CHAPTER ONE PDF UNIT ONE.pdf

LEVEL 2 UNIT ONE (CHAPTER 1) 1. Voting Rights: Shareholders can vote at company meetings on important issues like mergers, changes to the company's charter, and electing board members. This gives stockholders a say in major company...

LEVEL 2 UNIT ONE (CHAPTER 1) 1. Voting Rights: Shareholders can vote at company meetings on important issues like mergers, changes to the company's charter, and electing board members. This gives stockholders a say in major company decisions. 2. Dividend Rights: Stockholders may receive periodic dividend payments, a share of the company's profits. However, dividends aren't guaranteed like interest payments. Companies can choose to reduce or skip dividends without facing bankruptcy. 3. Right to Sell: Stockholders generally have the right to sell their shares at their discretion, though this may be limited in some countries or situations. The image emphasizes that stocks represent partial ownership in a company. By owning stock, you're not just buying a financial instrument, but becoming a partial business owner. This introduction covers the basics of owning stock, highlighting the combination of potential financial benefits (through dividends and selling shares) and corporate governance involvement (through voting rights) that come with stock ownership. Discretion" in this context means the freedom or right to make decisions according to one's judgment. So, when the image states that shareholders can sell their shares at their discretion, it means: 1. Shareholders have the freedom to decide when to sell their shares. 2. They can choose to sell all or part of their shares. 3. They can decide at what price they want to sell. This right gives shareholders control over their investments. They can hold onto shares if they believe the company will grow or sell them if they need the money or think the stock price might fall. However, the image notes that in some countries, this right can be limited. For example:  There might be lock-up periods for company insiders after an IPO.  Some shares might have restrictions on when they can be sold.  In certain markets, there might be daily limits on how much a stock price can move, effectively limiting when you can sell at a certain price. This image provides an overview of how companies typically evolve in terms of their ownership structure and how they raise capital through public offerings. Let me break it down in more detail: 1. Company Foundation:  o Companies usually start with one or a few entrepreneurs as founders. o Initially, ownership is concentrated among a small group of investors. 2. Initial Public Offering (IPO): o As the company grows, it may decide to raise more capital. o The company offers shares to the general public for the first time. o This process is called an Initial Public Offering or IPO. o It marks the transition from a private to a public company. 3. Seasoned Equity Offerings (SEO): o After the IPO, a company might need to raise additional capital. o It can do this by selling more shares to the public. o These subsequent share sales are called Seasoned Equity Offerings or SEOs. 4. Equity Primary Market: o Both IPOs and SEOs are part of what's known as the equity primary market. o This is where new securities are issued and sold to investors for the first time.  5. Role of Investment Banks: o Companies often seek help from investment banks for these offerings. o The bank's role includes a) Handling the distribution of shares to investors. b) Sometimes providing a guarantee to sell a certain number of shares. c) This guarantee is given in exchange for a fee. 6. Underwriting: o The process of an investment bank guaranteeing to sell shares is called underwriting. o It reduces the risk for the company by ensuring a minimum amount of capital will be raised. This process represents the typical journey of a company from a privately held entity to a publicly traded one, and how it continues to raise capital through the public markets. It also highlights the crucial role that investment banks play in facilitating these transactions and helping companies access public capital markets. Capital gains: Capital Gains and Dividends:  Capital gains: Increase in value of an investment over time.   Dividends: Regular payments made by companies to their shareholders. Investor Concerns and Stock Exchange Functions:  Investors want a way to quickly resell stocks to realize capital gains and get cash easily.  The stock exchange (secondary market) allows investors to buy and sell stocks.  On the stock exchange, investors trade stocks with each other.  The company doesn't get any money from these stock transactions.  Investors can sell stocks for cash without affecting the company's investments.  The secondary market helps economic growth by letting companies invest without worrying about investors' need for cash. Stock market indices: Definition and Importance:  Stock indexes are crucial tools that investors use to monitor the performance of the stock market.  When evaluating how the stock market has performed over a specific period, investors often refer to one of these indexes. What is an Index?:  An index is a numerical value that measures the change in a set of values over time.  Specifically, a stock index tracks the change in value of a selected group of stocks.  The stock index value is a weighted average of the prices of these stocks.  The index is a relative value, meaning it is expressed in comparison to the weighted average of prices at a starting date or base period.  Typically, the starting value or base of the index is set to a number like 100 or 1000. Example:  For instance, the Nifty index had its base value set at 1000 on its starting date, November 3, 1995. Characteristics of a Good Index:  A good stock market index effectively captures the behavior of the overall equity market.  It should be representative of the market, encompassing a wide range of stocks.  The index should be well-diversified, including stocks from various sectors.  Despite its diversity, the index should also be highly liquid, meaning the stocks within it can be easily bought or sold.   The movements of the index should accurately reflect the returns that a typical portfolio in the country might achieve. Importance of Market Index:  Market indexes are vital for several reasons: o They provide a benchmark for evaluating individual stock performance. o They help investors understand market trends and make informed investment decisions. o They can serve as a basis for index funds and other investment products. o They offer insights into the overall economic health by reflecting investor sentiment and market conditions. MARKET INDEX IS VERY IMPORTANT FOR: ECONOMIC SIGNIFICANCE OF INDEX MOVEMENT: What Index Movements Reflect:  Changing Expectations:  o Index movements are indicators of how the stock market's expectations about future corporate dividends are evolving. o An increase in the index signifies that the stock market believes future dividends will be better than previously anticipated. o A decrease in the index means the market's outlook on future dividends has become more pessimistic. Purpose of an Ideal Index:  Instant Market Perception: o An ideal index provides a real-time gauge of the stock market's perception of the corporate sector's prospects. o It helps investors understand the overall market sentiment quickly and effectively. Reasons for Stock Price Movements:  Company-Specific News: o Stock prices can move due to events directly related to a specific company, such as:  A new product launch that could boost future earnings.  The closure of a factory which might indicate operational issues or cost-cutting measures.  Country-Specific News:  o Stock prices can also move based on news affecting the entire country, such as:  Major political events like nuclear tests can affect national stability and investor confidence.  Economic policy announcements, such as the national budget, which can influence overall economic conditions and corporate profitability. The job of an Index:  Capturing Market-Wide Movements: o The primary role of an index is to reflect the overall movements of the stock market, particularly those driven by news about the country rather than individual companies. o By doing so, the index helps investors track the general economic sentiment and market trends.  Averaging Process: o Combining Stock Data:  Each stock's price movement includes a mix of company-specific news and broader market news.  When averaging the returns of many stocks, the individual stock-specific news tends to cancel out, leaving the common news that affects all stocks.  o Weighted Average:  The proper method for averaging involves taking a weighted average, where each stock is given a weight proportional to its market capitalization.  This means larger companies have a bigger impact on the index, reflecting their significance in the overall market. o Focus on Common News:  The resulting average captures the news and trends that are common across all stocks, which is typically news about the overall economy.  This makes the index a useful tool for gauging economic conditions and market sentiment on a broader scale. Types of stock market index: Sector Index  Definition: A sector index is designed to track the performance of a specific segment or sector of the stock market.  Purpose: Helps investors understand how a particular sector, like technology or real estate, is performing.  Example:  o BSE Realty Index: This index includes companies that are involved in the real estate sector within the Indian market. It shows how well the real estate sector is doing.  Specialization: o A sector index can focus on companies of a certain size (e.g., large-cap vs. small-cap), a particular type of management, or other specialized criteria. Broad-Based Index  Definition: A broad-based index covers a wide range of stocks from different sectors and represents the overall performance of the entire stock market or a large part of it.  Purpose: Gives a general sense of how the overall market is performing, rather than focusing on a single sector.  Examples: o BSE Sensex: Tracks 30 large, publicly-owned companies in India, reflecting the overall health of the Indian stock market. o NIFTY 50: Includes 50 major companies listed on the National Stock Exchange of India, representing a broad cross-section of the Indian economy.  Significance: o These indices are frequently cited in news and reports about the stock market.  o They are often used as benchmarks to gauge the performance of the stock market. o The performance of these indices is viewed as a barometer of the overall state of the economy, including trends and economic health. Types of Stock Market Indices 1. Market Value Weighted Index 2. Price Weighted Index 3. Equally Weighted Index Market Value Weighted Index  How It’s Constructed: 1. Calculate Market Capitalization:  For each stock in the index, multiply the current stock price by the number of shares issued (this gives the total value of the company’s stock). 2. Sum the Market Capitalizations:  Add up the market capitalizations of all the stocks in the index to get a total market value. 3. Compare to Base Period:  Compute a similar sum of market capitalizations from a base period (a previous  time when the index was set to a specific value, usually 100). 4. Calculate the Index Value:  Divide the current total market value by the base period total market value.  Multiply the result by the index’s base value (typically set to 100).  Assumption: o The index assumes investors would invest in each company in the index in proportion to its market capitalization. This means that companies with higher market caps have more influence on the index.  Examples: o S&P 500: Includes 500 large companies in the U.S. o NYSE Composite: Covers all stocks listed on the New York Stock Exchange. o NASDAQ Composite: Includes all stocks listed on the NASDAQ. o FTSE 100: Tracks 100 of the largest companies listed on the London Stock Exchange. o Tokyo Stock Exchange Price Index: Measures the performance of companies listed on the Tokyo Stock Exchange.  o MSCI Index: Represents various global stock markets. o BSE Sensex: Tracks 30 major companies listed on the Bombay Stock Exchange in India. o TTSE Composite Index: Reflects the performance of the Trinidad and Tobago Stock Exchange. Features of Market Value Weighted Index  Automatic Adjustments: o Stock Splits and Capital Changes:  When a stock split occurs or a company issues more shares, the index automatically adjusts. This is because a decrease in the stock price is counterbalanced by an increase in the number of shares outstanding, keeping the index value stable.  Reflects Market Value Changes: o Total Market Value:  The index captures changes in the total market value of all stocks included. It shows how the combined value of all companies in the index is performing.  Impact of Market Capitalization: o Greater Influence:  Companies with higher market capitalization have a more significant effect on the index  compared to companies with lower market capitalization. This means larger companies have more influence on the index’s movement.  Example:  In 1998, during a period when large-cap growth stocks dominated the U.S. markets, these larger companies had a major impact on the index. Calculation of Market Capitalization Weighted Index  Definitions: o Current Market Capitalization:  Sum of the current market price of each stock multiplied by the number of shares outstanding. o Base Market Capitalization:  Sum of the market price of each stock multiplied by the number of shares that were issued as of the base date (the date when the index was first set or a previous reference point).  Price Weighted Index:  Calculation: A price-weighted index is determined by averaging the stock prices of all companies included in the index. This means each company’s stock price contributes to the index based on its current price.  Formula: To compute the index, you sum up the prices of all stocks in the index and then divide this total by the number of stocks. For example, if there are 5 stocks in the index with prices of $10, $20, $30, $40, and $50, the index value would be the average of these prices: (10+20+30+40+50)/5=30(10 + 20 + 30 + 40 + 50) / 5 = 30(10+20+30+40+50)/5=30.  Investment Replication: Investors who want to replicate the performance of a price weighted index should purchase an equal number of shares of each stock in the index. This approach mirrors the index’s structure and performance.  Influence: The index is more affected by changes in the prices of high-priced stocks. A large price movement in a high-priced stock will impact the index more than a similar percentage change in a lower-priced stock.  Ease: This type of index is straightforward to calculate because it only requires summing prices and dividing by the number of stocks. It’s a useful benchmark for portfolios that hold equal numbers of shares in each company listed.   Examples: Two prominent examples of price weighted indices are the Dow Jones Industrial Average (DJIA), established in 1896, and the Nikkei 225, established in 1950. Both are among the most well-known indices in their respective markets.  Criticisms: o Adjustment for Stock Splits: The calculation requires adjustments if a company’s stock undergoes a split or reverse split. For instance, if a stock split occurs, the divisor used in the index calculation must be adjusted to maintain consistency. o Impact of High-Priced Stocks: A high-priced stock will have a greater impact on the index’s value than a low-priced stock, even if the percentage change in both stocks is the same. For example, a 10% increase in a $100 stock affects the index more than a 10% increase in a $10 stock. Equally Weighted Index Study Notes Overview of Equally Weighted Index  Definition: An equally weighted index involves investing an equal amount of money in each stock within the index, regardless of each stock's price or market capitalization.   Equal Importance: This approach ensures that each stock in the index has the same impact on the index's performance. Calculation and Impact on Index Movements  Investment Influence: The index's movements are determined by the percentage price changes of the equal dollar investments in each stock. o Arithmetic Mean:  Calculation: Average of the returns of all stocks in the index.  Effect: Represents the simple average return of the stocks. o Geometric Mean:  Calculation: nth root of the product of the returns of all stocks in the index.  Effect: Generally, results in a lower index value compared to the arithmetic mean, as it accounts for compounding effects and is typically lower unless all returns are equal. Examples of Equally Weighted Indices  Value Line Average Composite: An index that applies the equally weighted approach to its composition and calculation.  Financial Times Ordinary Share Index: Another example that follows the equally weighted methodology. Desirable attributes for index: Diversification: To reduce risk, an index should include stocks from different sectors (like technology, healthcare, etc.). This way, if one sector performs poorly, the other sectors might do better, balancing out the overall performance. Optimum Size: More stocks in an index generally mean better diversification, but there’s a limit. Adding too many stocks can make the index less effective or include less important ones. For example, the BSE Sensex has 30 stocks, and the NSE Nifty has 50, which helps balance between having enough diversity and keeping the index manageable. Market Capitalization: The index should mainly include stocks from large companies because their price changes are more significant. For instance, a stock needs to represent a certain percentage of the index’s total value to be included. Averaging: To make sure the index reflects the overall economy rather than individual company news; different methods of averaging are used:  Price Weighted: Stocks are weighted based on their price. Higher-priced stocks have a bigger impact on the index.  Market Capitalization Weighted: Stocks are weighted based on their total market value. Bigger companies have more influence.   Equally Weighted: All stocks have the same weight in the index, no matter their price or size. Liquidity: Ensure the stocks in the index are liquid, meaning they can be easily bought or sold without significantly affecting their price. This is measured by the "impact cost," which is the difference between the stock’s market price and the price paid when trading. For example, if a stock’s market price is Rs.200 but you pay Rs.202 due to transaction costs, the impact cost is 1%. Lower impact costs indicate higher liquidity. BSE index: Overview  Launch Year: The SENSEX was first compiled in 1986.  Base Year: The base year for the index is 1978-79. Calculation Methodologies  Initial Methodology (1986): o Market Capitalization-Weighted: This method weighted the index based on the market capitalization of the 30 constituent stocks. o Components: 30 large, well-established, and financially sound companies from key sectors.  Current Methodology (Since September 1, 2003): o Free-Float Market Capitalization-Weighted: This method adjusts the market capitalization based on  the shares available for trading (free float), excluding shares held by insiders or the government. o Global Standard: This methodology is commonly used by major global indices, including MSCI, FTSE, STOXX, S&P, and Dow Jones. SENSEX in Media and Market  Domestic and International Reporting: The SENSEX is widely reported in both domestic and international markets through various media, including print and electronic.  Scientific Design: The index is designed with a scientifically accepted construction and review methodology, ensuring accuracy and reliability. Market Trends and SENSEX  Equity Market Growth: The Indian equity market has experienced significant growth and activity since the early 1990s.  Market Trends: o Late 1990s: High activity in the TMT (Technology, Media, and Telecom) sectors. o Recent Trends: Increasing investor interest in the real estate sector.  Index Representation: The SENSEX effectively captures the booms and busts of the Indian equity market, reflecting major market trends and shifts. Historical Data and Significance  Historical Data: Provides a time series of data from 1979 onwards.  Prominence: As the oldest index in India, the SENSEX is considered one of the most significant and prominent brands in the country. Key Metrics  Base Index Value: 100  Date of Launch: January 1, 1986 SENSEX calculation methodology: Calculation Methodology  Free-Float Market Capitalization: o The SENSEX (Sensitive Index) uses the free-float market capitalization methodology to reflect the market value of the index's constituent stocks. o This approach adjusts the market value of the stocks by considering only those shares that are available for trading on the market. 2. Free-Float Definition  Available for Trading: o Free-Float Shares: These are shares that are available for trading and can be bought or sold by investors in the stock market.   Exclusions: o Promoters' Holding: Shares held by the company’s founders or major stakeholders. o Government Holding: Shares held by government bodies. o Strategic Holding: Shares held by institutions with a strategic interest. o Locked-in Shares: Shares that cannot be traded due to legal restrictions or agreements. 3. Market Capitalization  Full Market Capitalization: o Calculation: Determined by multiplying the total number of shares issued by the company's stock price. o Usage: Used in some stock indices to measure the overall value of a company without considering trading limitations.  Free-Float Market Capitalization: o Calculation: Uses only the shares available for trading. This method provides a more accurate picture of the market value since it reflects the liquidity of the stock. o Significance: For a company with a significant number of shares held by insiders or strategic  investors, its market capitalization in the index will be lower compared to full market capitalization. 4. Calculation Formula  Market Capitalization Calculation: o Formula: Market Capitalization = Stock Price × Number of Shares Issued.  Free-Float Market Capitalization Calculation: o Formula: Free-Float Market Capitalization = Market Capitalization × Free-Float Factor. o Free-Float Factor: A multiplier that adjusts the total market capitalization to account for only the shares available for trading. 5. Base Period and Value  Base Period: o Year: 1978-79 o Purpose: This period serves as a reference point for the index value calculation.  Base Value: o Index Value: 100 index points o Notation: Often written as 1978-79-100, indicating the initial value of the index when it was first calculated. 6. Index Calculation  Index Divisor:  o Function: The free-float market capitalization of the 30 component stocks is divided by the Index Divisor. o Purpose: The divisor adjusts for changes in the index over time, such as corporate actions (e.g., stock splits, dividends) and changes in index constituents. It ensures that the index remains comparable over time.  Adjustments: o Corporate Actions: Changes due to stock splits, mergers, or other corporate actions are accounted for by adjusting the divisor. 7. Continuous Calculation  Real-Time Updates: o During Market Hours: The SENSEX is recalculated continuously based on the latest trade prices of the constituent stocks. o Process: As trades are executed, the prices are updated in real time, and the index reflects these changes instantaneously. NIFTY 50 Overview of Nifty 50:  Index Composition: Nifty 50 is a diversified stock index consisting of 50 stocks across 13 sectors of the economy.  Purpose: It serves multiple functions such as benchmarking fund portfolios, supporting index-based derivatives, and facilitating index funds.  Management: Owned and managed by NSE Indices Limited (formerly India Index Services and Products Ltd), a specialized company focusing on indices. Market Representation:  Market Capitalization: As of March 29, 2019, the S&P CNX Nifty Index represents approximately 66.80% of the free float market capitalization of stocks listed on the NSE.  Traded Value: For the six months ending March 2019, the total traded value of all Nifty 50 constituents was about 53.4% of the total traded value of all NSE stocks. Impact Cost:  Portfolio Size Impact: For a portfolio size of Rs.50 lakhs, the impact cost of the Nifty 50 in March 2019 was 0.02%. Suitability:  Professional Maintenance: The Nifty 50 is professionally maintained, making it an ideal index for derivatives trading. Computation Method:   Market Capitalization Weighted Method: The index is computed based on market capitalization, reflecting the total market value of all constituent stocks relative to a base period.  Adjustments: The method accounts for changes in index constituents and corporate actions such as stock splits and rights issues without affecting the index value. Base Date and Value  Base Date: o What It Is: The date on which the index’s initial value is set. o Specific Date: November 3, 1995. o Why It Matters: This date marks one year of operations for the NSE's Capital Market Segment, establishing a starting point for the index.  Base Value: o What It Is: The initial value assigned to the index on the base date. o Specific Value: 1000. o Purpose: This value serves as a reference point to measure changes in the index over time.  Base Capital:  o What It Is: The total market value of the index constituents at the base date. o Specific Amount: Rs. 2.06 trillion. o Purpose: It provides a benchmark for the total value of the index. Criteria for Selecting Stocks in NIFTY 50 1. Liquidity (Impact Cost) o What It Is: Measures how easily a stock can be traded without affecting its price significantly. o Criteria: A stock must have an average impact cost of 0.50% or less over the past six months, based on 90% of observations. o Impact Cost Calculation:  Definition: The cost of executing a trade relative to the ideal price of the stock.  Ideal Price: Average of the best-buying price and the best-selling price.  Purpose: Ensures the stock can be traded efficiently without significantly impacting its price. 2. Floating Stock o What It Is: Shares of a company that is available for public trading and not held by insiders or related entities.  o Criteria: At least 10% of a company’s stock must be floating. o Why It Matters: Ensures that there is sufficient stock available for trading, which improves liquidity and marketability. 3. Others o IPO Eligibility:  What It Is: New companies listed through an Initial Public Offering (IPO).  Criteria for Inclusion: They must meet all standard index criteria (impact cost, market capitalization, floating stock) over 3 months, rather than the usual 6 months.  Purpose: Allows recent IPOs a quicker path to inclusion if they meet the necessary criteria. o Stock Replacement:  Reasons for Replacement:  Compulsory Changes: For example, if a stock is delisted or undergoes significant corporate actions (like mergers).  Replacement Criteria: A stock with the largest market capitalization and meeting other requirements (like liquidity and floating stock) will replace the outgoing stock.  Better Candidate: If a stock in the replacement pool has at least twice the market capitalization of the index stock with the lowest market cap, it may replace that stock.  Purpose: Ensures the index remains representative of the largest and most liquid companies.