Portfolio Management Services (PMS) Distributors Certification Examination PDF

 Workbook for NISM-Series-XXI-A: Portfolio Management Services (PMS) Distributors Certification Examination National Institute of Securities Markets...

 Workbook for NISM-Series-XXI-A: Portfolio Management Services (PMS) Distributors Certification Examination National Institute of Securities Markets www.nism.ac.in 2 This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Certification Examination for Portfolio Management Services (PMS) Distributors. Workbook Version: October 20231 Published by: National Institute of Securities Markets © National Institute of Securities Markets, 2023 Plot 82, Sector 17, Vashi Navi Mumbai – 400 703, India Website: www.nism.ac.in National Institute of Securities Markets Patalganga Campus Plot IS-1 & IS-2, Patalganga Industrial Area Village Mohopada (Wasambe) Taluka-Khalapur District Raigad-410222 Website: www.nism.ac.in All rights reserved. Reproduction of this publication in any form without prior permission of the publishers is strictly prohibited. 1This version of the workbook is for candidates appearing for NISM Series XXI-A: Portfolio Management Services (PMS) Distributors Certification Examination on or after January 24, 2023. 3  Foreword NISM is a leading provider of high-end professional education, certifications, training and research in financial markets. NISM engages in capacity building among stakeholders in the securities markets through professional education, financial literacy, enhancing governance standards and fostering policy research. NISM works closely with all financial sector regulators in the area of financial education. NISM Certification programs aim to enhance the quality and standards of professionals employed in various segments of the financial services sector. NISM’s School for Certification of Intermediaries (SCI) develops and conducts certification examinations and Continuing Professional Education (CPE) programs that aim to ensure that professionals meet the defined minimum common knowledge benchmark for various critical market functions. NISM certification examinations and educational programs cater to different segments of intermediaries focusing on varied product lines and functional areas. NISM Certifications have established knowledge benchmarks for various market products and functions such as Equities, Mutual Funds, Derivatives, Compliance, Operations, Advisory and Research. NISM certification examinations and training programs provide a structured learning plan and career path to students and job aspirants who wish to make a professional career in the Securities markets. Till March 2023, NISM has issued more than 17 lakh certificates through its Certification Examinations and CPE Programs. NISM supports candidates by providing lucid and focused workbooks that assist them in understanding the subject and preparing for NISM Examinations. The book covers about basics of investments, securities markets, investing in stocks, fixed income securities, derivatives and mutual funds. This book also provides an understanding about the role of portfolio managers, operational aspects of portfolio management services, the portfolio management process, performance measurement and evaluation of portfolio managers. The taxation, regulatory, governance and ethical aspects of portfolio managers have also been discussed in this workbook. Dr. C.K.G Nair Director 4 Disclaimer The contents of this publication do not necessarily constitute or imply its endorsement, recommendation, or favouring by the National Institute of Securities Markets (NISM) or the Securities and Exchange Board of India (SEBI). This publication is meant for general reading and educational purpose only. It is not meant to serve as guide for investment. The views and opinions and statements of authors or publishers expressed herein do not constitute a personal recommendation or suggestion for any specific need of an Individual. It shall not be used for advertising or product endorsement purposes. The statements/explanations/concepts are of general nature and may not have taken into account the particular objective/ move/ aim/need/circumstances of individual user/ reader/ organization/ institute. Thus, NISM and SEBI do not assume any responsibility for any wrong move or action taken based on the information available in this publication. Therefore, before acting on or following the steps suggested on any theme or before following any recommendation given in this publication user/reader should consider/seek professional advice. The publication contains information, statements, opinions, statistics and materials that have been obtained from sources believed to be reliable and the publishers of this title have made best efforts to avoid any errors. However, publishers of this material offer no guarantees and warranties of any kind to the readers/users of the information contained in this publication. Since the work and research is still going on in all these knowledge streams, NISM and SEBI do not warrant the totality and absolute accuracy, adequacy or completeness of this information and material and expressly disclaim any liability for errors or omissions in this information and material herein. NISM and SEBI do not accept any legal liability whatsoever based on any information contained herein. While the NISM Certification examination will be largely based on material in this workbook, NISM does not guarantee that all questions in the examination will be from material covered herein. 5 Acknowledgement This workbook has been developed and reviewed jointly by the Certification Team of National Institute of Securities Markets (NISM), Dr. Rachana Baid, Dr. Kameshwar Rao and Dr. Kishore Rathi. This book draws references from various NISM certification examinations workbooks and NISM acknowledges the contribution of those NISM Resource Persons. NISM gratefully acknowledges the contribution of the Examination Committee for NISM- Series-XXI-A: Portfolio Management Services Distributors Certification Examination consisting of industry experts. About NISM Certifications The School for Certification of Intermediaries (SCI) at NISM is engaged in developing and administering Certification Examinations and CPE Programs for professionals employed in various segments of the Indian securities markets. These Certifications and CPE Programs are being developed and administered by NISM as mandated under Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007. The skills, expertise and ethics of professionals in the securities markets are crucial in providing effective intermediation to investors and in increasing the investor confidence in market systems and processes. The School for Certification of Intermediaries (SCI) seeks to ensure that market intermediaries meet defined minimum common benchmark of required functional knowledge through Certification Examinations and Continuing Professional Education Programmes on Mutual Funds, Equities, Derivatives Securities Operations, Compliance, Research Analysis, Investment Advice and many more. Certification creates quality market professionals and catalyzes greater investor participation in the markets. Certification also provides structured career paths to students and job aspirants in the securities markets. 6 About the Certification Examination for Portfolio Management Service Distributors The examination seeks to create a common minimum knowledge benchmark for distributors of Portfolio Management Services (PMS). The certification aims to enhance the quality distribution and related support services in the PMS. Examination Objectives On successful completion of the examination, the candidate should:  Know the basics of investments, securities markets, investing in stocks, understanding fixed income securities, derivatives and mutual funds.  Understand the role of portfolio managers; operational aspects of portfolio management services and about the portfolio management process; performance measurement and evaluation of portfolio managers.  Get oriented to the taxation aspects and regulatory, governance and ethical aspects of portfolio managers. Assessment Structure The examination consists of 80 multiple choice questions and 3 case-based questions. The assessment structure is as follows: Multiple Choice Questions [80 questions of 1 mark each] 80*1 = 80 marks 3 Case-based Questions [2 cases (each case with 5 questions of 1 mark each)] 2*5*1 = 10 marks [1 case (with 5 questions of 2 marks each] 1*5*2=10 marks The examination should be completed in 2 hours. The passing score for the examination is 60 percent. There shall be negative marking of 25 percent of the marks assigned to a question. How to register and take the examination To find out more and register for the examination please visit www.nism.ac.in Important Please note that the Test Centre workstations are equipped with either Microsoft Excel or OpenOffice Calc. Therefore, candidates are advised to be well versed with both of these softwares for computation of numericals. The sample caselets and multiple choice questions illustrated in the book are for reference purposes only. The level of difficulty may vary in the actual examination. 7 Contents CHAPTER 1: INVESTMENTS............................................................................................. 12 1.1 What is Investment?..........................................................................................................12 1.2 Investment versus Speculation..........................................................................................13 1.3 Investment Objectives.......................................................................................................14 1.4 Estimating the required rate of return..............................................................................15 1.5 Types of Investments.........................................................................................................19 1.6 Channels for making investments......................................................................................25 CHAPTER 2: INTRODUCTION TO SECURITIES MARKETS.................................................... 30 2.1 Securities Market...............................................................................................................30 2.2 Primary and Secondary market.........................................................................................31 2.3 Market Participants and their Activities............................................................................36 CHAPTER 3: INVESTING IN STOCKS.................................................................................. 43 3.1 Equity as an investment.....................................................................................................43 3.2 Diversification of risk through equity instruments............................................................44 3.3 Risks of equity investments...............................................................................................45 3.4 Overview of Equity Market................................................................................................46 3.5 Equity research and stock selection..................................................................................48 3.6 Technical Analysis..............................................................................................................67 3.7 Understanding Corporate Governance..............................................................................70 CHAPTER 4: INVESTING IN FIXED INCOME SECURITIES..................................................... 72 4.1 Overview of Fixed Income Securities.................................................................................72 4.2 Bond Characteristics..........................................................................................................73 4.3 Determinants of bond safety.............................................................................................76 4.4 Valuation of Bonds.............................................................................................................79 4.5 Measuring Price Volatility of bonds...................................................................................87 CHAPTER 5: DERIVATIVES............................................................................................... 93 5.1 Definition of Derivatives....................................................................................................93 5.2 Types of derivative products.............................................................................................94 5.3 Structure of derivative markets.........................................................................................98 5.4 Purpose of Derivatives.......................................................................................................99 5.5 Commodity and Currency Futures and Options..............................................................100 8 5.6 Underlying concepts in derivatives..................................................................................102 CHAPTER 6: MUTUAL FUND.......................................................................................... 106 6.1 Concept and Role of Mutual Fund...................................................................................106 6.2 Benefits of investing through mutual funds....................................................................107 6.3 Legal Structure of Mutual Fund in India..........................................................................108 6.4 Working of mutual funds.................................................................................................109 6.5 Types of Mutual fund products........................................................................................112 6.6 Processes of investing in mutual funds...........................................................................113 6.7 Legal and Regulatory Framework – Key SEBI Regulation................................................115 6.8 Fact Sheet - Scheme Related Information.......................................................................116 6.9 Net Asset Value, Total Expense Ratio, Pricing of Units....................................................116 6.10 Mutual Fund Scheme Performance...............................................................................117 6.11 Key performance measures...........................................................................................117 CHAPTER 7: ROLE OF PORTFOLIO MANAGERS............................................................... 120 7.1 Overview of portfolio managers in India.........................................................................120 7.2 Types of portfolio management services........................................................................121 7.3 Organizational structure of PMS in India.........................................................................122 7.4 Registration requirements of a Portfolio Manager.........................................................123 7.5 General Responsibilities of a Portfolio Manager.............................................................128 7.6 Administration of investor’s portfolio.............................................................................129 CHAPTER 8: OPERATIONAL ASPECTS OF PORTFOLIO MANAGERS................................... 135 8.1 Entities which can invest in PMS.....................................................................................135 8.2 Disclosures to the prospective clients.............................................................................135 8.3 Process of On-boarding of clients....................................................................................142 8.4 Direct On-boarding in PMS..............................................................................................147 8.5 Liability in case of Default................................................................................................148 8.6 Redressal of investors grievances....................................................................................149 8.7 Disclosures to the regulator.............................................................................................149 8.8 Costs, expenses and fees of investing in PMS...............................................................150 CHAPTER 9: PORTFOLIO MANAGEMENT PROCESS......................................................... 157 9.1 Importance of Asset Allocation Decision.........................................................................157 9.2 Understanding correlation across asset classes and securities.......................................157 9 9.3 Steps in Portfolio Management Process..........................................................................158 9.4 Asset allocation decision..................................................................................................168 9.5 Strategic versus Tactical Asset Allocation........................................................................169 9.6 Rebalancing of Portfolio...................................................................................................170 CHAPTER 10: PERFORMANCE MEASUREMENT AND EVALUATION OF PORTFOLIO MANAGERS.................................................................................................................. 172 10.1 Parameters to define performance – risk and return...................................................172 10.2 Rate of return measures................................................................................................172 10.3 Risk measures................................................................................................................187 10.4 Risk-adjusted return.......................................................................................................190 10.5 Performance Evaluation: Benchmarking and peer group analysis................................194 10.6 Performance attribution analysis..................................................................................195 10.7 Performance reporting to the Investor.........................................................................197 10.8 Valuation of Securities by Portfolio Managers..............................................................198 10.9 Global Investment Performance Standards (GIPS®)......................................................199 10.10 GIPS Advertisement Guidelines...................................................................................200 CHAPTER 11: TAXATION............................................................................................... 204 11.1 Taxation of investors......................................................................................................204 11.2 Taxation of various streams of income..........................................................................211 11.3 Section 9A of ITA............................................................................................................220 CHAPTER 12: REGULATORY, GOVERNANCE AND ETHICAL ASPECTS OF PORTFOLIO MANAGERS.................................................................................................................. 223 12.1 Prevention of Money Laundering Act, 2002..................................................................223 12.2 SEBI (Prohibition of Insider Trading) Regulations 2015.................................................225 12.3 SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003.....................................................................................................228 12.4 SEBI (Portfolio Managers) Regulations, 2020................................................................229 12.5 Best practices for portfolio managers...........................................................................239 10 NISM Series-XXI-A: Portfolio Management Services (PMS) Distributors Certification Examination Syllabus Outline and weightages Units Name of Units Marks 1 Investments 5 2 Introduction to securities markets 3 3 Investing in stocks 8 4 Investing in fixed income securities 8 5 Derivatives 5 6 Mutual Funds 5 7 Role of portfolio managers 13 8 Operational aspects of portfolio managers 13 9 Portfolio management process 13 10 Performance measurement and evaluation of portfolio 13 managers 11 Taxation 5 12 Regulatory, governance and ethical aspects of portfolio 9 managers Total 100 11 CHAPTER 1: INVESTMENTS LEARNING OBJECTIVES: After studying this chapter, you should understand about:  Meaning of Investments  Difference between saving and investment  Difference between investment and speculation  Objectives of investments  Components of required rate of return  Relationship between risk and return  Types of risks  Types of investment opportunities  Channels for making investments 1.1 What is Investment? People earn money and spend money. They pass through various phases in their life cycle. During some phases, they earn more money than they spend. In other phases, they earn less than they spend. Therefore, sometimes they have to borrow money to meet the shortfall and in other times they end up having surplus money. As can be seen in Exhibit 1.1, rarely the income and spending of individuals or households match. Exhibit 1.1: The Life-Cycle Pattern of Savings for Households People have, broadly, two options to utilise their savings. They can either keep it with them until their consumption requirements exceed their income, or, they can pass on their saving to those whose requirements exceed their income with the condition of returning it back with some increment. Therefore, those who consume more than their current income must be 12 willing to repay more than what they received, to those who have provided the funds. Essentially, people make a trade-off between postponing their current consumption, and an expected higher amount for future consumption. The difference between the two is referred as return. 1.1.1 Saving versus Investment It is common to use the terms Savings and Investment interchangeably. However, they are not one and the same. Saving is just the difference between money earned and money spent. Investment is the current commitment of savings with an expectation of receiving a higher amount of committed savings. Investment involves some specific time period. It is the process of making the savings work to generate return. Hence when people are saving, they use the short-term deposits/short-term securities which are highly liquid assets- on the other hand when people are investing they commit funds to real assets, capital market securities such as stocks and bonds, and other long-term commitments that may not be as liquid as short-term assets. See Box 1.1 to understand the difference between Financial and Real assets. Secondly, the objectives of savers and investors are different. Savers tend to accumulate funds to address short-term goals, whereas investors have longer-term goals, such as building retirement corpus or funding children's college education expenses. Those who save funds have the choice of investing. Hence, every investor is a saver but not vice versa. Box 1.1: Financial Assets versus Real Assets Assets can broadly be categorised as financial assets such as shares, debentures, bank deposits, public provident fund, mutual fund investments and others, and physical assets such as gold, diamonds, other precious metals and real estate. Financial assets have the advantage of greater liquidity, flexibility, convenience of investing and ease of maintaining the investments. They are primarily income generating investments, though some of them, such as equity- oriented investments are held for long-term capital appreciation. There is greater ease of investing in such assets as it allows for small and frequent investments. 1.2 Investment versus Speculation Another term which needs to be distinguished from “Investment” is “Speculation”. Investment and speculation activities are so intermingled that it is very difficult to distinguish and separate them. An attempt can be made to distinguish between speculation and investment on the basis of criteria like investment time horizon and the process of decision making. 13 Financial transactions occur on a time continuum ranging micro milli-second, micro-second, second, minute, hour, day, week, month, year, decade, century and perpetual time period. There is a tendency to describe short-term activities as speculative in nature and long-term ownership of assets as investments, which is not appropriate. Another popular way to define speculation is by extending the dictionary meaning of the same. Dictionary meaning of the term speculation is “the forming of a theory or conjecture without firm evidence”. The activity of investment involves carrying out any exercise or process to determine the value of the asset and then buying the one whose value is determined to be higher than the current market price. However, while speculating, no cognizance is paid to the value of the asset. Here profit making seems to be the sole purpose without much consideration to the risk involved. 1.3 Investment Objectives Most of the investors invest with a goal in mind, regarding the value of the investment at the end of the investment period Investment objectives can be defined as investors’ goals expressed in terms of risk, return and liquidity preferences. Some investors may have the tendency to express their goals solely on the basis of return. They must be encouraged to state their goals in terms of both risk and return, as expressing goals only in terms of return may lead to inappropriate asset allocation and adoption of risky investment strategies. Given to themselves, an investor may want her wealth to double up by the end of the year. However, she must be made to understand that such a goal would entail excessive risk. The investor must be explained that the “risk leads return” and not the other way around. Hence a detailed analysis of the risk appetite of the investor i.e. her willingness and ability to take the risk should proceed any discussion of the desired return. The return objective may be simplified as follows: 1.3.1 Capital Preservation means minimizing or avoiding the chances of erosion in the principal amount of investment. Highly risk averse investors pursue this investment goal, as this investment objective requires no or minimal risk taking. Also, when funds are required for immediate short term, investors may state for capital preservation as the investment objective. 1.3.2 Capital Appreciation is an appropriate investment objective for those who want their portfolio value to grow over a period of time and are prepared to take risks. This may be an appropriate investment objective for long term investors. 1.3.3. Current Income is an investment objective pursued when investor wants her portfolio to generate income at regular interval by way of dividend, interest, rental income rather than 14 appreciation in the value of the portfolio. This investment objective is mostly pursued by people who are retired and want their portfolios to generate income to meet their living expenses. 1.3.4. Tax Saving: Sometimes investors do invest in some select investment alternatives, to reduce their tax burden. This is because the IT authorities provide tax benefits in terms of deductions from taxable income, or as tax rebate from the tax payable. 1.4 Estimating the required rate of return Investment is the commitment of rupee for a period of time to earn a) pure time value of money – for investors postpone their current consumption b) compensation for expected inflation during the period of investment for the change in the general price levels and c) risk premium for the uncertainty of future payments. The price paid for the exchange between current and future consumption is the pure rate of interest. If an investor postpones consumption worth Rs. 1000 today for a guaranteed future consumption worth Rs. 1020 then the pure rate of interest in this exchange is 2%. ((1020- 1000)/1000). It is the rate of return, the investor demands even if there is no inflation and no uncertainty associated with future payments. In reality, prices level rarely remains the same. Hence, if the investor expects a rise in the price level, they will require an additional return to compensate for it. Further, if there is a risk associated with future payment, investor will demand compensation for bearing the risk. The compensation for postponement of consumption is the pure time value of money. It is referred as real risk-free rate. Real risk-free rate when adjusted for inflation expectation is referred as nominal risk-free rate. Nominal risk-free rate plus risk premium is required rate of return. Required rate of return is the minimum rate of return investors expect when making investment decisions. It is to be noted that required rate of return is not guaranteed return or assured return. It is also different from expected or forecasted return. It is also different from realized return. 1.4.1 Nominal risk-free rate, real risk-free rate, and expected inflation The notion that money has time value is a fundamental concept in investments. It is the central theme in calculating the rate of return. It is better to receive a sum of money today than to receive the same sum tomorrow because it can be invested and earn returns. 15 Investors can invest in investment opportunities like risk-free bonds, where they are promised to receive an amount more than the amount they have invested.2 For example if an investor invests Rs.100 today at a risk free rate of 5% per year, the value of the investment at the end of one year will be Rs.100 + (Rs.100*5%)=Rs. 105. Thus, Rs.105 is the future value of this current investment, one year from now. The value today is its present value. i.e. Rs.100. Conversely, if an investor is certain of receiving Rs.105, one year from today, then its present value can be calculated as Rs.105/(1+5%)=Rs.100. These calculations substantiate an old age saying that “a dollar today is worth more than a dollar tomorrow”. The certainty of receiving the amount in future makes it a risk free investment. And the rate of return on the same is called a risk-free rate. In this case it is 5%. This risk-free rate is also referred as nominal rate of return. As can be seen, it ignores the potential change in the purchasing power of rupee. That is, though the investor is certain of receiving Rs.105 after one year, there is no guarantee that rupee will have the same purchasing power a year from now that it has today. From the nominal rate, inflation rate can be subtracted to calculate the real rate of return. Hence Nominal rate of return can be decomposed into: real rate of return and inflation rate. Real risk free rate is the basic rate of return or interest rate, assuming no inflation and no uncertainty about future cashflows. It is the compensation paid for postponing the consumption. For example, an investor gives up Rs. 100 today for more than Rs. 100 say Rs. 102 one year from today. This is a risk-free investment and the real risk-free rate of interest is 2% ((102/100) – 1). The desire for current consumption influences this rate. The desire for current consumption is influenced by the investment opportunities available in the economy. The availability of investment opportunities is determined by the real growth rate of the economy. Hence, the real risk free rate is determined by an interaction between subjective factors like the desire for consumption and objective factors like the available investment opportunities and the growth rate of the economy. As noted above, if investors expect the price level to rise during the period of investment, they would require a compensation for the expected rate of inflation. Continuing with the above example, “What if the price level in the economy increases by 6%?” In such situation, the investors should increase the required rate of return by the expected rate of inflation. If they do not do so, then they would be losing money in the real sense rather than getting a real rate of return. To maintain a consumption of Rs.102, the interest earned must be 8.12 per cent. The required nominal rate of return (NRR) would be as follows: 2 An investment avenue where there is certainty of receiving the promised amount in future. Example of risk-free investment is treasury (government) bond. 16  NRR = (1+Real rate of return) x (1+Expected rate of inflation) – 1 8.12 % = (1+ 2%) X (1+6%) -1 Thus, 8.12% rate of return is required in place of 2%. This rate of interest (comprising real rate of return plus the compensation for inflation compensation) is called the nominal rate of return. It is also considered as the nominal risk-free rate of return. 1.4.2 Risk Premium As discussed above, the nominal risk-free rate of return is the rate of return, an investor is certain of receiving on the due date. Investor is certain of the amount as well as the timing of the return. Hence, it is the risk-free rate of return. Some investment opportunities such as government securities (with some caveats) fit this pattern. The returns from most of the investment opportunities do not have certainty of the amount and the timing of cashflows. Further, the uncertainty of receiving the future cashflows vary amongst investments. In such cases, investors would require compensation for the uncertainty associated with future cashflows. This additional compensation over the nominal risk-free rate is called risk premium. If the investors perceive higher risk (more uncertainty with respect to the future payment), they would demand higher risk premium. 1.4.3 Types of risks Risk is usually understood as “exposure to a danger or hazard”, however it is not exposure to danger, rather the variability in impact when exposed to a danger. In investment, risk is defined as the possibility that the actual earnings could be different from what is expected to be earned. In more technical terms, the dispersion around the average expected return is defined as risk. Similarly, people use risk and uncertainty interchangeably. This also is not correct. Risk is not uncertainty. When one does not have any knowledge about the future variability in the expected outcomes or their causal factors, then such a situation is known as “uncertainty”. However, when there is some existing or developing theoretical or empirical knowledge about the factors leading to uncertainty, then such situation is considered as “risk”. In summary, Risk is known uncertainty. As research evidence or scientific advancements progress towards more clarity on the causal factors leading to some phenomena or event, then everyone begins to term that phenomenon as risk and no more uncertainty. There are various types of risk viz., business risk, financial risk, liquidity risk, political risk, exchange rate risk etc.. 1.4.3.1 Business risk Variability of income flows caused by the nature of a firm’s business, is defined as business risk. Sales volatility and operating leverage determines the level of business risk. For example, 17 an auto manufacturer incurs high operating costs viz-a-viz a retail food company. Earnings and sales of the auto manufacturer fluctuates substantially over the business cycle leading to high business risk. 1.4.3.2 Financial risk Financial risk relates to the means of financing assets – debt or equity. It is uncertainty caused by the use of debt financing. When a firm borrows, it is required to make fixed payments that must be paid ahead of payments to stockholders. Thus, the use of debt increases uncertainty of stockholder income. and causes an increase in the stock’s risk premium. This increase in uncertainty because of use of fixed cost of financing is referred as financial leverage. 1.4.3.3 Liquidity risk Liquidity has multiple connotations in the realm of finance. One such connotation is the ease of converting an asset into an amount of cash, nearer to its economic worth. The more difficult the conversion, the more is the liquidity risk. Liquidity risk is the uncertainty introduced by the secondary market of an investment. Treasury bills have almost no liquidity risk. They can be sold in a fraction of minute at a price worth their economic value. On the other hand, a piece of art may take longer to get converted into cash and the price may deviate significantly from its worth. 1.4.3.4 Exchange rate risk Exchange rate risk is the volatility of return introduced by acquiring investments denominated in a currency different from that of the investor. Changes in exchange rates affect the investors return when converting an investment back into the “home” currency. As more and more investors want to reap the benefits of a globally diversified portfolio, this risk increases. As an example, suppose that an Indian investor purchases a dollar denominated bond. On such bond, interest will be paid in dollar. If the rupee has appreciated in value compared to USD, when the interest is received in dollar and converted into rupee, the investor will receive less in rupee than expected. The risk in this entire episode is arising due to the unpredictability of volatile and uncontrollable currency exchange rates. 1.4.3.5 Political Risk Political risk is the volatility of returns caused by the possibility of a major change in the political or economic environment in a country. Individuals who invest in countries that have unstable political-economic systems must include an additional country risk-premium when determining their required rate of return. 1.4.3.6 Geopolitical Risk Geopolitics is influence of geography and politics on the social and economic relationships between countries. Geopolitical risk is the risk associated with wars, terrorist acts, and tensions between states that affect the normal and peaceful course of international relations. 18 An example of geopolitical risk could include a flare-up of tensions between China and USA and how it has impacted the global trade and economy. Another example is the border tensions between India and China that escalated in May 2020 1.4.3.7 Regulatory risk Regulatory risk is the risk associated with unpredictability about the regulatory framework pertaining to investments. It is the risk that existing regulations will become more stringent leading to higher transaction costs. Regulatory risk is higher in new investment opportunities and products than the matured and established ones. 1.4.4 Relationship between risk and return Exhibit 1.1 plots the usual relationship between risk and return. A positive relationship exists between risk and return. The greater the risk, the higher the return. The graph demonstrates that investors increase their required rate of return as their expectation about future volatility of returns increases. As a result the risk premium goes up. The graph is just to convey the meaning of a positive relationship, however, in reality, the relationship between risk return is nonlinear, that is there is no proportionate increase in return for every unit increase of risk. Similarly this graph is also different for different individuals, due to their risk appetite or risk aversion. Exhibit 1.1 Relationship between risk and required rate of return3 Positive Relationship between Risk and Return Return The slope indicates the required rate of return per unit of risk Risk 1.5 Types of Investments There are many investment avenues. Broadly, investments can be classified into financial or non-financial investments. Non-financial investments include real estate, gold, commodities etc. Non-financial investments are also called Real Investments. Financial instruments are essentially claims on future cash flows. On the basis of claims on the cash flows, there are two generic types of financial instruments—debt and equity. Financial investments can also be classified on the basis of transferability of ownership in the secondary market, as security 3 Chapter 1, An overview of Investment Process, Analysis of Investments and Management of Portfolios, Reilly & Brown, 10 th edition 19 and non-security form of investments. Security form of investments, like shares, bonds, notes, etc., are easily transferable in the secondary markets. Whereas non-security form of investments like, fixed deposits, insurance, etc., cannot be transferable to any other investor and they do not have secondary markets. Security form of financial investments are actively traded on both capital and money markets. 1.5.1 Equity: Role and characteristics Equity Shares represent ownership in a company that entitles its holders a share in profits and the right to vote on the company’s affairs. Equity shareholders are residual owners of firm’s profit after other contractual claims on the firm are satisfied and have the ultimate control over how the firm is operated. Equity Shareholders are residual claim holders. Investments in equity shares reward investors in two ways: dividend and capital appreciation. Investments in equities have proven time diversification benefits and considered to be a rewarding long-term investment. Time diversification benefits refer to the notion that fluctuation in investment returns tend to cancel out through time, thus more risk is diversified away over longer holding periods. It follows that investment in equities offer better risk- adjusted return if held for long time periods. The concept of listed versus unlisted equity/ investments are explained in Box 1.2. Box 1.2: Listed versus Unlisted Equities or for that matter any financial investment can also be classified on the basis of the trading platforms. Listed investments are traded on a stock exchange. Unlisted investments are bought and sold over the counter. The key difference between the two is the structure of buying or selling the securities. Listed investments follow the listing rules and requirements. The segment of listed investments is called public market. The mechanism of trading at exchange floors enhances liquidity in listed securities and also leads to continuous pricing. However, prices in the public markets are more prone to market sentiments. Both equity as well as fixed income securities trade in this segment. Unlisted investment space is referred as private market. Pricing of investment in unlisted space is not continuous. It is performed at regular intervals or when the need for the same arises for buying or selling. Since these investments do not trade in stock exchange, they are relatively less liquid in comparison to listed investments. Hence, investors may demand an extra compensation for the same called “illiquidity risk premium”. Buying and selling of unlisted investments takes longer time compared to the listed investments. 1.5.2. Fixed income securities: role and characteristics Debt instruments, also called fixed income instruments, are contracts containing a promise to pay a stream of cashflows during the term of the contract to the investors. The debt 20 contract can be transferable, a feature specified in the contract that permits its sale to another investor, or non-transferable, which prohibits sale to another party. Generally, the promised cashflow of a debt instrument is a periodic payment, but the parties involved can negotiate almost any sort of cashflow arrangement. A debt contract also establishes the financial requirements and restrictions that the borrower must meet and the rights of the holder of the debt instruments if the borrower defaults. Debt securities are issued by companies, municipalities, states and sovereign governments to raise money to finance a variety of projects and activities. Debt instruments can further be classified on the basis of issuer into government debt securities and corporate debt securities where the issuer is a non-government entity. Government securities form the largest component of debt market in India as well as world over. Government versus corporate debt securities A Government Security (G-Sec) is a tradeable instrument issued by the Central Government or the State Governments. It acknowledges the Government’s debt obligation. Such securities are short term (usually called treasury bills, with original maturities of less than one year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both, treasury bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). G-Secs carry practically no risk of default and, hence, are called risk-free gilt-edged instruments. A key source of funds for corporates is debt financing. Companies issue debt securities of various maturity profiles. Many of these corporate debt papers are listed on stock exchanges. However, a bigger component of corporate borrowings lies in the unlisted space. Corporate fixed income securities pay higher interest rates than the government securities due to default risk. The difference between the yield on a government security and the corporate security for the same maturity is called “credit spread”. Higher the probability of default greater would be the credit spread. Credit Spread could also be understood as the “Risk Premium” which the companies are paying to raise the debt, or the investors are charging for bearing default risk. High yield versus investment grade The probability of default on a fixed income paper is captured by ratings given by rating agencies. Table 1.1 gives the rating symbols given by CRISIL (a rating agency registered with SEBI). This is further discussed in Section 4.3. 21 Table 1.1 Rating scale and description Rating Description CRISIL AAA Instruments with this rating are considered to have the highest (Highest Safety) degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk. CRISIL AA Instruments with this rating are considered to have the high degree of (High Safety) safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk. CRISIL A Instruments with this rating are considered to have the adequate (Adequate Safety) degree of safety regarding timely servicing of financial obligation. Such instruments carry low credit risk. CRISIL BBB Instruments with this rating are considered to have the moderate (Moderate Safety) degree of safety regarding timely servicing of financial obligation. Such instruments carry moderate credit risk. CRISIL BB Instruments with this rating are considered to have the moderate risk (Moderate Risk) of default regarding timely servicing of financial obligation. CRISIL B Instruments with this rating are considered to have the high risk of (High Risk) default regarding timely servicing of financial obligation. CRISIL C Instruments with this rating are considered to have the very high risk (Very High Risk) of default regarding timely servicing of financial obligation. CRISIL D Instruments with this rating are in default or are expected to be in (Default) default soon. As can be observed in the rating description, higher rating denotes lower default risk and vice versa. The convention in the market is to classify bonds with rating BBB and above as investment grade and bonds below the BBB as high yield or junk bonds. Many institutional investors are prohibited from investing in junk bonds as they involve high default risk. Money Market versus capital market Money market securities have maturities of one year or less than one year. Treasury bills, commercial papers, certificate of deposits up to one year maturity are referred as money market instruments. Capital market is a place for long term fund mobilization. Securities with maturities greater than one year are referred to as capital market securities. Stocks and bonds are capital market securities. Since the investment horizon in capital market is longer, the uncertainty about the future cash flows go up. Investors require extra compensation for the same. It is referred as “term premium”. 22 1.5.3 Commodities: Role and characteristics Both soft commodities such as corn, wheat, soybean, soybean oil and sugar and hard commodities which are mined such as gold, silver, oil, copper and aluminium are other investment avenues available to investors. Soft commodities are perishable hence they exhibit high volatility in their prices. These commodities are subject to higher business cycle risk as their prices are determined by the demand and supply of the end products in which they are consumed. Soft commodities historically have shown low correlation to stocks and bonds.4 Hence, they provide benefits of risk diversification when held in a portfolio along with stock and bonds. Prediction of weather is an important factor while investing in soft commodities. Exposure to these commodities can be taken through derivative contracts like forwards or futures. Hence, investors must carefully understand the risk involved in the same. Prices of hard commodities are determined by the interaction between global demand and supply. Hard commodities such as gold and silver have been the investments avenues for centuries, as reserve assets. Due to its global acceptability gold has acquired the status of a “safe haven” asset. It is viewed as an attractive investment in times of economic uncertainty and geopolitical crisis. Gold has shown diversification benefits historically. Unlike most of the financial investments, commodities do not generate any current income and the investor in these commodities would have to count only on capital appreciation. 1.5.4. Real Estates: Role and Characteristics Real estate is the largest asset class in the world. It has been a significant driver of economic growth. It offers significant diversification opportunities. It has been historically viewed as good inflation hedge. Investors can invest into real estate with capital appreciation as investment objective as well as to generate regular income by way of rents. It is usually a long- term investment. Real estate is classified into two sub-classes: commercial real estate or residential real estate. It can be further broken down into terms of tier I, tier II and tier III cities. Real estate investments often involve large commitments. Real estate funds or real estate investment trusts REITs have emerged as a good option to enable investors to take exposure to this asset class with smaller outflow commitments. 1.5.5. Structured products Structured products are customized and sophisticated investments. They provide investors 4 a technical term used to measure movement between two variables. The benefits of diversification rests on correlation between investments. Lower the correlation between investments, higher the benefits of diversification i.e. reduction in risk. 23 risk-adjusted exposure to traditional investments or to assets that are otherwise difficult to obtain. Structured products greatly use derivatives to create desired risk exposures. Many structured products are designed to provide risk-adjusted returns that are linked to equity market indices, sector indices, basket of stocks with some particular theme, currencies, interest rates, commodity or a basket of commodities. Structured products can be designed for a short term or for long terms. The terms can be customized to meet the requirements of the investing community. These products require investments a larger denominations. They may offer investment protection from 0% to 100% and/or attractive yields. The performance of the structured product is largely driven by the underlying strategy subject to market conditions. Hence, they must not be taken as capital protection or guaranteed or assured return products. 1.5.6. Distressed Securities Distressed securities are the securities of the companies that are in financial distress or near bankruptcy. Investors can make investments in the equity and debt securities of publicly traded companies. These may be available at huge discounts, however investments in them require higher skills and greater experience in business valuation than regular securities. These securities can be considered from the perspective of diversification of risk. These securities are also referred as ‘fallen angels’ and many types of funds and institutional investors are prohibited from holding these securities because of the high risk involved. It is a popular investment segment among hedge fund managers as they have deep experience in valuation and credit analysis. 1.5.7 Other investment opportunities Art and paintings and rare collectibles are emerging as an attractive long-term investment opportunity. This category of investment has been generating moderate returns in the long term. It also has low correlation with financial investments such as equities and bonds. Hence, it provides good risk diversification benefit. However, these are big ticket investments. Also, art is not a standard investment product as each work is unique. The market for the same is unregulated. These investments do not provide any income and just like gold, capital appreciation is the only way of reward. In terms of liquidity, this category is relatively more illiquid. To make rewarding investment decisions, specialized knowledge in arts is more crucial than in traditional financial assets due to higher levels of information asymmetry and adverse selection problems. There are art and painting based investment funds. Investors can take exposure through these funds. 24 1.6 Channels for making investments Investors can invest in any of the investment opportunities discussed above directly or through intermediaries providing various managed portfolio solutions. 1.6.1 Direct investments Direct investments are when investors buy the securities issued by companies and government bodies and commodities like gold and silver. Investors can buy gold or silver directly from the sellers or dealers. In case of financial securities, a few fee-based financial intermediaries aid investors buy or sell investments viz. brokers, depositories, advisors etc., for fees or commission. Registered Investment Advisers Investors can take the advice from SEBI Registered Investment Adviser (RIAs). As per SEBI Regulation relating to RIAs which came in the year 2013, only qualified professionals who are licensed by SEBI as Registered Investment Advisers (RIAs) can act as ‘advisers’. These advisers are paid fees by the investors who hire them for investment advice. After this regulation, the distributors of financial products like mutual fund distributors, share brokers and insurance agents who would earlier act as investment advisers, can no longer claim the title. These advisers, like other fee-based professionals, are only accountable to their investors. They are required to follow a strict code of conduct and offer advice in the investors’ best interests. They are also required to disclose any conflict of interest. Advisers do basic risk profiling, assess the needs and requirements of the investors, understand their financial health and develop ‘financial plans’. They help in inculcating a sense of discipline in investors. Thus advisor can help investors create an optimum investment portfolio and help them in making rational investment decisions. 1.6.2. Investments through managed portfolios Alternatively, investors can invest through investment vehicles which pool money from investors and invest in variety of securities and other investments on their behalf. In other words, investors make indirect investments. These investment vehicles are professionally managed. Through these managed portfolios they can avail the professional expertise at much lower costs. The following are examples of managed portfolio solutions available to investors in India:  Mutual Funds  Alternative Investment Funds  Portfolio Managers 25   Collective Investment Schemes Mutual Fund A mutual fund is a trust that pools the savings of a number of investors who share a common financial goal. Money collected through mutual fund is then invested in various investment opportunities such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realized are shared by its unit holders in proportion to the number of units owned by them. Mutual fund is a pass-through intermediary in the true sense. The following are the benefits of investing through mutual funds:  Professional investment management  Risk reduction through diversification  Convenience  Unit holders account administration and services  Reduction in transaction costs  Regulatory protection  Product variety However, mutual fund products are not ‘get rich quick’ investments. They are not risk-free investments. Mutual funds are strictly regulated by SEBI under Mutual Fund Regulation 1996. Mutual fund industry offers tremendous variety. There are products for different types of investment objectives and goal. Alternative Investment Fund Alternative Investment Fund or AIF is a privately pooled investment vehicle which collects funds from sophisticated investors, for investing it in accordance with a defined investment policy for the benefit of its investors. The words ‘privately pooled’ denote that the fund is pooled from select investors and not from the general public at large. These private investors are institutions and high net worth individuals who understand the nuances of higher risk taking and complex investment arrangements. The minimum investment value in AIF is one crore rupees. AIFs are categorized into three categories under the SEBI AIF Regulations for the purposes of registration and other operational requirements. These categories are mentioned below. Category I AIF – is an AIF that invests in start-up or early stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable and shall include venture capital funds, SME Funds, social venture funds, infrastructure funds, special situation funds and such other AIFs as may be 26 specified under the regulations from time to time. Other funds that are considered economically beneficial and are provided special incentives by the government or any regulator are also considered as part of this category. Category II AIF – is an AIF that does not fall in Category I and III and which does not undertake leverage or borrowing other than to meet day-to-day operational requirements or as permitted in the regulations. For this purpose, AIFs such as private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other Regulator are included under this category. Category III AIF – is an AIF that employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. AIFs such as hedge funds or funds which trade with a view to make short term returns or such other funds which are open ended and for which no specific incentives or concessions are given by the government or any other Regulator are included under this Category. Internationally, the investors in a hedge fund (AIF category III) are very popular among large institutional funds such as pension funds, investment funds, insurance companies, endowment funds, investment banks, family offices and HNIs. All these investors have large pools of funds and look for varied investment options beyond traditional investments. Hedge funds cater to the needs of such investors through alternative asset classes. Portfolio Management Services A portfolio manager is a body corporate who advises or directs or undertakes on behalf of the investors the management or administration of a portfolio of securities. There are two types of portfolio management services available. The discretionary portfolio manager individually and independently manages the funds of each investor. The non-discretionary portfolio manager manages the funds in accordance with the directions of the investors. The portfolio manager enters into an agreement in writing with the investor, clearly defining the relationship and setting out their mutual rights, liabilities and obligations relating to the management of funds or portfolio of securities. Portfolio management services are regulated by SEBI under Portfolio Manager Regulations. The regulations have not prescribed any scale of fee to be charged by the portfolio manager to its clients. However, the regulations provide that the portfolio manager shall charge fee as per the agreement with the client for rendering portfolio management services. The fee so charged may be a fixed amount or a return based fee or a combination of both.5 The portfolio manager is required to accept minimum Rs. 50 lakhs or securities having a minimum worth of 5 The fees could also be AUM based fixed fees or carry profit sharing or a combo. 27 Rs. 50 lakhs from the client while opening the account for the purpose of rendering portfolio management service to the client. Portfolio manager cannot borrow on behalf of his clients. Portfolio managers provide investment solutions unique to the needs of the investors. Mutual Funds Alternate Investment Funds and Portfolio Managers Mutual Funds, Alternate Investment Funds (AIFs) and Portfolio Managers (PMs) are managed portfolios. All three provide indirect way of investing in securities and other investments to investors. All three are regulated by SEBI. However, Mutual funds are more stringently regulated compared to AIF and PMS as mutual funds cater to retail investors. In case of AIF, the minimum amount required for investment is Rs. 1 crore and in case of PMS it is Rs. 50 lakhs. AIF and PMS cater to institutional and high net worth investors. These investors are expected to understand complex investment strategy and risks involved. The investment restrictions of PMS and AIF are also relatively less compared to mutual funds. So though, there are some similarities between them, there are important differences too. 28 Chapter 1: Sample Questions 1. If there is an uncertainty with respect to the future payment, the investor would require return more than the nominal required rate of return. The additional component is called ________. a. Alpha b. Risk free rate of return c. Risk premium d. Both b & c 2. Future value of the investment is influenced by __________. a. Time period b. Rate of return c. Both a & b d. None of the above 3. ____________________ represent ownership in a company that entitles its holders to participate in its profits and the right to vote on the company’s affairs. a. Bonds b. Commercial Papers c. Equity Shares d. All the above 4. Which of the following statements about Speculation is FALSE? a. It is investment without any significant analysis or thought b. Speculation is based on some conjectures without evidence c. Profit is the strongest motivation for Speculation d. Speculation always leads to higher returns 5. Liquidity Risk refers to _________? a. The ease with which one can convert an asset into Cash b. The possibility of realising almost the entire economic worth of an asset. a. Only A b. Only B c. A and B 29 CHAPTER 2: INTRODUCTION TO SECURITIES MARKETS LEARNING OBJECTIVES: After studying this chapter, you should understand about:  Meaning of securities and the functions of securities market  Structure 1.1. Define the term Security and understand of Securities the basics of Securities Markets--Primary Markets markets and Secondary 1.2.  Ways to issue securities  Functions of different market participants  Institutional investors and retail participants 2.1 Securities Market The securities market provides an institutional structure that enables a more efficient flow of capital in the economy. If a household has some savings, such savings can be deployed to fund the capital requirement of a business enterprise, through the securities markets. The businesses issue securities, raise money from the household through a regulated contract, lists the securities on a stock exchange to ensure that the security is liquid (can be sold when needed) and provides information about its activities and financial performance to the household. This basic arrangement in the securities markets enables flow of capital from households to business, in a regulated institutionalised framework. The term “securities” has been defined in Section 2 (h) of the Securities Contracts (Regulation) Act 1956. The Act defines securities to include: a) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or a pooled investment vehicle or other body corporate; b) derivative 6; c) units or any other instrument issued by any collective investment scheme to the investors in such schemes; d) security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002; e) units or any other such instrument issued to the investors under any mutual fund scheme (securities do not include any unit linked insurance policy or scrips or any such instrument or unit, by whatever name called which provides a combined benefit risk on the life of the persons and investment by such persons and issued by an insurer referred to in clause (9) of section 2 of the Insurance Act, 1938 (4 of 1938); 6As per SCRA, derivatives includes a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; a contract which derives its value from the prices, or index of prices, of underlying securities; commodity derivatives; and such other instruments as may be declared by the Central Government to be derivatives. [Amended by the Finance Act 2017] 30 f) units or any other instrument issued by any pooled investment vehicle g) any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be; h) government securities; i) such other instruments as may be declared by the Central Government to be securities (including onshore rupee bonds issued by multilateral institutions like the Asian Development Bank and the International Finance Corporation, electronic gold receipts, zero coupon zero principal instruments ); j) rights or interest in securities. A security represents the terms of exchange of money between two parties. Securities are issued by companies, financial institutions or the government. They are purchased by investors. Security ownership allows investors to convert their savings into financial assets which provide a return. The issuers of securities are able to reach out to a broader group of investors. For example, in the absence of a well-developed securities market, a household with surplus fund may have to hold all of their savings in a bank deposit even if they are willing to take on some risk for higher returns. But with the different types of equity and fixed income securities available with varying levels of risk and return, investors can choose to invest their surplus funds in the type of security that suits their specific preferences. Thus, the objectives of the issuer and the investor are complementary and the securities market provides a vehicle to mutually satisfy their goals. The issuer of the security provides the terms on which the capital is being raised. The investor in the security has a claim to the rights represented by the securities. These rights may involve ownership, participation in management or claims on assets. The market in which securities are issued, purchased by investors and subsequently transferred among investors is called the securities market. 2.2 Primary and Secondary market The securities market has two interdependent and inseparable segments, viz., the primary market and the secondary market. The primary function of the securities market is to enable the flow of capital from those that have it to those that need it. Securities market helps in transfer of resources from those with idle or surplus resources to others who have a productive need for them. To state formally, securities market provides channels for conversion of savings into investments and back. The investors in the Indian securities market 31 have a wide choice of financial products to choose from depending upon their risk appetite and return expectations. The securities market has two interdependent and inseparable segments: Primary Market: The primary market, also called the new issue market, is where issuers raise capital by issuing securities to investors. Fresh securities are issued in this market. Secondary Market: The secondary market facilitates trades in already-issued securities, thereby enabling investors to exit from an investment or new investors to buy already existing securities. The primary market facilitates creation of financial assets, and the secondary market facilitates their marketability/tradability which makes these two segments of Financial Markets - interdependent and inseparable. 2.2.1 Primary Market As stated above, primary market is used by companies (issuers) for raising fresh capital from the investors. Primary market offerings may be a public offering or an offer to a select group of investors in a private placement program. The shares offered may be new shares issued by the company, or it may be an offer for sale, where an existing large investor/investors or promoters offer a portion of their holding to the public. Let us understand various terms used in the primary market context. Public issue: Securities are issued to the members of the public, and anyone eligible to invest can participate in the issue. This is primarily a retail issue of securities. Initial Public Offer (IPO): An initial public offer of shares or IPO is the first sale of a corporate’s common shares to investors at large. The main purpose of an IPO is to raise equity capital for further growth of the business. Eligibility criteria for raising capital from the public investors is defined by SEBI in its regulations and include minimum requirements for net tangible assets, profitability and net-worth. SEBI’s regulations also impose timelines within which the securities must be issued and other requirements such as mandatory listing of the shares on a nationwide stock exchange and offering the shares in dematerialized form etc. Further Public Offer (FPO): When an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, it is called a further public offer or FPO. When a company wants additional capital for growth or desires to redo its capital structure by retiring debt, it raises equity capital through a fresh issue of capital in a further public offer. An FPO may also be through an offer for sale, which usually happens when it is necessary to increase the public shareholding in the company to meet the regulatory requirements. 32 Rights Issue: Shares offered to existing shareholders in proportion to their existing holding in the share capital of the company are termed as “Rights shares” popularly known as rights issue. In the rights issue, the shareholders have a right to participate in the issue. It is pre- emptive rights given by the status to existing shareholders. In this rights issue, the offer is required to be made to the existing shareholders on pro-rata to their existing holdings. The shareholders who are offered may or may not subscribe to the same. They may subscribe partly or fully the offer. Private Placement: When an issuer makes an issue of securities to a select group of persons and which is neither a rights issue nor a public issue, it is called private placement. This is primarily a wholesale issue of securities to institutional investors. It could be in the form of a Qualified Institutional Placement (QIP) or a preferential allotment. According to Companies Act 2013, an offer to subscribe to securities, made to less than 200 persons, is called private placement of securities. The requirements of SEBI’s regulations with respect to a public issue does not apply to a private placement. A privately placed security can be listed on a stock exchange provided it meets the listing requirements of SEBI and the stock exchange. Private placement of securities can be done by a company irrespective of whether it has made a public offer of shares or not. Preferential Issue: Preferential issue is when a listed issuer issues shares or convertible securities, to a select group of persons. The issuer is required to comply with various provisions defined by SEBI relating to pricing, disclosures in the notice, lock-in, in addition to the requirements specified in the Companies Act. Qualified Institutions Placements (QIPs): Qualified Institutions Placement (QIP) is a private placement of shares made by a listed company to certain identified categories of investors known as Qualified Institutional Buyers (QIBs). QIBs include financial institutions, mutual funds and banks among others. SEBI has defined the eligibility criterion for corporates to be able to raise capital through QIP and other terms of issuance under QIP such as quantum and pricing etc. Bonus Issues: A bonus issue of shares is made to the existing shareholders of a company without any consideration from them. The entitlement to the bonus shares depends upon the existing shareholding of the investor. A bonus issue in the ratio 1:3 entitles the shareholder to 1 bonus share for every 3 held. The company makes the bonus issue out of its free reserves built from genuine profits. A company cannot make a bonus issue if it has defaulted on the payment of interest or principal on any debt securities issued or any fixed deposit raised. A company has to get the approval of its board of directors for a bonus issue. In some cases, the shareholders of the company also need to approve the issue. A bonus issue once 33 announced cannot be withdrawn. The record date for the bonus issue will be announced and all shareholders as on the record date will be entitled to receive the bonus. Onshore and Offshore Offerings: While raising capital, issuers can either issue the securities in the domestic market and raise capital or approach investors outside the country. If capital is raised from domestic market, it is called onshore offering and if capital is raised from the investors outside the country, it is termed as offshore offering. Offer for Sale (OFS): An Offer for Sale (OFS) is a form of share sale where the shares offered in an IPO or FPO are not fresh shares issued by the company, but an offer by existing shareholders to sell shares that have already been allotted to them. An OFS does not result in increase in the share capital of the company since there is no fresh issuance of shares. The proceeds from the offer go to the offerors, who may be a promoter(s) or other large investor(s). The disinvestment program of the Government of India, where the government offers shares held by it in Public Sector Undertakings (PSUs), is an example of OFS. It may be stated that OFS is a secondary market transaction done through the primary market route. Employee Stock Ownership Plan: Some companies offer employee stock ownership plans that enable employees to own a small stake in the share capital of the company, as an incentive to participate in making the business successful. The terms and conditions on which employees can exercise the rights would be mentioned in the ESOP scheme. The option given to the employees can be exercised after a certain lock in period, which is generally more than one year. The dates on which the employees become entitled to exercise the right to acquire the shares is called as “vesting date.” The rights may vest fully or partially over the vesting period. For example, an employee is given 1000 options on 31st March, 2016 which can be exercised in phases like 30% on completion of one year, 30% on completion of second year and the balance on completion of the third year from the date of such grant. Foreign Currency Convertible Bonds (FCCBs): FCCBs are foreign currency (usually dollar) denominated debt raised by companies in international markets but which have the option of converting into equity shares of the company before they mature. The payment of interest and repayment of principal is in foreign currency. The conversion price is usually set at a premium to the current market price of the shares. FCCBs allow companies to raise debt at lower rates abroad. Also, the time taken to raise FCCBs may be lower than what it takes to raise pure debt abroad. An Indian company that is not eligible to raise equity capital in the domestic market is not eligible to make an FCCB issue either. Unlisted companies that have raised capital via FCCB in foreign markets are required to list the shares on the domestic markets within a stipulated time frame. 34 FCCBs are regulated by RBI notifications under the Foreign Exchange Management Act, 1999 FEMA). The Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism), 1993 lays down the guidelines for such issues. Depository Receipts - ADR / GDR: Depository receipts (DRs) are financial instruments that represent shares of a local company but are listed and traded on a stock exchange outside the country. DRs are issued in foreign currency, usually dollars. To issue a DR, a specific quantity of underlying equity shares of a company is lodged with a custodian bank, which authorizes the issue of depository receipts against the shares. Depending on the country of issue and conditions of issue, the DRs can be converted into equity shares. DRs are called American Depository Receipts (ADRs) if they are listed on a stock exchange in the USA such as the New York Stock Exchange (NYSE). If the DRs are listed on a stock exchange outside the US such as London Stock Exchange (LSE), they are called Global Depository Receipts (GDRs). The listing requirements of stock exchanges can be different in terms of size of the company, state of its finances, shareholding pattern and disclosure requirements. When DRs are issued in India and listed on Indian stock exchanges here with foreign stocks as underlying shares, these are called Indian Depository Receipts (IDRs). SEBI has laid down the guidelines to be followed by companies for IDRs. Anchor Investor: In the year 2009, SEBI introduced the concept of anchor investor in public issues. The volume and value of anchor subscriptions serve as an indicator of the firm's soundness of the offer. It also sets a benchmark and gives a guideline for issue pricing and interest among QIBs. Anchor investor means a qualified institutional buyer who makes an application for a value of ten crore rupees or more in a public issue made through the book building process in accordance with Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations. 2.2.2 Secondary Market While the primary market is used by issuers for raising fresh capital from the investors through issue of securities, the secondary market provides liquidity to these instruments. An active secondary market promotes the growth of the primary market and capital formation, since the investors in the primary market are assured of a continuous market where they have an option to liquidate or exit their investments. Thus, in the primary market, the issuers have direct contact with the investors, while in the secondary market, the dealings are between investors only. Secondary market can be broadly divided into two segments: Over-The-Counter (OTC) Market: OTC markets are the markets where trades are directly negotiated between two or more counterparties. In this type of market, the securities are traded and settled over the counter among the counterparties directly. 35 Exchange Traded Markets: The other option of trading in securities is through the stock exchange route, where trading and settlement is done through the stock exchange. The trades executed on the exchange are settled through a clearing corporation, which acts as a counterparty and guarantees the settlement of the trades to both buyers and sellers. Trading: A formal contract to buy/sell securities is termed as trading. As defined above, trading can be done either in the Over-The-Counter (OTC) or Exchange Traded Market. Securities/stock exchanges in India feature an electronic order matching system that facilitates automatic, speedy and efficient execution of trades. Clearing and Settlement: Clearing and settlement are post trading activities that constitute the core part of equity trade life cycle. Clearing activity is all about ascertaining the net obligations of buyers and sellers for a specific time period. Settlement is the next step of settling obligations by buyers and sellers by paying money (if transaction is a buy transaction) or delivering securities (if it is a sell transaction). While OTC transactions are settled directly between the counterparties, clearing corporation is the entity through which settlement of securities takes place for all the trades done on stock exchanges. The details of all transactions performed by the members (and their brokers) are made available to the Clearing Corporation by the stock exchange. The Clearing Corporation gives an obligation report to members and custodians who are required to settle their money or securities obligations within the specified deadlines, failing which they are required to pay penalties. In practice, the clearing corporation provides full novation of contracts between buyers and sellers, which means it acts as buyer to every seller and seller to every buyer. As a result, the operational risk of the transaction is substantially reduced to a trading investor. Risk Management: In OTC transactions, counterparties are expected to take care of the credit risk on their own. In exchange traded world, the clearing corporation, as defined above, gives settlement guarantee of trades to the counterparties (all buyers and sellers). This exposes the clearing corporation to the risk of default by the buyers and sellers. To handle this risk, the clearing corporation charges various kinds of margins, most prominent among these margins are Initial or upfront margin and mark to market (MTM) margins. Initial margin is a percentage of transaction value arrived at based on concept of “Value At Risk” philosophy and MTM margin is the notional loss which an outstanding trade has suffered during a specified period on account of price movements. 2.3 Market Participants and their Activities Market Participants in securities markets include buyers, sellers and various intermediaries between the buyers and sellers. Some of these entities are defined in brief below: 2.3.1 Market Infrastructure Institutions and other intermediaries Stock Exchanges -Stock Exchanges provide a trading platform where buyers and sellers can 36 transact in already issued securities. Stock markets such as NSE, BSE and MSEI are nationwide exchanges. Trading happens on these exchanges through electronic trading terminals which feature anonymous order matching. Stock exchanges also appoint clearing and settlement agencies and clearing banks that manage the funds and securities settlement that arise out of these trades. Depositories - Depositories are institutions that hold securities (shares, debentures, bonds, government securities, mutual fund units) of investors in electronic form. Investors open an account with the depository through a registered Depository Participant. They also provide services related to transactions in the securities held in dematerialized form. Currently there are two Depositories in India that are registered with SEBI—Central Depository Services Limited (CDSL), and National Securities Depository Limited (NSDL). Depository Participant- A Depository Participant (DP) is an agent of the depository through which it interfaces with the investors and provides depository services. Depository participants enable investors to hold and transact in securities in the dematerialized form. While the investor-level accounts in securities are held and maintained by the DP, the company level accounts of securities issued is held and maintained by the depository. Depository Participants are appointed by the depository with the approval of SEBI. Public financial institutions, scheduled commercial banks, foreign banks operating in India with the approval of the Reserve Bank of India, state financial corporations, custodians, stock- brokers, clearing corporations, NBFCs and Registrar to an Issue and Share Transfer Agents complying with the requirements prescribed by SEBI, can be registered as a DP. Trading Members/Stock Brokers :Trading members or Stock Brokers are registered members of a Stock Exchange. They facilitate buy and sell transactions of investors on stock exchanges. All secondary market transactions on stock exchanges have to be essentially conducted through registered brokers of the stock exchange. Trading members can be individuals (sole proprietor), Partnership Firms or Corporate bodies, who are permitted to become members of recognized stock exchanges subject to fulfilment of minimum prudential requirements. Trades have to be routed only through the trading terminals of registered brokers of an exchange, to be accepted and executed on the exchange electronic system. Brokers can trade on their own account using their own funds. Such transactions are called proprietary trades. SEBI registration to a broker is granted based on factors such as availability of adequate office space, equipment and manpower to effectively carry out his activities, past experience in securities trading etc. SEBI also ensures the capital adequacy of brokers by requiring them to deposit a base minimum capital with the stock exchange and limiting their gross exposures to a multiple of their base capital. 37 Brokers receive a commission for their services, which is known as brokerage. Several brokers provide research, analysis and recommendations about securities to buy and sell, to their investors. Authorized persons (AP): Authorised Persons are agents of the brokers (previously referred to as sub-brokers) and are registered with the respective stock exchanges.7 APs help in reaching the services of brokers to a larger number of investors. Several brokers provide various services such as research, analysis and recommendations about securities to buy and sell, to their investors. Brokers may also enable screen-based electronic trading of securities for their investors, or support investor orders over phone. Brokers earn a commission for their services. Custodians: A Custodian is an entity that is vested with the responsibility of holding funds and securities of its large clients, typically institutions such as banks, insurance companies, and foreign portfolio investors. Besides safeguarding securities, a custodian also settles transactions in these securities and keeps track of corporate actions on behalf of its clients. It helps in:  Maintaining a client’s securities and funds account  Collecting the benefits or rights accruing to the client in respect of securities held  Keeping the client informed of the actions taken or to be taken on their portfolios. Clearing Corporation - Clearing Corporations play an important role in safeguarding the interest of investors in the Securities Market. Clearing agencies ensure that members on the Stock Exchange meet their obligations to deliver funds or securities. These agencies act as a legal counterparty to all trades and guarantee settlement of all transactions on the Stock Exchanges. It can be a part of an exchange or a separate entity. Clearing Banks - Clearing Bank acts as an important intermediary between clearing members and the clearing corporation. Every clearing member needs to maintain an account with the clearing bank. It is the clearing member’s responsibility to make sure that the funds are available in its account with clearing bank on the day of pay-in to meet the obligations arising out of trades executed on the stock exchange. In case of a pay-out, the clearing member receives the amount in their account with clearing bank, on pay-out day. Merchant Bankers- Merchant bankers are entities registered with SEBI and act as issue managers, investment bankers or lead managers. They help an issuer access the security market with an issuance of securities. 7Vide SEBI Circular: SEBI/HO/MIRSD/DoP/CIR/P/2018/117 dated August 3, 2018, all the registered Sub-Brokers needed to migrate to act as an AP and/ or Trading Member (TM). 38 They are single point of contact for issuers during a new issue of securities. They evaluate the capital needs of issuers, structure an appropriate instrument, get involved in pricing the instrument and manage the entire issue process until the securities are issued and listed on a stock exchange. They engage and co-ordinate with other intermediaries such as registrars, brokers, bankers, underwriters and credit rating agencies in managing the issue process. Underwriters - Underwriters are intermediaries in the primary market who undertake to subscribe any portion of a public offer of securities which may not be bought by investors. They serve an important function in the primary market, providing the issuer the comfort that if the securities being offered to public do not elicit the desired demand from investors, they (underwriters) will step in and buy the securities. When the underwriters make their commitments at the initial stages of the IPO, it is called hard underwriting. For example, if the shares are not subscribed by investors, then the underwriters have to bring in the amount by subscribing to the shares. Soft underwriting is the commitment given once the pricing is determined. The shares that devolve are usually placed with other financial institutions, thereby limiting the risk to the underwriter. Soft underwriting also comes with a clause that provides the option to exit from the commitment in the event of certain events occurring. The risk in hard underwriting is much higher than in soft underwriting. 2.3.2 Institutional Participants Investors in securities market can be broadly classified into Retail Investors and Institutional Investors. Institutional Investors comprises mutual funds, pension funds, insurance companies, hedge funds, alternative investment funds, foreign portfolio investors and Investment Advisers. Some of them are defined here in brief: Mutual Funds: A mutual fund is a professionally managed collective investment scheme that pools money from many investors to purchase securities on their behalf. Mutual fund companies invest the pooled money in stocks, bonds, and other securities, depending upon the investment objective of the scheme which is stated upfront. A fund manager, with the help of a research team, takes all the major decision in terms of which companies to invest in, the percentage of each stock in the portfolio, when to exit and so on. Pension Funds: A fund established to facilitate and organize the investment of the retirement funds contributed by the employees and employers or even only the employees in some cases. The pension fund is a common asset pool meant to generate stable growth over the long term, and provides a retirement income for the employees. Pension funds are commonly 39 run by a financial intermediary for the company and its employees, although some larger corporations operate their pension funds in-house. Insurance Companies: Insurance companies' core business is to insure assets. Depending on the type of assets that are insured, there are various insurance companies like life insurance and general insurance etc. These companies have huge corpus and they are one of the most important investors in the Indian economy by investing in equity investments, government securities and other bonds. Like mutual funds, each insurance company also has designated people who are responsible for investment decisions. Alternative Investment Funds: The SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations) define the term ‘Alternative Investment Fund’ (AIF) as one which is primarily a privately pooled investment vehicle. Under the SEBI AIF Regulations 2012, we can list the following types of funds as AIFs: Venture Capital Fund, Angel Fund, Private Equity Fund, Debt Fund, Infrastructure Fund, SME Fund, Hedge Fund and Social Venture Fund. Foreign Portfolio Investors (FPIs): A Foreign Portfolio investor (FPI) is an entity established or incorporated outside India that proposes to make investments in India. These international investors must register with the SEBI to participate in the Indian securities markets. Investment Advisers: Investment advisers work with investors to help them decide on asset allocation and make a choice of investments based on an assessment of their needs, time horizon return expectation and ability to bear risk. They may also be involved in creating investment plans for investors, where they help investors define their financial goals and propose appropriate saving and investment strategies to meet these goals. The details are discussed later. EPFO: EPFO (Employees’ Provident Fund Organization) is a statutory body set up under the Employees’ Provident Funds & Miscellaneous Provisions Act, 1952. EPFO comes under the purview of Ministry of Labour and Employment. From 2015, EPFO is allowed to invest up to 15 per cent of incremental deposits in equity or equity related schemes.8 National Pension System: National Pension System (NPS) is a pension cum investment scheme launched by Government of India to provide old age security to Citizens of India. This defined contribution pension system is regulated by P