computed as: Market price per share divided by Earnings per share Earnings per share (EPS) are the profit after taxes divided by the number of shares outstanding. It indicates the amount of profit that company has earned, for every share it has issued. PE is represented as a multiple. When one refers to a stock trading at 12x, it means the stock is trading at twelve times its earnings. If it is expected that earnings of a firm will grow then the market will be willing to pay a higher multiple per rupee of current earnings. The focus is therefore on ‘prospective’ PE or how much the current price is discounting the future earnings. 37 NISM-Series-XII: Securities Markets Foundation Certification Examination If the growth in EPS is likely to be high, and therefore the current high PE based on historical numbers may not be the right one to look at. It is common to look at the PE multiple of the index to gauge if the market is overvalued or undervalued. The PE multiple moves high when prices run ahead of the earnings numbers and the market is willing to pay more and more per rupee of earnings. Many would consider a market PE of 22x or above as an overvalued zone. When markets correct and uncertainty about future earnings increases, the PE multiple also drops. A PE of 12x or lower is considered an undervalued zone. Analysts also compare the PE of one company with another, to check the relative value. The PE multiple at which a stable, large and well known company would trade in the market, is likely to be higher than the PE multiple the market is willing to pay for another smaller, less known, and risky company in the same sector. 2.7.2 Price to Book Value (PBV) The PBV ratio compares the market price of the stock with its book value. It is computed as: Market price per share divided by the Book Value per share The book value is the accounting value per share, in the books of the company. It represents the net worth (capital plus reserves) per share. An important limitation of this number is that most assets on the books of the company are shown at cost less depreciation, and are not inflation adjusted. Therefore, the realizable value of the assets is not reflected in the book value. Since the book value considers the net worth of a company, it is an important number in fundamental analysis. If the market price of the stock were lower than the book value and the PBV is less than one, the stock may be undervalued. In a bullish market when prices move up rapidly, the PBV would move up, indicating rich valuation in the market. 2.7.3 Dividend Yield Dividend is declared as a percentage of the face value of the shares. A 40 percent dividend declared by a company will translate into a dividend of Rs. 4 per share with a face value of Rs. 10 (i.e. 10*40% =4). If the share was trading in the stock market for a price of Rs. 200 per share, this means a dividend yield of 2 percent (i.e. 4/200*100 = 2%). The dividend declared by a company is a percentage of the face value of its shares. When the dividend received by an investor is compared to the market price of the share, it is called the dividend yield of the share. It is computed as: Dividend per share divided by Market price per share 38 NISM-Series-XII: Securities Markets Foundation Certification Examination The dividend yield of a share is inversely related to its share price. If the price of equity shares moves up, the dividend yield comes down, and vice versa. Some companies have a history of growing and consistent dividends. They are sought by investors who seek a regular income. Public sector units, especially PSU banks, in India tend to have a higher dividend yield. Dividend yields are also used as broad indicators of the market cycles. A bull market will be marked by falling dividend yields, as prices move up. A bear market will have a relatively higher and increasing dividend yields as prices tend to fall. 2.8. Risk and Return from Investing in Equity Investing in equity shares of a company means investing in the future earning capability of a business. The returns to an equity investor are in two forms: a) dividend that may be periodically paid out and b) increase in the value of the investment in the secondary market. The returns to an equity investor depend on the future residual cash flows of the company, or the profits remaining after every other claim has been paid. A company may use such surplus to pay dividends, or may deploy them in the growth of the business by acquiring more assets and expanding its scale. This means, an investor buys equity shares with an eye on the future benefits in terms of dividends and appreciation in value. The return to an investor depends on the price he pays to participate in these benefits, and the accruing future benefits as expected. The risk to an equity investor is that the future benefits are not assured or guaranteed, but have to be estimated based on dynamic changes in the business environment and profitability of the business. Equity returns are essentially volatile and price movements of equity shares in the stock markets tend to be ‘noisy.’ This is because a large number of players simultaneously act on new information about stocks, and re-align their positions based on their expectations about the stock’s future performance. Since this process is dynamic and tries to incorporate all available information about a stock’s performance into the price, a stock with stable and consistent growth and profits appreciates in price; a stock whose performance is deteriorating, depreciates in price. Prices move up when buyers are willing to acquire a stock even at higher and higher prices; prices move down when sellers accept lower and lower prices for a stock. The stock prices thus mirror the performance of the stocks, and are a good barometer of how well a stock, a sector, or the economy as a whole is functioning. Stock markets are subject to bull and bear cycles. A bull market is when buyers are willing to pay higher and higher prices, as the overall optimism for better future performance of stocks is high. This happens when businesses are expanding, growing at an above average rate, face favourable and growing demand for their products and services, and are able to price them 39 NISM-Series-XII: Securities Markets Foundation Certification Examination profitably. The returns to equity investors go up as stock prices appreciate to reflect this optimism. But a bull market can overdo its exuberance. As buyers pay a higher and higher price for a stock, prices move beyond what can be justified by the underlying intrinsic value. Also businesses tend to overarch themselves, borrowing to fund expansion based on optimistic forecasts. Input costs for raw materials and labour and interest costs for capital increase as the bull market reaches its peak. Unrealistic expansion in prices tends to correct itself with a crash. The bull market paves way to a bear market when stock prices fall and correct themselves. A downturn in economic cycles can lead to stress for several businesses, when they face lower demand for their products and services, higher input and labour costs, lower ability to raise capital, and in many cases risks of survival. When the economic conditions change, several businesses that began profitably may come under stress and begin to fail. Bear markets in equity reflect this pessimism, stocks prices fall. Sellers quit in despair, accepting a lower price and a loss on their stocks. As prices may fall well below intrinsic values, buyers who find the valuation attractive will start coming into stocks that now are priced reasonably, or lower. Lower interest rates lead to investment, and slowly the bear cycle gives way to the next bull cycle. 2.9. Basic Features of a Debt Instrument Debt capital can be created by borrowing from banks and other institutions or by issuing debt securities. For example, if a company wishes to borrow Rs.100 crore, it has two options. If it takes a bank loan for the total amount, then the bank is the sole lender to the company. Alternately, it can access a larger pool of investors by breaking up the loan amount into smaller denominations. If it issues one crore debt securities, each with a face value of Rs.100, then an investor who brings in Rs.1000 would receive 10 securities. The lending exposure of each investor is limited to the extent of his investment. A debt security denotes a contract between the issuer (company) and the lender (investor) which allows the issuer to borrow a sum of money at pre-determined terms. These terms are referred to as the features of a debt security and include the principal, coupon and the maturity of the security:  Principal The principal is the amount borrowed by the issuer. The face value of the security is the amount of the principal that is due on each debt security. Each investor, therefore, is owed a portion of the principal represented by his investment. 40 NISM-Series-XII: Securities Markets Foundation Certification Examination  Coupon The coupon is the rate of interest paid by the borrower. The interest rate is usually specified as a percentage of face value, and depends on factors such as the risk of default of the issuer, the credit policy of the lender, debt maturity and market conditions. The periodicity of interest payment (quarterly, semi-annually, annually) is also agreed upon in the debt contract.  Maturity The maturity of a bond refers to the date on which the contract requires the borrower to repay the principal amount. Once the bond is redeemed or repaid, it is extinguished and ceases to exist. Examples of debt securities include debentures, bonds, commercial papers, treasury bills and certificates of deposits. In the Indian securities markets, a debt instrument denoting the borrowing of a government or public sector organization is called a bond and that of the private corporate sector is called debenture. Some have also argued that debentures are secured debt instruments, while bonds are unsecured. These differences have vanished over time. The terms, bonds and debentures are usually used interchangeably these days. All debt securities grant the investor the right to coupon payments and principal repayment as per the debt contract. Some debt securities, called secured debt, also give investors rights over the assets of the issuing company. If there is a default on interest or principal payments, those assets can be sold to repay the investors. Investors with unsecured debt do not enjoy this option. Some debt securities are listed on stock exchanges such as the National Stock Exchange or the Bombay Stock Exchange, so they can be traded in the secondary market. Unlisted securities have to be held until maturity. 2.10. Types and Structures of Debt Instruments The basic features of a debt security can be modified to meet the specific requirements of the issuer or lender. The simplest form of debt is known as a plain vanilla bond and requires interest to be paid at a fixed rate periodically, and principal to be returned when the bond matures. The bond is usually issued at its face value, say Rs. 100, and redeemed at par, the same Rs.100. The plain vanilla bond structure allows slight variations such as higher or lower than par redemption price; or varying the frequency of interest between monthly, quarterly and annual 41 NISM-Series-XII: Securities Markets Foundation Certification Examination payments. However, there are other ways in which bond structures can be altered so that they are no longer in the plain vanilla category. Varying Coupon Structures Zero Coupon Bond A zero coupon bond does not pay any coupons during the term of the bond. The bond is issued at a discount to the face value, and redeemed at face value. The effective interest earned is the difference between face value and the discounted issue price. A zero coupon bond with a long maturity is issued at a very big discount to the face value. Such bonds are also known as deep discount bonds. In some cases, the bond may be issued at face value, and redeemed at a premium. The effective interest earned by an investor is the difference between the redemption value and the face value. The defining characteristic is that there should be no intermediate coupon payments during the term of the bond. Example: Zero Coupon Bond In October 2018, ABC Communications Holdings Ltd. raised Rs. 4,280 crore through an issue of zero coupon bonds. The bonds were launched in two separate series of slightly differing maturities. Issuer: ABC Communications Holdings Ltd Security: Zero coupon bond, secured by receivables Issue Date: October 2018 Maturity Date: Series 1 in July 2021, Series 2 in December 2021. Maturity value: Rs.100 Issue price: Series 1- Rs. 85.80 Series 2- Rs. 82.55 Floating Rate Bond Floating rate bonds are instruments where the interest rate is not fixed, but re-set periodically with reference to a pre-decided benchmark rate. For instance, a company can issue a 5-year floating rate bond, with the rates being reset semi-annually at 50 basis points above the 1- year yield on central government securities. Every six months, the 1-year benchmark rate on 42 NISM-Series-XII: Securities Markets Foundation Certification Examination government securities is ascertained from the prevailing market prices. The coupon rate the company would pay for the next six months is calculated as this benchmark rate plus 50 basis points. Floating rate bonds are also known as variable rate bonds and adjustable rate bonds. These terms are generally used in the case of bonds whose coupon rates are reset at longer time intervals of a year and above. These bonds are common in the housing loan market. Other Variations in Coupon Structure Some of other structures are: (a) deferred interest bonds, where the borrower could defer the payment of coupons in the initial 1 to 3 year period; (b) Step-up bonds, where the coupon is stepped up periodically, so that the interest burden in the initial years is lower, and increases over time. Callable Bonds Callable bonds allow the issuer to redeem the bonds prior to their original maturity date. Such bonds have a call option in the bond contract, which lets the issuer alter the tenor of the security. For example, a 10-year bond may be issued with call options at the end of the 5 th year such as in the illustration below. Such options give issuers more flexibility in managing their debt capital. If interest rates decline, an issuer can redeem a callable bond and re-issue fresh bonds at a lower interest rate. The investor in a callable bond, however, loses the opportunity to stay invested in a high coupon bond, if the call option is exercised by the issuer. XYZ Bonds 2018 Series 3 Issuer XYZ Bank Credit Rating Care AAA

NISM-Series-XII Securities Markets Foundation Certification Examination PDF

Document Details

Tags

Related

Summary

Full Transcript

Upgrade to continue