Set C Summarized Notes PDF - Financial Markets
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Mansi Bhoir
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This document provides a summarized compilation of course notes on financial markets, compiled by Mansi Bhoir. It covers key sections, stakeholders, and the Indian Financial Market scenario, including money market instruments and the credit policy of the Reserve Bank of India. The summary is intended to aid in understanding the material and exam preparation.
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Preface This PDF has been created as a summarized compilation of all the chapters covered in the course. Over the course of two days, I worked diligently to condense and highlight the key concepts from the module. My aim was to capture the most essential information that would aid in understanding t...
Preface This PDF has been created as a summarized compilation of all the chapters covered in the course. Over the course of two days, I worked diligently to condense and highlight the key concepts from the module. My aim was to capture the most essential information that would aid in understanding the material and help with exam preparation. I found this summary to be very useful in my own preparation and it contributed significantly to my success in clearing the SPOM set. However, since I compiled this document in a short time frame, there is a slight chance that some concepts might be missing or not covered in as much depth as in the original study material. I recommend cross-referencing this summary with the official study material whenever needed to ensure you have a comprehensive understanding of the topics. I hope this document proves helpful to you as it did for me. Best of luck with your studies! - Mansi Bhoir 1 (Set C notes by Mansi) Chapter 1 Introduction Key Sections and Insights: 1. Introduction to Financial Markets: ○ Financial markets provide avenues for buying and selling financial assets like stocks, bonds, commodities, derivatives, and currencies. ○ Major types include stock, bond, commodity, currency, derivatives, and money markets. 2. Role in Economic Development: ○ Financial markets channel savings into productive investments. ○ They help in job creation, improving living standards, and increasing government revenue through taxes. 3. Functions of Financial Markets: ○ Facilitate savings allocation to productive use. ○ Enable price discovery of securities. ○ Provide liquidity to financial assets. ○ Lower transaction costs by disseminating information. 4. Stakeholders: ○ Primary stakeholders: Shareholders, lenders, companies, mutual funds. ○ Service providers: Brokers, underwriters, depositories, custodians. ○ Regulators: SEBI, RBI, IRDAI, PFRDA. ○ Administrators: AMFI, FEDAI, FIMMDA, AIBI. 5. Indian Financial Market Scenario: ○ Indian markets are developing and regulated by SEBI and RBI. ○ Components include money and capital markets, each with distinct instruments like treasury bills, bonds, equity, and commercial papers. 6. Global Context and Comparisons: ○ Indian markets are compared with global counterparts like SEC (USA) and international regulatory frameworks. 2 (Set C notes by Mansi) Detailed Summary of "Introduction to Financial Markets" 1. Introduction to Financial Markets Financial markets are platforms where financial instruments such as equity stocks, bonds, foreign exchange, commodities, derivatives, etc., are traded. They serve as a bridge between individuals or entities with surplus funds and those needing funds. 2. Major Types of Financial Markets Stock Market: Facilitates trading in company equity stocks. Returns are achieved through capital appreciation and dividends. The market reflects economic and corporate performance and is volatile. Bond Market: Provides long-term funding for government and corporate projects. Bonds involve repayment of principal with interest. Commodity Market: Trades natural resources like gold, oil, and agricultural products. Pricing is determined for future delivery. Currency Market: Used for foreign currency trading, aiding importers, exporters, and hedgers. Money Market: Focuses on short-term funding (less than a year) and liquidity management. Instruments include treasury bills and certificates of deposit. Derivatives Market: Deals in financial contracts (derivatives) based on underlying asset values. 3. Importance of Financial Markets Capital Access: Facilitates capital flow from surplus units to deficit units. Investment Opportunities: Provides fair and transparent investment options under regulatory oversight. Job Creation: Engages brokers, underwriters, and other financial professionals. Economic Growth: Channels savings into productive investments, driving demand, production, and government revenue. 4. Role of Financial Markets in Economic Development Channels savings into investments. Supports job creation and improves living standards. Enhances government revenues through tax collection. Promotes continuous investment and economic expansion. 3 (Set C notes by Mansi) 5. Functions of Financial Markets Efficient Allocation of Savings: Transforms savings into productive investments. Price Discovery: Determines the value of securities through trading. Liquidity: Ensures easy trading of financial assets. Transaction Cost Reduction: Disseminates information to reduce research costs. 6. Stakeholders in Financial Markets 1. Primary Stakeholders: ○ Shareholders: Company owners who trade shares in secondary markets. ○ Lenders: Entities issuing bonds for funds with repayment and interest. ○ Companies: Raise funds through equity or debt. ○ Mutual Funds: Pool investor money to invest in diversified portfolios. 2. Service Providers: ○ Merchant Bankers: Manage public issues and corporate advisory services. ○ Brokers: Facilitate buying and selling of stocks. ○ Underwriters: Guarantee the subscription of public issues. ○ Depositories: Maintain electronic records of securities. ○ Custodians: Safeguard securities and manage transactions. 3. Regulators: ○ SEBI: Governs securities markets and protects investors. ○ RBI: Regulates banking and monetary policies. ○ IRDAI: Oversees the insurance sector. ○ PFRDA: Regulates pension funds. 4. Administrative Authorities: ○ AMFI: Develops mutual funds industry standards. ○ FEDAI: Oversees forex business among banks. ○ FIMMDA: Focuses on bond, money, and derivatives markets. ○ AIBI: Monitors merchant banking activities. ASSOCIATION OF IBANKERS OF INDIA 7. The Indian Financial Market Scenario Regulation: Governed by SEBI and RBI with developing systems and enablers. Components: ○ Money Market Instruments: 4 (Set C notes by Mansi) Treasury Bills, Call Money, Certificates of Deposit, and Commercial Papers. ○ Capital Market: Divided into primary (direct fundraising) and secondary (trading existing securities) markets. 8. Indian Capital Market Equity Market: Measured by market capitalization-to-GDP ratio. The trend shows a rise in valuation, though earnings growth hasn’t kept pace. Historical Returns: Equity returns show volatility, with long-term holding periods yielding more consistent positive returns. 9. Bond Market Bonds are issued by governments and corporations for long-term funding. This provides diversification and steady returns to investors. Government securities dominate, followed by corporate bonds. 10. Contributions to the Economy Credit provision supports infrastructure projects and economic activity. Liquidity provision safeguards against cash needs. Risk management services mitigate financial and market risks. 11. Challenges and Opportunities Indian Markets: Developing but need improvements in transparency, efficiency, and international competitiveness. Global Comparisons: While regulators like SEBI and RBI are robust, global counterparts like the SEC (USA) offer stricter penalties and regulations. Conclusion The financial markets are integral to economic growth, resource mobilization, and wealth creation. They require robust regulatory frameworks, efficient operations, and active participation from all stakeholders to thrive and support sustainable development. 5 (Set C notes by Mansi) The money market is a segment of the financial market that deals with short-term borrowing, lending, and trading of instruments with maturities of one year or less. Below are the components of the money market 1. Treasury Bills (T-Bills) Definition: Short-term debt instruments issued by the Central Government. Maturities: Available in 91-day, 182-day, and 364-day variants. Purpose: Used to meet short-term funding needs of the government. Characteristics: Issued at a discount and redeemed at par value. 2. Cash Management Bills (CMBs) Definition: Short-term instruments issued by the Government of India for addressing temporary cash flow mismatches. Maturities: Less than 91 days. Features: Issued at a discount to face value and function like Treasury Bills. 3. Call Money, Notice Money, and Term Money Call Money: Overnight borrowing and lending among banks and primary dealers for one day. Notice Money: Borrowing and lending for a period of 2 to 14 days. Term Money: Tenure exceeding 14 days. Purpose: Helps maintain liquidity and meet short-term funding needs of banks. 4. Certificates of Deposit (CDs) Definition: Short-term instruments issued by banks to raise funds. Maturities: Typically issued for 3 months, 6 months, or 1 year. Features: Issued at a discount to face value; saves operational costs by raising funds in bulk. 5. Commercial Papers (CPs) 6 (Set C notes by Mansi) Definition: Unsecured short-term instruments issued by corporations (mainly Non-Banking Financial Companies (NBFCs), primary dealers, and financial institutions). Maturities: Usually up to one year. Features: Issued at a discount and offer higher risk and yield compared to T-Bills. 6. Repurchase Agreements (Repos) Definition: Short-term loans involving the sale and repurchase of the same security. Types: ○ Repo: From the seller's perspective (borrowing). ○ Reverse Repo: From the buyer's perspective (lending). Features: Conducted only with approved securities like government bonds and Treasury Bills. 7 (Set C notes by Mansi) Chapter 2 1. Credit Policy of the Reserve Bank of India (RBI) The credit policy is a plan executed by the RBI to regulate money supply and credit in the economy, ensuring stability and supporting growth. Meaning: It aims to control the demand and supply of money and credit through instruments like interest rates and liquidity measures. Objectives: ○ Price Stability: Maintains inflation at desired levels by adjusting interest rates. ○ Economic Growth: Ensures adequate liquidity to support economic expansion. ○ Exchange Rate Stability: Prevents excessive fluctuations in currency exchange rates. ○ Balance of Payments Equilibrium: Ensures foreign currency demand matches supply. ○ Adequate Credit Flow: Channels funds to productive sectors, boosting employment and living standards. ○ Moderate Interest Rates: Encourages investment by balancing inflation control with economic growth. Analytics: Credit policy influences the economy through: ○ Interest Rate Channel: Impacts borrowing costs and investment. ○ Exchange Rate Channel: Affects imports, exports, and foreign exchange rates. ○ Quantum Channel: Regulates money supply and credit. ○ Asset Price Channel: Influences asset prices and economic output. Instruments: ○ Cash Reserve Ratio (CRR): Portion of deposits banks must keep with the RBI. 4.5% ○ Statutory Liquidity Ratio (SLR): Funds banks must maintain as liquid assets. 18% ○ Liquidity Adjustment Facility (LAF): Allows borrowing through Repo 6.5% and Reverse Repo agreements 3.35%. ○ Marginal Standing Facility (MSF): Emergency borrowing mechanism for banks. ○ Open Market Operations (OMO): RBI buys/sells government securities to control liquidity. ○ Market Stabilization Scheme (MSS): Absorbs excess liquidity through government-issued securities. Govt. of india borrowed from rbi and issues Tbills. 2. Federal Reserve Policy (Fed Policy) The Federal Reserve (Fed) is the central bank of the United States, managing monetary policy to maintain economic stability. 8 (Set C notes by Mansi) Functions: ○ Promotes maximum employment and stable prices. ○ Monitors and minimizes systemic risks. ○ Ensures the safety and efficiency of payment systems. ○ Protects consumers and supports community development. Policy Tools: ○ Open Market Operations (OMO): Buying/selling securities to manage liquidity. ○ Discount Rate: Interest rate charged to banks for borrowing from the Fed. ○ Reserve Requirements: Mandatory reserves banks must hold against deposits. ○ Interest on Reserve Balances: Fed pays interest on required and excess reserves. ○ Overnight Reverse Repurchase Agreement (RRP): Fed sells securities with a buyback agreement. ○ Term Deposit Facility: Temporarily removes excess reserves from the banking system. Impact on Global Markets: ○ Changes in the Fed Funds Rate influence global capital flows, borrowing costs, and investments. ○ Higher Fed rates often lead to foreign investor pullouts from emerging markets like India. Quantitative Easing (QE): Govt. pumping money ○ Central banks purchase securities to lower interest rates, increase money supply, and encourage lending during crises. ○ Potential downsides include inflation, asset bubbles, and income inequality. 3. Cost Inflation Index (CII) The Cost Inflation Index (CII) is used to account for inflation when calculating long-term capital gains for tax purposes. Purpose: Adjusts the purchase price of assets for inflation, reducing taxable gains. Formula: Indexed Cost of Acquisition=CII for Sale YearCII for Purchase Year×Purchase Price\text{Indexed Cost of Acquisition} = \frac{\text{CII for Sale Year}}{\text{CII for Purchase Year}} \times \text{Purchase Price} CII = CII during sale of asset x Cost of asset CII during purchase Example: A house bought for ₹25,00,000 in 2005 (CII: 406) and sold for ₹70,00,000 in 2015 (CII: 1081) would have an indexed acquisition cost of ₹66,50,000. This reduces the taxable gain significantly. 9 (Set C notes by Mansi) 4. Consumer Price Index (CPI) The Consumer Price Index (CPI) measures changes in retail prices of goods and services consumed by households. Purpose: Tracks inflation's impact on purchasing power and guides monetary policy. Features: ○ Based on a fixed basket of goods and services. ○ Includes categories like food, housing, education, and medical care. Issues: ○ CPI doesn’t fully reflect household inflation perceptions. ○ Fixed costs like food and housing dominate the index but aren’t directly affected by rate changes. ○ Price increases are perceived faster than reductions. 5. Wholesale Price Index (WPI) The Wholesale Price Index (WPI) tracks price changes for bulk transactions at the early stages of trading. Features: ○ Covers commodities under Primary Articles, Fuel and Power, and Manufactured Products. ○ Excludes services and focuses on wholesale prices. Uses: ○ Estimates inflation at wholesale levels. ○ Acts as a deflator in GDP calculations. ○ Guides government interventions for essential commodities. Difference from CPI: ○ WPI reflects wholesale-level price changes, while CPI tracks retail-level changes. ○ CPI includes services; WPI does not. 10 (Set C notes by Mansi) Chapter 3: Capital Market – Primary 1. Basics of Capital Markets Definition: A segment of the financial market where long-term debt and equity instruments are traded. Purpose: ○ Mobilize savings for investments. ○ Provide a platform for governments, banks, and corporations to raise long-term funds. ○ Act as a bridge between savers and investors. Importance: ○ Indicates the economic health of a country. ○ Encourages productive allocation of resources. ○ Offers liquidity and price discovery for securities. Regulation: Governed by SEBI to ensure transparency and protect investor interests. 2. Evolution of the Indian Capital Market 1. Before 1990s: ○ Dominated by development financial institutions like IDBI, IFCI, and ICICI. ○ Pricing of securities was controlled by the Controller of Capital Issues. ○ Limited stock exchanges, with Bombay Stock Exchange (BSE) being dominant. 2. After 1990s: ○ Major reforms introduced in 1991–1992. ○ Establishment of the National Stock Exchange (NSE) in 1992. Started functioning in 1994 ○ SEBI gained statutory powers in 1992. ○ Enhanced transparency, efficiency, and alignment with international standards. 3. Functions of the Capital Market Mobilizing resources for investments. Facilitating buying and selling of securities. Enabling efficient price discovery. Ensuring timely settlement of transactions. 4. Major Constituents of the Capital Market 11 (Set C notes by Mansi) Regulators: SEBI. Market Infrastructure: Stock exchanges, clearing corporations, and depositories. Participants: Stockbrokers, mutual funds, merchant bankers, credit rating agencies, foreign institutional investors, and more. 5. Segments of the Capital Market 1. Primary Market: ○ Deals with the issuance of new securities. ○ Includes Initial Public Offerings (IPOs) and Further Public Offerings (FPOs). ○ Facilitates fund-raising directly from investors. 2. Secondary Market: ○ Trades securities already issued in the primary market. ○ Provides liquidity and marketability to securities. 6. Capital Market Instruments 1. Shares: ○ Equity shares: Represent ownership in a company; provide voting rights and dividends. ○ Preference shares: Priority in dividends but limited or no voting rights. 2. Bonds/Debentures: ○ Long-term debt instruments providing fixed returns. ○ Includes provisions like call features, maturity terms, and refunding options. 3. Depository Receipts: ○ ADRs and GDRs facilitate international investment in domestic securities. 4. Derivatives: ○ Contracts deriving value from an underlying asset, such as futures and options. 12 (Set C notes by Mansi) 7. Primary Market Aspects 1. Types of Issues: ○ Public Issues: IPOs and FPOs. ○ Rights Issues: Offered to existing shareholders in proportion to their holdings. ○ Bonus Issues: Free shares issued from reserves. ○ Private Placements: Shares offered to select investors. 2. Offer Documents: ○ Includes prospectuses, red herring prospectuses, and abridged letters of offer. ○ Contains details like financials, risks, and terms of the issue. 13 (Set C notes by Mansi) 3. IPO Grading: ○ Optional assessment of IPO fundamentals by credit rating agencies ○ Graded on a scale of 1 (poor) to 5 (excellent).. Intermediaries in the Primary Market 1. Merchant Bankers: ○ Manage public issues, ensure regulatory compliance, and perform due diligence. 2. Underwriters: ○ Guarantee subscription and ensure issue success. 3. Registrars and Transfer Agents: ○ Handle applications, allotment, and record-keeping. 14 (Set C notes by Mansi) 4. Debenture Trustees: ○ Protect debenture holders’ interests and ensure compliance with SEBI regulations. Headpoint Summary: Steps in Public Issue 1. Board Meeting and Resolution: ○ A board meeting is convened to pass a resolution authorizing the public issue of shares. 2. Holding General Meeting: ○ Shareholders' approval is obtained through a general meeting if required by the company’s Articles of Association. 3. Appointment of Intermediaries: ○ Appointment of merchant bankers, underwriters, registrars, bankers to the issue, and brokers is completed. A Memorandum of Understanding (MoU) is signed with them. 4. Preparation of Draft Prospectus: ○ A draft prospectus is prepared and approved by the board. It includes critical details such as premium justification, net asset value (NAV), highlights of the issue, risk factors, and a refund clause if the minimum subscription is not achieved. 5. Filing with SEBI and Registrar of Companies (ROC): ○ The draft prospectus, agreements, and supporting documents are filed with SEBI and the ROC along with prescribed fees and certifications. 6. Stock Exchange Intimation: ○ A copy of the company’s Memorandum and Articles of Association is submitted to the stock exchanges where the shares are to be listed for approval. 7. Finalization of Collection Centers: ○ Lead managers finalize locations where prospective investors can collect application forms and prospectuses. 8. Printing and Distribution of Prospectus: ○ After receiving approvals, the prospectus and application forms are printed and distributed within 90 days of registration with the ROC. 9. Public Announcement and Advertisement: 15 (Set C notes by Mansi) ○ Announcement regarding the issue is made at least ten days before the subscription list opens. Advertisements should avoid brand names unless commercially established. 10.Opening Subscription List: ○ The subscription list remains open for a minimum of 3 working days and a maximum of 10 working days, or 7 days (extendable by 3 days) for book-built issues. 11.Separate Bank Account: ○ A dedicated account is opened to collect proceeds, with all branches informed about the subscription timeline. 12.Minimum Subscription Compliance: ○ Allotment is prohibited if the minimum subscription is not achieved, and application money must be refunded within 4 days. 13.Promoters’ Contribution: ○ The promoters must ensure their contribution is raised and certified before the issue opens. 14.Share Allotment: ○ A return of allotment is filed within 30 days of share allotment. Oversubscription requires consultation with stock exchanges for allocation guidelines. 15.Compliance Report Submission: ○ A compliance report and certificate from auditors or company secretaries must be submitted to SEBI within 45 days of issue closure. 16.Issuance of Share Certificates: ○ Share certificates must be issued within 2 months of allotment as per the Companies Act. 8. Book-Building Process Definition: Price discovery mechanism for determining the demand and price of securities. Steps: ○ Determine price band. 16 (Set C notes by Mansi) ○ Collect bids from investors. ○ Fix final issue price based on demand. Headpoint Summary: Green Shoe Option and SPAC Green Shoe Option 1. Definition: ○ A price stabilization mechanism where companies over-allot shares beyond the initially issued quantity to stabilize prices post-listing. 2. Process: ○ Company issues shares and enters an agreement for an additional allocation of up to 15% of the issue size. ○ Promoters lend extra shares to stabilizing agents for 30 days. ○ Stabilizing agents can: Buy from the market: If the price falls below the issue price, stabilizing agents purchase shares to support the price. Exercise overallotment: If prices remain stable or rise, additional shares are issued, and the borrowed shares are returned to the promoters. 3. Significance: ○ Provides liquidity and prevents excessive volatility. ○ Introduced in India by SEBI in 2003. ○ Only stabilization measure approved by the SEC in the USA. 4. Origin: ○ Named after the Green Shoe Manufacturing Company, the first to use this mechanism in 1919 17 (Set C notes by Mansi) Special Purpose Acquisition Companies (SPACs) 1. Definition: ○ Listed shell corporations created to raise funds through an IPO and merge with unlisted or private companies. 2. Key Features: ○ Known as "blank cheque companies" as investors are unaware of the exact acquisition target. ○ Funds raised are held in trust until a suitable target is identified. ○ If no target is found within two years, funds are returned to investors. 3. Operation: ○ SPAC sponsors attract investors by leveraging their reputation. ○ Investors can purchase additional shares via warrants at a predetermined price after listing. ○ After merging with a private company, the SPAC adopts the acquired entity’s brand and name. 4. Advantages: ○ Provides a faster and less expensive route to listing compared to traditional IPOs. ○ Popular in technology and high-growth sectors. 5. Controversies: ○ Critics argue SPACs dilute shareholder value, as sponsors often acquire shares at a significant discount. ○ Concerns over inadequate regulatory scrutiny compared to traditional IPOs 9. Special Purpose Acquisition Companies (SPACs) Definition: Listed entities created to acquire private companies and merge with them. Features: ○ Known as "blank check companies." ○ Raise funds via IPOs and later identify acquisition targets. ○ Funds are returned to investors if no acquisition occurs within two years. 10. Disinvestment and Exit Offers 1. Disinvestment: ○ Selling government stakes in public enterprises to private entities. 2. Exit Offers: ○ Delisting or strategic sale of shares to exit the market. 18 (Set C notes by Mansi) 19 (Set C notes by Mansi) 20 (Set C notes by Mansi) Detailed Explanation of ADR and GDR American Depository Receipts (ADRs) Definition: ADRs are negotiable receipts issued by a U.S. depository bank, representing shares of a foreign company. These allow U.S. investors to trade in foreign company shares using U.S. dollars. Key Features: ○ Currency: Traded in U.S. dollars on American stock exchanges like NYSE and NASDAQ. ○ Transferability: Easily transferable among investors like any negotiable instrument. ○ Underlying Shares: The trading in ADRs reflects trading in the underlying shares held by a custodian in the foreign company's home country. ○ Dividend Payments: Dividends are distributed to ADR holders in U.S. dollars. ○ Stamp Duty: Transfer of ADRs does not attract stamp duty, simplifying the transaction process. Listing Process: ○ Involves collaboration between the issuing foreign company, U.S. investment bankers, legal counsel, and the depository bank. ○ Listed on U.S. exchanges after fulfilling requirements set by the SEC. Example: India’s ABC Ltd. issues ADRs through a U.S. bank. Investors purchase these ADRs via an American stock exchange, reflecting ownership in ABC Ltd. shares. 21 (Set C notes by Mansi) Global Depository Receipts (GDRs) Definition: GDRs are negotiable certificates issued by a depository outside India to non-resident investors, representing publicly traded shares or convertible bonds of an Indian issuer. Key Features: ○ Currency: Denominated in foreign currency (e.g., USD or EUR). ○ Underlying Security: Backed by equity shares or bonds of the issuing company in India. ○ Listing: Traded on international exchanges like the London Stock Exchange or Luxembourg Stock Exchange. ○ Dividend Conversion: Dividends declared in the issuer’s domestic currency are converted by the depository into foreign currency for payment to investors. ○ Risk: GDRs do not carry the risk of capital repayment. Advantages for Issuers: ○ Allows raising funds from international markets. ○ Enhances visibility and global investor base. Warrants with GDRs: Warrants may be attached to GDRs, offering investors an option to convert them into equity shares later. Warrants help increase demand for GDRs by offering potential upside, but dividends are not paid on warrants until conversion. Example: An Indian company raises funds internationally by issuing GDRs listed on the London Stock Exchange. These certificates enable global investors to trade and hold equity-like instruments without direct exposure to the Indian market. Detailed Explanation of Futures and Options Futures Definition: A futures contract is a legally binding agreement to buy or sell an underlying asset at a predetermined price on a specified future date. It is standardized and traded on organized exchanges. Key Features: ○ Underlying Asset: Futures contracts derive their value from an underlying asset like stocks, commodities, or indices. ○ Expiry Date: Futures have a set expiry date, after which the contract is settled. For example, equity futures typically expire on the last Thursday of each month. 22 (Set C notes by Mansi) ○ Settlement: Physical Delivery: The actual asset is exchanged. Cash Settlement: The difference in prices is paid in cash. ○ Leverage: Futures require an upfront margin payment, allowing larger exposure with less capital. ○ Unlimited Risk and Reward: Both buyers and sellers of futures contracts face potentially unlimited gains or losses. Uses: ○ Hedging: Mitigates price risks of the underlying asset. ○ Speculation: Allows traders to profit from price movements without owning the asset. Options Definition: An options contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (strike price) on or before a specified date. Key Features: ○ Types of Options: Call Option: Provides the right to buy the underlying asset. Put Option: Provides the right to sell the underlying asset. ○ Strike Price: The predetermined price at which the asset can be bought or sold. ○ Premium: The buyer pays a premium to the seller for the option right. ○ Obligation: The buyer has no obligation to exercise the option. The seller is obligated to fulfill the contract if the buyer exercises their right. ○ Limited Risk for Buyers: Buyers’ losses are limited to the premium paid, while their profit potential is unlimited. Sellers face potentially unlimited losses with limited profit (the premium). Uses: ○ Hedging: Protects against unfavorable price movements in the underlying asset. ○ Speculation: Enables traders to capitalize on anticipated price changes. 23 (Set C notes by Mansi) Comparison Between Futures and Options Aspect Futures Options Nature of Buyer and seller are obligated to Buyer has the right but not the Obligation fulfill the contract. obligation. Risk/Reward Unlimited for both parties. Limited risk for buyer, unlimited for seller. Premium No upfront premium; margin is Buyer pays a premium to the Payment required. seller. Usage Hedging and speculation. Hedging, speculation, and income generation. Detailed Explanation of Anchor Investor Portion Who Are Anchor Investors? Definition: Anchor investors are Qualified Institutional Buyers (QIBs) who purchase shares one day before the IPO opens. They help establish a fair price and build investor confidence by showing early demand for the shares. Purpose: ○ Anchor investors "anchor" the issue by subscribing to shares at a fixed price. ○ They demonstrate demand, encouraging other investors to participate. ○ SEBI introduced this concept in June 2009 to enhance the ability of issuers to sell their issues effectively. 24 (Set C notes by Mansi) Importance of Anchor Investors 1. Guiding Role: ○ Companies with complex structures or those not profitable at the net level benefit from anchor investors' participation. ○ Examples include Sadhbhav Infrastructure Projects and Adlabs Entertainment. 2. Validation of Pricing: ○ Anchor investors, being experienced institutions, provide critical insights into the valuation of an issue. 3. Confidence Boost for Other Investors: ○ If anchor investors show interest, retail and institutional investors are likely to follow. Case Example: Prabhat Dairy's IPO failed to attract anchor investors due to pricing issues, leading to poor retail participation Guidelines for Anchor Investors 1. Application Size: ○ An anchor investor must apply for shares worth at least ₹10 crore in the public issue. 2. Reservation in QIB Portion: ○ Up to 60% of shares reserved for QIBs can be allocated to anchor investors. 3. Domestic Mutual Fund Allocation: ○ One-third of the anchor investor portion is reserved for domestic mutual funds. 4. Timeline: ○ Bidding for anchor investors opens one day before the issue opens. ○ Allocation of shares to anchor investors is completed on the same day as bidding. 5. Payment: ○ Anchor investors pay the full application amount at the time of bidding. 6. Lock-In Period: ○ Shares allotted to anchor investors cannot be sold for 30 days from the date of allotment. Additional Rules If the final price discovered in the book-building process is higher than the price offered to anchor investors, they must pay the difference. If the final price is lower, no refund is provided. 25 (Set C notes by Mansi) Chapter 4: Capital Market – Secondary 1. Introduction to Secondary Market Definition: A market where securities issued in the primary market are traded among investors. Known as the stock market. Structure: Comprised of recognized stock exchanges regulated under government rules and guidelines. Key Instruments: Equity shares, bonds, preference shares, and debentures. 2. Functions of Secondary Market 1. Economic Indicator: Reflects the health of the economy through stock performance. 2. Valuation of Securities: Helps determine market value based on demand and supply. 3. Transaction Safety: Ensures secure electronic trading. 4. Contributes to Economic Growth: Facilitates reinvestment and capital formation. 5. Investor Motivation: Encourages investment by reducing perceived risks. 6. Investor Protection: Ensures safety and fair dealings. 7. Encourages Corporate Performance: Companies strive for better performance as stock prices reflect their valuation. 3. Development of the Stock Market in India Historical Growth: ○ Origin in the 18th century; formalized with the Companies Act, 1860. ○ Bombay Stock Exchange (BSE) established in 1875. ○ Significant expansion in the 20th century, with other exchanges like Ahmedabad, Calcutta, and Madras. Challenges Before 1990s: ○ Lack of transparency, high transaction costs, and poor risk management. Post-1991 Reforms: ○ Introduction of NSE in 1994, offering modern technology and products. ○ Establishment of OTCEI for small and medium enterprises. 4. Stock Market Organization in India Participants: ○ Brokers: Facilitate trade for investors; regulated by SEBI. 26 (Set C notes by Mansi) ○ Custodians: Manage securities and ensure proper safekeeping. ○ Depositories: Enable dematerialized trading (e.g., NSDL, CDSL). ○ Clearing Corporations: Handle settlements and reduce counterparty risks. 5. Demutualization of Stock Exchanges Definition: Transforming a member-owned exchange into a shareholder-owned company. The stock exchange is restructured into a for-profit company with a board of directors. The Bombay Stock Exchange (BSE) demutualized in 2005, converting itself into a corporate entity. Purpose: ○ Reduces conflicts of interest by separating ownership and management. ○ Ensures better transparency and governance. Benefits: ○ Access to funds for technology upgrades. ○ Enhanced investor confidence. 6. Share Trading in Secondary Market Steps for Retail Investors: 1. Open a bank account. 2. Open a Demat account to hold securities. 3. Open a trading account for transactions. 4. Place buy/sell orders electronically. 5. Settle transactions via brokers and clearing corporations. 7. Stock Market Operations 1. Functions of Stock Exchanges: ○ Provides liquidity, ensures fair price determination, and aids in capital formation. ○ Reflects the overall economic health. 2. Stock Market Indices: ○ Represent market trends and guide investor decisions (e.g., Sensex, Nifty). ○ Calculated using market capitalization or free-float methods. 8. Risk Management in Secondary Market Mechanisms: 27 (Set C notes by Mansi) 1. Trading Rules: Prevent insider trading and unfair practices. 2. Circuit Breakers: Temporary halts during high volatility. 3. Clearing and Settlement: Handled by organizations like NSCCL. 4. Securities Lending and Borrowing: Facilitates short selling and liquidity. Detailed Explanation of Algorithmic Trading and Basket Trading Algorithmic Trading Definition: Algorithmic trading, also known as algo-trading or automated trading, is the use of computer programs to execute trading activities like buying and selling stocks, options, futures, currencies, and cryptocurrencies. 1. It is also referred to as high-frequency trading (HFT) or black-box trading. Key Features: 1. Automation: Executes trades based on predefined criteria, such as price, volume, or timing. 2. Precision: Removes emotions from trading, ensuring logical and optimal decision-making. 3. Speed: Executes trades in microseconds or milliseconds. 4. Cost Reduction: Minimizes transaction costs by optimizing trade execution. Example of Algorithmic Strategy: 1. Moving Averages: Buy when a stock’s 50-day moving average crosses above its 200-day moving average. Sell when the 50-day moving average falls below the 200-day moving average. Benefits: 1. Best price execution. 2. Timely and accurate placement of trade orders. 3. Simultaneous monitoring of multiple market conditions. 4. Reduced risk of manual and emotional errors. 5. Backtesting capability with historical data. 6. Handles large volumes of data efficiently. Challenges: 1. System failures or network issues. 2. Imperfect algorithms can lead to losses. 3. High competition as multiple participants use similar algorithms. 28 (Set C notes by Mansi) Basket Trading Definition: Basket trading involves buying or selling a group of securities in a single transaction, often used by institutional investors to manage portfolios efficiently. Key Features: 1. Comprehensive Trade: Includes 15 or more securities in one transaction. 2. Portfolio Management: Enables large-scale trades that mirror an index or benchmark. 3. Customization: Investors can create personalized baskets aligned with their financial goals. Applications: 1. Index Funds: Managers match portfolio compositions with target indices by buying securities in proportional weights. 2. Options and Commodities: Traders use baskets for commodities (e.g., wheat, soybeans) or options strategies. Benefits: 1. Efficiency: Simplifies allocation across securities. 2. Cost-Effective: Reduces individual transaction costs. 3. Flexibility: Adjust securities within the basket as needed. 4. Time-Saving: Easier monitoring compared to individual trades. Example: An index fund creates a basket that includes securities representing an index like NIFTY 50, ensuring allocation mirrors index performance. Chapter 4 Additional topics 1. Fluctuation of Index Concept: ○ Reflects future earnings potential of listed companies. ○ Stock market valuation depends on discounted future earnings (dividends and capital gains). 29 (Set C notes by Mansi) Computation: ○ Index closing price is based on the weighted average price of trades in the last 30 minutes of trading. ○ If no trades occur, the last traded price during the session is used. 2. Computation of Index Steps: ○ Calculate market capitalization of each constituent company. ○ Compute total market capitalization by summing individual company values. ○ ○ Market capitalization-weighted methods are the most common globally 3. Free Float Market Capitalization Definition: 1. Excludes privately held shares from market capitalization. 2. Only considers publicly held, tradable shares. Advantages: 1. Realistic valuation of companies. 2. Reduces distortion caused by large-cap companies with restricted shares. 3. Facilitates broad-based indexing 30 (Set C notes by Mansi) 31 (Set C notes by Mansi) 4. Index Management Rebalancing: ○ Adjusts weights of securities in the index periodically (quarterly). ○ Reflects market price changes. Reconstitution: ○ Revises constituent securities based on inclusion criteria. ○ Accounts for market changes like bankruptcies and mergers 5. Trading Rules Objective: 1. Ensure fair trading practices and prevent insider trading. Mechanisms: 1. Margins to limit excessive positions by brokers. 32 (Set C notes by Mansi) 2. Real-time monitoring of exposure limits. 3. Prohibition of certain cross-dealings between brokers on the same exchange 6.Circuit Breakers Definition: 1. Temporary halts in trading to curb excessive market volatility. Triggers: 1. Set at 10%, 15%, and 20% index movements. Advantages: 1. Allows participants to reassess market conditions. 2. Prevents panic selling 7. Earmarking Concept: ○ Reservation of funds or securities for specific purposes during the trading process. ○ Helps in ensuring trade settlements occur smoothly 8. NSCCL (National Securities Clearing Corporation Ltd.) Role: ○ Facilitates clearing and settlement of trades. ○ Manages risk by confirming trades, determining obligations, and netting positions 【86:14†source】. 33 (Set C notes by Mansi) 9. Market Making System Purpose: ○ Ensures liquidity in stocks with lower trading activity. Mechanism: ○ Designated market makers provide continuous buy and sell quotes【 86:10†source】. 10. SLB (Securities Lending and Borrowing) Definition: ○ Allows lending of securities for a fixed tenure in return for lending fees. Benefits: ○ Facilitates short selling. ○ Enhances liquidity in the market. 11. STP (Straight Through Processing) Definition: ○ Automated process to settle trades without manual intervention. Significance: 34 (Set C notes by Mansi) ○ Reduces settlement time and operational risk【86:10†source】. 12. Margin Trading Definition: ○ Allows investors to buy securities by borrowing funds against margins provided. Mechanism: ○ Margin amount is deposited with brokers. Risk: ○ Amplifies both gains and losses【86:11†source】. 13. Short Selling Definition: ○ Selling securities not currently owned, with the intention of buying them back later at a lower price. Purpose: ○ Used for speculation or hedging【86:10†source】. 14. Buyback Definition: 1. Companies repurchase their shares from the market. Objective: 1. Improve earnings per share. 2. Consolidate ownership. 3. Utilize surplus cash effectively【86:10†source】. 15. Block and Bulk Deals Block Deals: ○ Trades involving a minimum of 5 lakh shares or ₹5 crore. ○ Conducted during a special trading window. Bulk Deals: ○ Trades where more than 0.5% of a company’s shares are transacted on a single trading day. ○ Reported to stock exchanges【86:10†source】. 35 (Set C notes by Mansi) 16. Emerging Markets 1. GIFT City (Gujarat International Finance Tec-City) Introduction: ○ India’s first operational smart city and global financial center located in Gandhinagar, Gujarat. ○ Covers 886 acres with a Domestic Tariff Area (DTA) and a Special Economic Zone (SEZ). Key Features: ○ Infrastructure: Planned 62 million square feet with 67% commercial, 22% residential, and 11% social space. Integrated "Walk to Work" city with modern urban amenities. ○ IFSC (International Financial Services Center): Offers a business and regulatory environment akin to global financial hubs like London and Singapore. Services include aircraft and ship leasing, offshore insurance, banking, and asset management. Two international stock exchanges with $11 billion daily trading volumes. ○ IFSCA (Regulator): Unified regulatory body for IFSC to ensure business ease and top-notch governance. Significance: ○ Facilitates Indian firms' access to international markets. ○ Brings offshore financial transactions back to India【90:0†source】【90:2†source】. 2. Power Exchange Overview: ○ Power Exchange India Limited (PXIL), established in 2008, was the first institutionally promoted power exchange in India. ○ Revolutionized Indian power markets by providing electronic platforms for trading electricity. Key Features: ○ Nationwide platform for seamless power trading and transmission clearance. 36 (Set C notes by Mansi) ○ Contracts offered: Day Ahead, Day Ahead Contingency, Intra-Day, Weekly, and Renewable Energy Certificates. ○ Certified for quality, information security, and environmental management since 2016. Impact: ○ Enhances market efficiency and improves decision-making for stakeholders【 90:2†source】【90:3†source】. 3. Social Stock Exchange (SSE) Introduction: ○ A dedicated stock exchange segment for social enterprises to raise funds. ○ Bridges social enterprises with fund providers to support activities with measurable social impact. Eligible Entities: ○ Not-for-Profit Organizations (NPOs): Includes charitable trusts, societies under the Societies Registration Act, and Section 8 companies under the Companies Act. ○ For-Profit Social Enterprises: Must demonstrate social intent by allocating at least 67% of their activities toward underserved populations or eligible objectives. Fundraising Mechanisms: ○ Issue of Zero Coupon Zero Principal Instruments, donations via mutual fund schemes, or other SEBI-approved methods. Regulatory Framework: ○ Entities must comply with disclosures and reporting requirements to ensure transparency and accountability【90:1†source】【90:5†source】. 4. Energy Exchange Overview: ○ Indian Energy Exchange (IEX) is the country’s premier automated energy trading platform. 37 (Set C notes by Mansi) ○ Operational since 2008, regulated by the Central Electricity Regulatory Commission (CERC). Key Features: ○ Facilitates physical delivery of electricity, renewables, and certificates. ○ Strong ecosystem with over 7,500 participants across India, including distribution utilities, renewable energy (RE) generators, and industrial consumers. ○ Pioneered cross-border electricity trade, promoting integrated South Asian power markets. Technological Edge: ○ Provides intuitive and customer-centric technology for efficient price discovery and procurement. Achievements: ○ Listed on NSE and BSE since 2017. ○ Recognized for quality and security management standards 38 (Set C notes by Mansi) 39 (Set C notes by Mansi) 40 (Set C notes by Mansi) Chapter 5: Money Market 1. Basics of Money Market Definition: A market for short-term funds, typically ranging from overnight to one year. Purpose: Facilitates short-term borrowing and lending for banks, financial institutions, companies, and governments. Key Features: ○ Acts as a mechanism to manage liquidity imbalances in the economy. ○ Provides access to funds at realistic prices for borrowers and lenders. ○ Promotes the integration of the financial market globally. 2. Money Market Participants 1. Reserve Bank of India (RBI): ○ Implements monetary policies and regulates liquidity. ○ Intervenes in the money market through tools like repos and reverse repos. 2. Scheduled Commercial Banks (SCBs): ○ Key suppliers and borrowers in the money market. ○ Mobilize savings via deposits and lend for short-term needs. 3. Cooperative Banks: ○ Operate similarly to commercial banks with regional focus. 4. Financial Institutions (LIC, UTI, GIC): ○ Participate in call money markets as lenders. 5. Corporates: ○ Raise funds through commercial paper or inter-corporate deposits. 6. Mutual Funds: ○ Invest surplus funds in money market instruments for short durations. 7. Discount and Finance House of India (DFHI): ○ A specialized institution that rediscounts treasury bills, CDs, and commercial bills. 41 (Set C notes by Mansi) 3. Money Market Instruments 1. Call/Notice Money: ○ Funds lent or borrowed for up to 14 days (notice money) or overnight (call money). ○ Highly liquid and market-driven. 2. Treasury Bills (T-Bills): ○ Issued by the RBI at a discount for 91, 182, and 364 days. ○ Risk-free and widely traded in the secondary market. ○ Example: A ₹100 T-Bill issued at ₹98.25 maturing in 64 days yields 10.13%. 42 (Set C notes by Mansi) 3. Commercial Bills/BILLS OF EXCHANGE: ○ Arise from trade transactions; banks discount them to provide working capital. ○ Self-liquidating and transparent. 43 (Set C notes by Mansi) 4. Certificates of Deposit (CDs): ○ Negotiable term deposits issued by banks and financial institutions. ○ Minimum denomination of ₹1 lakh with tenures from 7 days to 3 years. 44 (Set C notes by Mansi) 5. Commercial Paper (CP): ○ Unsecured promissory notes for short-term funds. ○ Issued at a discount with a maturity range of 7 days to 1 year. ○ Example: A CP with a face value of ₹6 crores sold for ₹5.72 crores yields 19.58%. 45 (Set C notes by Mansi) G-SEC BONDS 46 (Set C notes by Mansi) 4. CRR and SLR 1. CRR (Cash Reserve Ratio): ○ Percentage of deposits that banks must maintain with the RBI. ○ Used to regulate liquidity and prevent cash shortages. ○ Example: Out of ₹10,000 in deposits, ₹300 is held as CRR. 2. SLR (Statutory Liquidity Ratio): ○ Reserve requirement maintained by banks in cash, gold, or government securities. ○ Helps stabilize liquidity and supports government borrowing programs. 5. Interest Rate Determination 1. MIBOR (Mumbai Interbank Offer Rate): ○ The rate at which Indian banks lend to each other overnight. ○ Acts as a benchmark for short-term borrowing. 2. LIBOR (London Interbank Offer Rate): ○ Global benchmark rate for short-term loans between international banks. ○ Used for pricing loans and financial derivatives. 6. Government Securities Market Includes instruments like dated securities, zero-coupon bonds, and capital-indexed bonds. Enables the government to raise funds for public expenditure and liquidity management. 7. Recent Developments 1. Debt Securitization: ○ Converts financial assets into marketable securities. ○ Enhances liquidity and access to funds. 2. Money Market Mutual Funds (MMMFs): 47 (Set C notes by Mansi) ○ Offer retail investors an opportunity to invest in short-term money market instruments with a lock in period of 46 days. 8. Repo, Reverse Repo, and Ready Forward Contracts Repo (Repurchase Agreement): Borrowers sell securities with an agreement to repurchase them at a higher price. Reverse Repo: Opposite of a repo; used by the RBI to absorb liquidity. Ready Forward Contracts: Short-term loans against government securities. Dirty Price - Bond’s actual price, it includes accrued interest. DP = CP + accrued interest Clean Price - Bond’s price not including accrued interest 48 (Set C notes by Mansi) 9. Day Count Convention Standardized method to calculate interest payments or yields. T-Bills use a 364-day year for calculations. 49 (Set C notes by Mansi) 50 (Set C notes by Mansi) Chapter 6: Bond Market 1. Introduction to Bond Markets Definition: ○ The bond market, also known as the debt market, fixed-income market, or credit market, facilitates the issuance and trading of debt securities. ○ Bonds are issued by governments and corporations to raise funds for infrastructure, operations, or expansion. Historical Context: ○ Ancient debt instruments date back to 2400 B.C. ○ In India, bonds were introduced by the East India Company during the 18th century for public borrowing. 2. What is a Bond? Bonds are debt instruments where investors lend money to the issuer in exchange for periodic interest payments (coupons) and the repayment of principal at maturity. Key Concepts: 1. Face Value: Amount repaid at maturity. 2. Coupon Rate: Interest rate paid on the face value. 3. Maturity: Duration of the bond until repayment. 4. Yield: Return on investment from a bond. YTM 51 (Set C notes by Mansi) 5. Current Yield: Ratio of annual interest to the bond’s current price. 52 (Set C notes by Mansi) Summary of Types of Yield Curves 1. Normal Yield Curve Shape: Upward-sloping. Significance: Indicates that long-term bonds offer higher yields than short-term bonds. Economic Implication: ○ Associated with economic growth and expansion. ○ Reflects investor expectations for future interest rates and inflation. Reason: Investors demand higher compensation for the uncertainty associated with longer maturities. 53 (Set C notes by Mansi) 2. Inverted Yield Curve Shape: Downward-sloping. Significance: Long-term bonds offer lower yields than short-term bonds. Economic Implication: ○ Often seen as a precursor to economic recessions. ○ Indicates market pessimism about future economic growth. Reason: ○ Expectations of declining interest rates and lower inflation in the future. 3. Steep Yield Curve Shape: A steeper upward slope than the normal curve. Significance: Indicates a sharp rise in long-term bond yields relative to short-term yields. Economic Implication: ○ Suggests the beginning of economic recovery or expansion following a recession. Reason: Long-term yields increase quickly due to higher growth expectations, while short-term yields remain stable. 54 (Set C notes by Mansi) 4. Flat Yield Curve Shape: Nearly horizontal. Significance: Similar yields across all maturities. Economic Implication: ○ Represents a transition phase, often between a normal and inverted curve. ○ Indicates uncertainty or mixed investor sentiment about future economic conditions. Reason: ○ Balanced demand for both short-term and long-term securities. 5. Humped Yield Curve Shape: Bell-shaped or humped. Significance: Medium-term bonds offer higher yields than both short-term and long-term bonds. Economic Implication: ○ Represents a rare and transitional market condition. ○ Not a clear indicator of future market expectations. Reason: ○ Often results from temporary factors, such as sudden shifts in monetary policy or market anomalies. 55 (Set C notes by Mansi) 3. What Affects Bond Prices? 1. Interest Rates: ○ Inversely related to bond prices; as interest rates rise, bond prices fall and vice versa. 2. Credit Quality: ○ Higher credit ratings attract higher prices. 3. Maturity Period: ○ Longer maturity leads to greater sensitivity to interest rate changes. 4. Types of Bonds Based on Security: ○ Secured Bonds: Backed by assets. ○ Unsecured Bonds: Backed by the issuer’s credit. Convertible Bonds: Can be converted into equity shares. Zero-Coupon Bonds: Issued at a discount and pay no periodic interest. Callable Bonds: Issuer can redeem early. Puttable Bonds: Investor can sell back early. Junk Bonds: High-risk bonds offering higher yields. 56 (Set C notes by Mansi) 5. Risks in Bonds 1. Inflation Risk: Reduces the purchasing power of returns. 2. Interest Rate Risk: Rising rates lower bond prices. 3. Credit Risk: Default by the issuer. 4. Liquidity Risk: Difficulty in selling bonds in narrow markets. 5. Exchange Rate Risk: Impact of currency fluctuations on foreign bonds. 57 (Set C notes by Mansi) 58 (Set C notes by Mansi) 6. Relation Between Bond Price and Interest Rates Bond prices and interest rates share an inverse relationship. Duration: Measures price sensitivity to interest rate changes. 7. Primary vs. Secondary Bond Market Primary Market: ○ Bonds are issued directly to investors. Secondary Market: ○ Bonds are traded among investors without issuer involvement. 8. Types of Bond Markets 1. Corporate Bonds: Issued by companies. 2. Government Bonds: Considered risk-free; issued by central or state governments. 3. Municipal Bonds: Issued by local authorities. 4. Mortgage-Backed Bonds: Backed by mortgage loans. 5. Emerging Market Bonds: Issued by developing economies. 9. Bond Market Strategies Active: Focus on higher returns by leveraging market trends. Passive: Hold bonds to maturity for stable returns. Hybrid: Combination of active and passive approaches. 10. Bond Market Index Tracks bond performance across sectors. Examples: ○ Nifty Bharat Bond Index. ○ Nifty AAA Bond Plus SDL Index. 11. Bond Market vs. Stock Market 59 (Set C notes by Mansi) Feature Bond Market Stock Market Risk Lower Higher Returns Lower Higher Earnings Interest Dividends Type Volatility Less More 12. Bond Ratings Evaluate creditworthiness of issuers. Agencies: S&P, Moody’s, Fitch. Ratings range from investment-grade (low risk) to non-investment grade (high risk). 60 (Set C notes by Mansi) 61 (Set C notes by Mansi) Chapter 7: Derivative Market 1. Introduction to Derivatives Definition: A derivative is a financial instrument whose value is derived from an underlying asset (e.g., equity, index, commodity, or interest rate). Characteristics: ○ Value depends on the underlying asset’s price. ○ Used for price discovery, hedging, speculation, and arbitrage. ○ Leveraged instruments that amplify risks and rewards. ○ Can be cash or delivery-settled based on the contract type. 2. Elements of Derivative Contracts Legally binding agreements between two parties. Key components: ○ Buyer and seller. ○ Underlying asset. ○ Future execution date. ○ Pre-agreed price. ○ Transfer of risk. 3. Growth Drivers for Derivatives High asset price volatility. Market globalization and integration. Technological advancements. Innovative risk management tools. Sophistication in derivative products. 4. Benefits of Derivatives Effective price risk management. Enhances market efficiency and liquidity. Reduces transaction costs. Enables speculation and leverage. Provides operational and financial advantages. 62 (Set C notes by Mansi) 5. Risks in Derivatives Credit Risk: Default by counterparties. Market Risk: Adverse price movements. Liquidity Risk: Inability to exit positions. Legal Risk: Regulatory issues. Operational Risk: Inadequate documentation or fraud. 6. Types of Derivatives 1. Forwards: ○ Customized contracts to buy/sell an asset on a future date at a pre-determined price. ○ Private, over-the-counter (OTC) agreements prone to counterparty risk. 2. Futures: ○ Exchange-traded forward contracts with standardized terms. ○ Daily mark-to-market margin ensures minimized counterparty risk. 63 (Set C notes by Mansi) 3. Options: ○ Gives the buyer the right (but not the obligation) to buy (Call) or sell (Put) an asset. ○ Premiums paid to sellers; risk varies between buyers and sellers. 64 (Set C notes by Mansi) 4. Swaps: 65 (Set C notes by Mansi) ○ Agreements to exchange cash flows, typically based on interest rates or currencies. 7. Hedging, Speculation, and Arbitrage 1. Hedging: ○ Reduces risk from adverse price movements by taking an offsetting position. ○ Example: A trader with long stock positions may buy put options as protection. 2. Speculation: ○ Involves taking positions for profit without an intent to deliver/receive the underlying. ○ Example: Intraday trades in futures. 3. Arbitrage: ○ Profiting from price differences in identical/similar assets across different markets. ○ Example: Buying stock on NSE at ₹101 and selling on BSE at ₹102. 8. Key Concepts in Derivatives Spot Price: Price of the asset in the cash market. Futures Price: Contract price for future delivery. Strike Price: Agreed price for options. Initial Margin: Security deposit for trading futures/options. Mark-to-Market (MTM): Daily adjustment of positions to reflect gains/losses. 9. Option Contracts Call Options: Buyer has the right to buy the underlying at a specific price. Put Options: Buyer has the right to sell the underlying at a specific price. ITM (In-the-Money): Favorable intrinsic value for the buyer. ATM (At-the-Money): Strike price equals spot price. OTM (Out-of-the-Money): Unfavorable intrinsic value. 10. Swaps Used to hedge risks like interest rate changes or currency fluctuations. Examples: ○ Interest Rate Swaps: Fixed rate exchanged for a floating rate. 66 (Set C notes by Mansi) ○ Currency Swaps: Exchange of principal and interest in different currencies. ○ Credit Default Swaps (CDS): Insurance against credit risk. 11. Practical Applications Forwards Example: A company hedging currency risk by locking the exchange rate for future payments. Options Example: A trader buying NIFTY call options anticipating index growth. Swaps Example: Two firms exchanging debt obligations to leverage comparative advantages. 67 (Set C notes by Mansi) Chapter 8: Institutions and Intermediaries 1. Depository System Definition: A depository is an institution that holds securities in dematerialized form, enabling electronic trading and settlement. Key Functions: ○ Dematerialization: Conversion of physical securities into electronic form. ○ Rematerialization: Converting electronic securities back into physical form. ○ Transfer of Ownership: Facilitates electronic transfer of securities without physical movement. ○ Safekeeping: Ensures secure holding of securities. Examples: 68 (Set C notes by Mansi) ○ In India, the two main depositories are NSDL (National Securities Depository Limited) and CDSL (Central Depository Services Limited). 2. Stock and Commodity Exchanges Stock Exchanges: Platforms for trading equity, derivatives, and other securities. ○ Oldest exchange in Asia: Bombay Stock Exchange (BSE). ○ Major reforms include electronic trading systems introduced by NSE in 1994. Commodity Exchanges: ○ Facilitates trading of commodities like metals, energy, and agricultural products. ○ Examples: MCX (Multi Commodity Exchange), NCDEX (National Commodity and Derivatives Exchange). Stock Exchanges Abroad 1. New York Stock Exchange (NYSE) USA ○ Established in 1792, it is the world's foremost securities marketplace. ○ Operates both physical auctions and electronic trading. ○ Prices are determined through demand and supply dynamics. 2. Nasdaq USA ○ Founded in 1971, known for its electronic trading platform. ○ Focuses on liquidity, technology, and growth companies. ○ Companies listed meet strict earnings and governance standards. 3. London Stock Exchange (LSE) UK ○ Traces origins to 1760; formally established in 1773. ○ Provides company services, trading platforms, and information services. ○ Known for stability and investor protection. International Commodity Exchanges 1. Chicago Mercantile Exchange (CME) USA ○ Focuses on financial and commodity derivatives, including agriculture and energy. 2. New York Mercantile Exchange (NYMEX) USA ○ Largest physical commodity futures exchange, covering metals and energy. 3. London Metal Exchange (LME) UK ○ Specializes in base metals like aluminum, copper, and zinc. 4. Intercontinental Exchange (ICE) 69 (Set C notes by Mansi) ○ Operates futures contracts in commodities like cocoa, cotton, and crude oil. Functions of Stock Exchanges 1. Liquidity and Marketability ○ Provides a continuous market where securities can be converted into cash. 2. Fair Price Determination ○ Ensures prices are based on demand and supply, reflecting near-perfect competition. 3. Source of Long-Term Funds ○ Enables corporates and governments to raise funds through equity and bonds. 4. Capital Formation ○ Mobilizes savings into investments, aiding economic growth. 5. Economic Indicator ○ Reflects the health of the economy, influencing monetary and fiscal policies. 3. Intermediaries in Capital Markets Key Intermediaries: 1. Debenture trustee 2. Merchant Bankers: Manage public issues, mergers, and acquisitions. 3. Brokers and Sub-Brokers: Facilitate buying and selling of securities for investors. 70 (Set C notes by Mansi) 4. Registrars to an Issue: Handle application processes, allotment of shares, and refund management. 5. Portfolio Managers: Provide investment advisory and portfolio management services. 6. Underwriters: Guarantee subscription of shares during public issues. 71 (Set C notes by Mansi) 4. Institutional Investors Types: 1. Commercial Banks 2. Endowment fund 3. Mutual Funds: Pool money from investors to invest in diversified assets. 4. Pension Funds: Long-term investments aimed at retirement benefits. Regulated by Pension Fund Regulatory and Development Authority (PFRDA). 5. Hedge Funds: Use high-risk strategies for high returns, often limited to wealthy investors. 6. Insurance Companies: Significant institutional investors focusing on fixed-income securities. 5. Foreign Portfolio Investors (FPIs) Definition: FPIs are overseas investors who invest in Indian securities like shares, bonds, and derivatives. Categories: ○ Based on regulatory requirements and capital contribution levels. Significance: ○ Brings liquidity and foreign exchange inflow to domestic markets. Factors Influencing FPIs: ○ Interest rate differentials. ○ Political and economic stability Categories of FPIs Category I Foreign Portfolio Investors This category includes highly regulated entities or those associated with governments and international organizations: 1. Government and Government-Related Investors 72 (Set C notes by Mansi) ○ Central banks, sovereign wealth funds, international/multilateral organizations. ○ Entities controlled (at least 75%) by such government-related investors. 2. Pension and University Funds ○ Institutions that manage funds for education or retirement purposes. 3. Appropriately Regulated Entities ○ Insurance and reinsurance companies, banks, asset managers, investment managers, and portfolio advisors. 4. Entities from Financial Action Task Force (FATF) Member Countries ○ Includes appropriately regulated funds and unregulated funds managed by a regulated investment manager. ○ University-related endowments (in existence for more than five years). 5. Special Cases ○ Entities owned (at least 75%) by another eligible entity or investment manager from FATF member countries. Category II Foreign Portfolio Investors This category includes entities not meeting Category I criteria but still eligible to invest: 1. Appropriately regulated funds that are ineligible for Category I. 2. Endowments, foundations, and charitable organizations. 3. Corporate bodies and family offices. 4. Individuals and unregulated funds in forms like limited partnerships or trusts. 6. Custodians Role: ○ Offer safekeeping services for securities and ensure compliance with regulatory requirements. ○ Provide services like trade settlement, dividend collection, and tax compliance. Compliance Officer: ○ Ensures adherence to SEBI guidelines and resolves non-compliance issues. 7. Clearing Houses Definition: ○ Centralized entities ensuring timely settlement of trades, reducing credit risk between parties. Key Features: ○ Margins like Initial Margin and Variation Margin are used to ensure financial security. ○ Guarantee fund minimizes default risk. 73 (Set C notes by Mansi) 8. Role of SEBI in Regulating Institutions and Intermediaries Objective: ○ Protect investors' interests, promote transparency, and regulate market practices. Key Functions: ○ Approving intermediaries' registration. ○ Issuing guidelines for corporate governance. ○ Monitoring compliance and taking enforcement actions. Examples from the Chapter NSDL and CDSL: Major players in India’s depository system. BSE and NSE: Pioneered modern trading practices in Indian stock markets. FPIs: Withdrawal trends often correlate with US interest rate hikes. 74 (Set C notes by Mansi) Chapter 9: Commodity Market 1. Introduction to Commodity Markets Commodity markets facilitate trading in physical goods like metals, agriculture, and raw materials. Historically rooted in barter systems, modern commodity markets have evolved into sophisticated platforms for price discovery and trading. They play a critical role in determining prices influenced by factors like monsoons, political decisions, and global dynamics. 2. Role of Commodity Markets Facilitator: Connects producers and buyers, enabling efficient interactions. Price Discovery: Helps in determining fair prices through demand-supply dynamics. Influence on Prices: Acts as a platform for real-time pricing and provides insights for growers on which crops to cultivate. Negative Impact of Speculation Excessive speculation, short-selling, and black money can distort markets. Regulatory bodies like ESMA and mechanisms like position limits help mitigate such risks. 3. Commodity Market in India Key Exchanges: ○ MCX: India's leading commodity futures exchange, operational since 2003. ○ NCDEX: Focuses on agricultural commodities with a robust online system. ○ NMCE: First online multi-commodity exchange in India, emphasizing transparency and compulsory delivery-based settlements. Notable Initiatives: ○ Agridex: Launched in May 2020, it is India’s first agricultural futures trading index covering 10 liquid commodities. It allows easier participation in agricultural markets. Challenges: 1. Lack of exponential growth. 75 (Set C notes by Mansi) 2. Limited market access for farmers. 3. Speculation and weak regulatory practices. 4. Political interventions in commodities like sugar. Way Forward: 1. Enhance farmer-market connectivity. 2. Government support for education and awareness. 3. Strengthen regulatory frameworks under SEBI. 4. Applications of Derivatives in Commodities Differences Between Commodity and Financial Derivatives: 1. Storage Cost: Commodities need storage, unlike financial derivatives. 2. Complexity: Commodity markets face lower volumes and transparency. 3. Higher Costs: Commodities involve storage, transport, and delivery costs. 4. Physical Delivery: Quality variations make commodity delivery challenging. Trading and Settlement: 76 (Set C notes by Mansi) 1. Order Matching: Broker enters the trader's order; matched trades are cleared. 2. Trade Clearing: Registered clearinghouses ensure delivery or settlement. 3. Delivery Process: Includes warehousing and dematerialization for smooth transactions. Key Terms: Short Position: Seller agrees to deliver. Long Position: Buyer agrees to purchase. Margin: Deposit by traders to manage risks. 5. Global Commodity Exchanges 77 (Set C notes by Mansi) 1. London Metal Exchange (LME): ○ Established in 1877, specializes in metals like copper, tin, and aluminum. ○ Operates through open outcry, electronic platforms, and telephone markets. 2. Eurex Exchange: ○ Europe’s largest futures and options market, known for electronic trading. ○ Offers factor index-based futures covering risk factors like size and momentum. 3. Chicago Mercantile Exchange (CME): ○ US-based platform offering diverse trades, including metals, agriculture, and weather derivatives. ○ Known for its SPAN software for margin calculation. 78 (Set C notes by Mansi) 79 (Set C notes by Mansi) Chapter 11: Private Equity 1. Meaning of Private Equity: PE is equity capital provided by PE firms to enterprises, often startups or emerging sectors. Unlike public equity, PE involves high risk and uses leveraged strategies to amplify returns. PE investors aim for long-term growth and exit via valuation increases. Types of Funding by a Venture Capitalist: 1. Seed Capital: ○ Initial funding provided to a startup for acquiring fixed assets (e.g., machinery, computers) or setting up operational bases like leased premises. ○ It is typically small and used to get the business started. ○ Incubators often specialize in providing seed funding and exit when other investors come in. 2. Crowdfunding: ○ Involves raising funds through platforms that allow a large number of small investors to invest in startups listed on the platform. ○ It leverages collective investments from the crowd. 3. Early-Stage Funding: ○ Also known as Series A Funding. ○ Provided for setting up operations, production plants, or service lines, and for working capital requirements. 4. Interim Funding: ○ Used to stabilize cash flows or ramp up operations after breaking even. ○ Includes: Bridge Financing: A short-term loan that provides temporary funding until a larger or long-term financing solution is arranged. Mezzanine Financing: A hybrid of debt and equity financing. It may involve debt that can convert into equity, giving the investor a say in management and higher returns, but at a higher cost to the borrower. 5. Expansion Funding: ○ Offered to enterprises running at full capacity and creating market value. 80 (Set C notes by Mansi) ○ Supports long-term financing for growth and positions the business for acquisition by larger companies. Summary of the Funding Lifecycle: 1. Seed Capital: Starts the business. 2. Early-Stage Funding: Develops operations. 3. Interim Funding: Stabilizes and grows. 2. Classification of Private Equity: Venture Capital (VC): Funding startups with potential for high returns through stages like seed, early-stage, interim, and expansion funding. Buyouts: ○ Leveraged Buyouts (LBOs): Acquisition financed largely with debt, followed by restructuring. ○ Management Buyouts (MBOs): Managers buy the company, often supported by PE funding. 81 (Set C notes by Mansi) 1. Fee Structure: Commonly referred to as the "2 and 20" model: ○ 2% Management Fee: Paid annually by Limited Partners (LPs) to the General Partner (GP) for managing the fund. ○ 20% Carried Interest (Carry): Percentage of net profits from the fund paid to the GP as an incentive. 2. Harvest Year: The projected year when the investor plans to exit the investment and realize returns, typically through methods like an IPO, acquisition, or sale. 3. Down Round: Occurs when the valuation of the venture in a new funding round is lower than the valuation in previous rounds. 82 (Set C notes by Mansi) This implies the company’s perceived value has decreased, which results in the dilution of ownership for existing investors. 4. Methods for Computing Anti-Dilution Rights: Protects existing investors from ownership dilution during a down round by adjusting the equity they hold. Common methods include: ○ Full Ratchet: Existing investors maintain their percentage ownership by recalculating their share price at the new lower valuation. ○ Weighted Average: Adjusts ownership based on the average price of new shares issued. 5. Up Round: Opposite of a down round. Occurs when the new valuation is higher than the previous one, indicating growth and increasing the value of existing shares. 6. Break Fee: A fee payable to the investor if: ○ The company declines the investment after agreeing to the Term Sheet. ○ The company breaches exclusivity or other binding terms. 7. Exclusivity Agreement: Prevents the company from negotiating or accepting investments from other parties for a specific period, protecting the investor’s rights. 8. Liquidation Preference: Ensures the investor gets paid before common stockholders in the event of liquidation or a sale. For example, if a company is liquidated, the investor will recover their investment amount plus a predefined return before other shareholders receive any proceeds. 9. Series A and B: Series A: The initial round of funding, typically used to establish operations. Series B: Follow-up funding rounds after specific milestones are achieved. 83 (Set C notes by Mansi) 10. ROI (Return on Investment): The rate of return expected by the investor on their investment. 11. Terminal Value: The expected value of the enterprise at the end of the investment period, often calculated as a multiple of EBITDA or other metrics. 12. Tranches: Funds are released in parts (tranches) based on achieving specific agreed-upon milestones. 13. Deemed Liquidation: Includes events like mergers, acquisitions, or sales that trigger liquidation preferences, even if the company isn’t technically liquidated. 3. Cost of Investing: Comprises the weighted average cost of capital and fund management expenses. 4. Exit Routes: Initial Public Offering (IPO): Successful exit by listing shares publicly. Strategic Acquisition: Sale of PE stake to larger companies. Secondary Sale: Transfer of ownership to another PE firm. Management Repurchase: Buyback of ownership by the company’s founders. Liquidation: The least favorable route involving capital loss. 5. Valuation of Transactions: Pre-money & Post-money Valuation: Determines the enterprise's value before and after investment. Ownership Dilution: Additional investments dilute the original stakeholders' equity. Liquidation Preference: Ensures PE funds receive returns before other shareholders. Tranches: Staggered investments based on milestones. 6. Private Equity Funds: 84 (Set C notes by Mansi) Funds operate through GPs (investment managers) and LPs (investors like pension funds). GPs earn through management fees and incentive-based hurdle rates. Investments are structured to align the interests of GPs and LPs. 85 (Set C notes by Mansi) 86 (Set C notes by Mansi) Chapter 12 Investment Banking 1. Concept of Investment Banking Definition: Investment banking refers to financial intermediary services that assist companies in raising capital through underwriting and issuing securities, along with providing advisory services for mergers, acquisitions, and other financial matters. Global Players: Goldman Sachs, Morgan Stanley, J.P. Morgan, Deutsche Bank, Citi, and Barclays. Indian Presence: Key players include Bank of America, Citigroup, and J.P. Morgan. 2. Main Areas of Investment Banking 1. Corporate Finance: ○ Mergers and Acquisitions Advisory: Assists companies in negotiating and structuring deals, performing due diligence, and coordinating transactions. ○ Underwriting: Helps raise funds by guaranteeing the sale of securities, either through negotiated agreements or competitive bidding. 2. Sales: ○ Sales teams facilitate orders from high-net-worth individuals and institutions and earn commissions. 3. Trading: ○ Involves buying and selling securities like shares and bonds for clients and providing market liquidity. ○ Proprietary trading is also a key function, where traders use the bank’s capital for investments. 4. Research: ○ Analysts evaluate stocks, bonds, and markets to recommend investment actions, indirectly driving sales and trading revenue. 5. Syndicate: ○ Manages the placement of securities in public offerings and allocates bonds during debt deals. 87 (Set C notes by Mansi) 3. Commercial Banking vs. Investment Banking Key Differences: ○ Investment banks focus on raising capital via securities, while commercial banks provide loans from customer deposits. ○ Investment banks earn underwriting commissions, while commercial banks earn interest on loans. ○ Investment banks are regulated by SEBI, while commercial banks fall under the RBI. 4. Functions of Investment Banking 1. Issue of IPO: ○ Helps companies comply with SEBI regulations, conduct due diligence, and manage pricing and distribution. 2. Follow-On Offering: ○ Guides already listed companies in issuing additional shares for growth. 3. Issue of Debt: ○ Advises companies to raise funds through bonds, especially during unfavorable equity market conditions. 4. Mergers & Acquisitions (M&A): 88 (Set C notes by Mansi) ○ Provides buy-side or sell-side advisory services, including identifying targets/buyers, term sheet preparation, due diligence, and deal closure. Buy-Side Advisory Head Points: 1. Shortlisting of Companies to Be Acquired: ○ Identification of suitable target companies for acquisition using the bank's network of relationships with private equity funds, companies, and intermediaries. 2. Preparing and Executing Term Sheet: ○ Drafting a term sheet with all terms and conditions of the merger or acquisition transaction. ○ Facilitating negotiations with the target company. 3. Due Diligence: ○ Investigating the target company from legal, commercial, and financial perspectives. ○ Verifying assets and liabilities, identifying risks, and providing protection against these risks. 4. Transaction Closure: ○ Finalizing agreements with the target company post-due diligence. ○ Arranging finance for the transaction if required. Sell-Side Advisory Head Points: 1. Preparation of Information: ○ Preparing detailed business profiles of the client company for potential buyers to present the deal effectively. 2. Target Shortlisting: ○ Identifying and shortlisting potential buyers, including private companies, public companies, private equity funds, hedge funds, and international buyers. 3. Preparing and Executing Term Sheet: ○ Assisting the client in entering into a term sheet with potential acquirers, detailing transaction terms. 4. Due Diligence and Deal Closure: ○ Supporting the client during the due diligence process. 89 (Set C notes by Mansi) ○ Negotiating and finalizing the agreement with the buyer to complete the transaction. Let me know if you need further details or explanations!
