NISM-Series XV Research Analyst Certification Examination PDF
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2023
NISM
Dr. C.K.G. Nair
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This document is a workbook for the NISM-Series-XV Research Analyst Certification Examination, published by the National Institute of Securities Markets (NISM) in May 2023. It covers various topics relating to investments, including Indian securities markets, fundamental and quantitative analysis of companies, industry trends, risk and return, valuation, and corporate actions.
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XV Research Analyst Workbook for NISM-Series-XV: Research Analyst Certification Examination National Institute of Securities Markets www.nism.ac.in This workbook has been de...
XV Research Analyst Workbook for NISM-Series-XV: Research Analyst Certification Examination National Institute of Securities Markets www.nism.ac.in This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Certification Examination for Research Analyst (NISM-Series-XV: Research Analyst Certification Examination). Workbook Version: May 20231 Published by: National Institute of Securities Markets © National Institute of Securities Markets, 2020 NISM Registered Office 5th floor, NCL Cooperative Society, Plot No. C-6, E-Block, Bandra Kurla Complex, Bandra East, Mumbai, 400051 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. 1 This version of the workbook is for candidates appearing for NISM Series XV: Research Analyst Certification Examination on or after June 30, 2023. 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. This book covers all important topics required to undertake research on companies. These include the basics of Indian securities markets, various terminologies used in the equity and debt markets, top down and bottom up approach to fundamental research, basic principles for micro and macro-economic analysis and key industry drivers, qualitative and quantitative dimensions with respect to company analysis, fundamentals of risk and return, valuation principles, corporate actions and the regulatory environment. The book also covers the essential aspects of writing a good research report. It will be immensely useful to all those who want to learn about the various aspects of equity research. Dr. C.K.G. Nair Director Disclaimer The contents of this publication do not necessarily constitute or imply its endorsement, recommendation, or favoring by the National Institute of Securities Markets (NISM) or the Securities and Exchange Board of India (SEBI). This publication is meant for general reading and educational purpose only. 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 what so ever based on any information contained herein. While the NISM Certification examination will be largely based on material in this workbook, NISM does not guarantee that all questions in the examination will be from material covered herein. 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 (CPE) Programmes on Mutual Funds, Equities, Derivatives, Securities Operations, Compliance, Research Analysis, Investment Advice, Portfolio Management 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. About the Workbook This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Certification Examination for Research Analyst. NISM-Series-XV: Research Analyst Certification Examination seeks to create a common minimum knowledge benchmark for all associated persons registered as Research Analyst under SEBI (Research Analyst) Regulations, 2014, individuals employed as research analyst and partners of a Research Analyst. The book covers all important topics required to perform research on companies. These include the basics of Indian securities markets, various terminologies used in the equity and debt markets; top down and bottom up approach to fundamental research; basic principles for micro and macro- economic analysis and key industry drivers; qualitative and quantitative dimensions with respect to company analysis; fundamentals of risk and return; valuation principles; philosophy of various corporate actions and the legal and regulatory environment. The book also covers the essential aspects of writing a good research report. Acknowledgement This workbook has been developed jointly by the Certification Team of NISM and Mr. Manish Bansal and reviewed by Mr. Bihari Lal Deora, NISM’s Resource Persons. NISM gratefully acknowledges the contribution of the Examination Committee for NISM-Series-XV: Research Analyst Certification Examination consisting of industry experts. About the Certification Examination for Research Analyst The examination seeks to create a common minimum knowledge benchmark for all associated persons registered as research analyst under SEBI (Research Analyst) Regulations, 2014, individuals employed as research analyst and partners of a research analyst, engaged in preparation and/or publication of research report or research analysis. An associated person shall be required to pass the NISM-Series-XV: Research Analyst Certification Examination to fulfill the requirements specified under Regulation 7(2) of the SEBI (Research Analysts) Regulations, 2014. This certification aims to enhance the quality of services provided by research analyst in the financial services industry. Examination Objectives On successful completion of the examination, the candidate should: Know the basics of Indian securities markets and different terminologies used in equity and debt markets. Know about the top down and bottom-up approach to fundamental research. Know the basic principles for micro and macro-economic analysis, the sources of different information for analysis and the various macroeconomic variables affecting the analysis. Know the key industry drivers and sources of information for industry analysis. Understand about the qualitative and quantitative dimensions with regards to company analysis. Know about the fundamentals of risk and return, valuation principles and the philosophy of various corporate actions. Understand the qualities of a good research report. Assessment Structure The examination consists of 92 multiple choice questions of 1-mark each and 2 case-based questions (each case having 4 questions of 1-mark each), adding to a total of 100 marks. The assessment structure is as follows: Multiple Choice Questions [92 questions of 1 mark each] 92*1 = 92 Case-based Questions [2 cases (each case with 4 questions of 1 mark each)] 2*4*1 = 8 The examination should be completed in 2 hours. The passing score for the examination is 60 marks (i.e., 60%). There shall be negative marking of 25% of the marks assigned to the question for each wrong answer. 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 case lets and multiple choice questions illustrated in the book are for reference purposes only. The level of difficulty may vary in the actual examination. CONTENTS CHAPTER 1: INTRODUCTION TO RESEARCH ANALYST PROFESSION....................................... 13 1.1 Primary Role of a Research Analyst............................................................................................ 13 1.2 Primary Responsibilities of a Research Analyst.......................................................................... 14 1.3 Basic Principles of Interaction with Companies/Clients............................................................. 16 1.4 Important Qualities of a Research Analyst................................................................................. 17 CHAPTER 2: INTRODUCTION TO SECURITIES MARKET........................................................... 20 2.1 Introduction to Securities and Securities Market...................................................................... 20 2.2 Product Definitions / Terminology............................................................................................. 22 2.3 Structure of Securities Market................................................................................................... 32 2.4 Various Market Participants and Their Activities....................................................................... 37 2.5 Kinds of Transactions.................................................................................................................. 43 2.6 Dematerialization and Rematerialization of securities.............................................................. 47 CHAPTER 3: TERMINOLOGY IN EQUITY AND DEBT MARKETS................................................ 49 3.1 Terminology in Equity Market.................................................................................................... 50 3.2 Terminology in Debt Market...................................................................................................... 57 3.3 Types of Bonds........................................................................................................................... 61 CHAPTER 4: FUNDAMENTALS OF RESEARCH......................................................................... 68 4.1 What is Investing?...................................................................................................................... 68 4.2 The role of research in investment activity................................................................................ 69 4.3 Technical Analysis....................................................................................................................... 70 4.4 Fundamental Analysis................................................................................................................. 71 4.5 Quantitative Research................................................................................................................ 72 4.6 Behavioral Approach to Equity Investing................................................................................... 73 CHAPTER 5: ECONOMIC ANALYSIS....................................................................................... 75 5.1 Basic Principles of Microeconomics........................................................................................... 75 5.2 Basic Principles of Macroeconomics.......................................................................................... 76 5.3 Introduction to Various Macroeconomic Variables................................................................... 76 5.4 Role of economic analysis in fundamental analysis................................................................... 84 5.5 Secular, cyclical and seasonal trends.......................................................................................... 85 5.6 Sources of Information for Economic Analysis........................................................................... 88 CHAPTER 6: INDUSTRY ANALYSIS......................................................................................... 90 6.1 Role of industry analysis in fundamental analysis...................................................................... 90 6.2 Defining the industry.................................................................................................................. 90 6.3 Understanding industry cyclicality............................................................................................. 92 6.4 Market sizing and trend analysis................................................................................................ 93 6.5 Secular trends, value migration and business life cycle............................................................. 93 6.6 Understanding the industry landscape...................................................................................... 97 6.7 Key Industry Drivers and Industry KPIs..................................................................................... 107 6.8 Regulatory environment/framework....................................................................................... 110 6.9 Taxation.................................................................................................................................... 110 6.10 Sources of information for industry analysis............................................................................ 113 CHAPTER 7: COMPANY ANALYSIS – BUSINESS AND GOVERNANCE...................................... 115 7.1 Role of company analysis in fundamental research................................................................. 115 7.2 Understand Business and Business Models............................................................................. 116 7.3 Pricing Power and Sustainability of This Power....................................................................... 117 7.4 Competitive Advantages/Points of differentiation over the Competitors............................... 117 7.5 Strengths, Weaknesses, Opportunities and Threats (SWOT) Analysis..................................... 119 7.6 Quality of Management and Governance Structure................................................................ 122 7.7 Risks in the Business................................................................................................................. 126 7.8 History of credit rating............................................................................................................. 127 7.9 ESG framework for company analysis...................................................................................... 127 7.10 Sources of Information for Analysis......................................................................................... 128 CHAPTER 8: COMPANY ANALYSIS – FINANCIAL ANALYSIS................................................... 130 8.1. Introduction to financial statement......................................................................................... 131 8.2. Stand-alone financial statement and consolidated financial statement.................................. 131 8.3. Balance Sheet........................................................................................................................... 133 8.4. Basics of Profit and Loss Account (P/L).................................................................................... 139 8.5. Statement of changes in shareholder’s equity......................................................................... 145 8.6. Basics of Cash Flows................................................................................................................. 146 8.7. Notes to accounts..................................................................................................................... 150 8.8. Important Points to Keep In Mind While Looking At Financials............................................... 151 8.9. Reading audit report to understand the quality of accounting............................................... 151 8.10. Financial statement analysis using ratios................................................................................. 152 8.11. Commonly used ratios.............................................................................................................. 154 8.12. Dupont analysis........................................................................................................................ 160 8.13. Forecasting using ratio analysis................................................................................................ 161 8.14. Peer Comparison...................................................................................................................... 162 8.15. Other aspects to study from financial reports......................................................................... 162 CHAPTER 9: CORPORATE ACTIONS..................................................................................... 171 9.1 Philosophy of Corporate Actions.............................................................................................. 171 9.2 Dividend.................................................................................................................................... 172 9.3 Rights Issue............................................................................................................................... 172 9.4 Bonus Issue............................................................................................................................... 174 9.5 Stock Split................................................................................................................................. 174 9.6 Share Consolidation.................................................................................................................. 175 9.7 Merger and Acquisition............................................................................................................ 176 9.8 Demerger / Spin-off.................................................................................................................. 177 9.9 Scheme of arrangement........................................................................................................... 177 9.10 Loan Restructuring................................................................................................................... 177 9.11 Buyback of Shares..................................................................................................................... 178 9.12 Delisting and relisting of Shares............................................................................................... 179 9.13 Share Swap............................................................................................................................... 180 CHAPTER 10: VALUATION PRINCIPLES................................................................................ 182 10.1 Difference between Price and Value........................................................................................ 182 10.2 Why Valuations are required.................................................................................................... 182 10.3 Sources of Value in a Business – Earnings and Assets.............................................................. 183 10.4 Approaches to valuation.......................................................................................................... 183 10.5 Discounted Cash Flows Model for Business Valuation............................................................. 184 10.6 Relative valuation..................................................................................................................... 189 10.7 Earnings Based Valuation Matrices.......................................................................................... 189 10.8 Assets based Valuation Matrices.............................................................................................. 193 10.9 Relative Valuations - Trading and Transaction Multiples......................................................... 196 10.10 Sum-Of-The-Parts (SOTP) Valuation......................................................................................... 197 10.11 Other Valuation Parameters in New Age Economy and Businesses........................................ 197 10.12 Capital Asset Pricing Model...................................................................................................... 197 10.13 Objectivity of Valuations.......................................................................................................... 197 10.14 Some Important Considerations in the Context of Business Valuation................................... 198 CHAPTER 11: FUNDAMENTALS OF RISK AND RETURN......................................................... 204 11.1 Concept of Return of Investment and Return on Investment.................................................. 204 11.2 Calculation of Simple, Annualized and Compounded Returns................................................. 204 11.3 Risks in Investments................................................................................................................. 207 11.4 Measuring risk.......................................................................................................................... 212 11.5 Concepts of Market Risk (Beta)................................................................................................ 213 11.6 Sensitivity Analysis to Assumptions......................................................................................... 214 11.7 Concept of Margin of Safety..................................................................................................... 214 11.8 Comparison of Equity Returns with Bond Returns................................................................... 214 11.9 Calculating risk adjusted returns.............................................................................................. 215 11.10 Basic Behavioral Biases Influencing Investments..................................................................... 216 11.11 Some Pearls of Wisdom from Investment Gurus across the World......................................... 217 11.12 Measuring liquidity of equity shares........................................................................................ 219 CHAPTER 12: QUALITIES OF A GOOD RESEARCH REPORT.................................................... 221 12.1 Qualities of a Good Research Report....................................................................................... 221 12.2 Checklist Based Approach to the Research Reports................................................................. 223 12.3 A Sample Checklist for Investment Research Reports............................................................. 224 CHAPTER 13: LEGAL AND REGULATORY ENVIRONMENT..................................................... 228 13.1 Regulatory infrastructure in Financial Markets........................................................................ 228 13.2 Important regulations in Indian Securities Market.................................................................. 232 13.3 Code of Conduct for Research Analysts................................................................................... 246 13.4 Management of Conflicts of Interest and Disclosure Requirements for Research Analysts... 247 13.5 Exchange surveillance mechanisms: GSM and ASM................................................................ 255 ANNEXURE- 1.................................................................................................................... 262 ANNEXURE- 2.................................................................................................................... 264 ANNEXURE - 3................................................................................................................... 266 ANNEXURE - 4................................................................................................................... 274 Syllabus Outline with Weightages Chapter No. Chapter Name Weightage Chapter 1 Introduction to Research Analyst Profession 3 Chapter 2 Introduction to Securities Market 4 Chapter 3 Terminology in Equity and Debt Markets 4 Chapter 4 Fundamentals of Research 5 Chapter 5 Economic Analysis 10 Chapter 6 Industry Analysis 10 Chapter 7 Company Analysis – Business and Governance 8 Chapter 8 Company Analysis – Financial Analysis 16 Chapter 9 Corporate Actions 5 Chapter 10 Valuation Principles 16 Chapter 11 Fundamentals of Risk and Return 5 Chapter 12 Qualities of a Good Research Report 4 Chapter 13 Legal and Regulatory Environment 10 CHAPTER 1: INTRODUCTION TO RESEARCH ANALYST PROFESSION LEARNING OBJECTIVES: After studying this chapter, you should know about: Role of a research analyst Primary responsibilities of a research analyst Basic principles of interaction with companies and/or clients Important qualities that are desired in a Research Analyst 1.1 Primary Role of a Research Analyst Imagine you've decided to buy a new phone. What would be your process of selection? For the price range decided, you would short list a set of brands, compare various technical specifications and depending upon what factors are important to you - whether it’s the battery-life or the megapixels of camera, you take the decision. This process is very similar to the kind of work Research Analysts (RAs) do, to help their clients take investment decisions. There is Research - collection of information from various sources and then Analysis - processing of data to take decisions. Data and information are imperative to the function of the research analyst. RAs need information pertinent to the investment being evaluated. This would include information about the macro and micro economic factors, industry-specific information and company-specific information. Economic information may be collected from government statistics and data provided by the central bank i.e. the Reserve Bank of India. Data on global factors may be collected from International agencies such as the International Monetary Fund (IMF), Asian Development Bank (ADB), World Bank and other Global Development Financial Institutions. Industry-specific journals and publications may be used to collect information on industries/sectors. Company-specific information may be collected from various sources including the financial statements/Annual reports filed by the companies as part of regulatory compliance requirements, meeting officials of the company authorized to provide it and other sources such as plant/factory visits, market surveys and employee/stakeholder interviews. Analysis and decision making process is a combination of understanding qualitative factors that affect operational performance, such as efficiency of operations, competitiveness, business plans and work ethics of the management among others and quantitative factors such as revenues, costs, profitability and risks to these financials. Therefore, RAs spend lot of time interacting with companies and others, accumulating data, analysing it and arriving at a decision on whether to buy, hold or sell a particular security/stock. Research Analysts are defined by the nature of analysis they do, the coverage, and use of the recommendations they provide. Let us understand some of them: Sell-side Analysts - They typically publish research reports in public domain on the securities of companies or industries with specific recommendation to buy, hold, or sell the subject security. These recommendations include the analyst’s expectations of the future earnings of the company and future price performance of the security (“price target”). These analysts work for firms that provide investment banking, broking, advisory services for clients. Buy-side Analysts - They generally work for Asset managers like mutual funds, hedge funds, pension funds, Alternative investment funds, Foreign Portfolio investors or portfolio managers that purchase and sell securities for their own investment accounts or on behalf of their investors/clients. These analysts generate investment recommendations for their internal consumption viz. use by the fund managers within organization. Research reports of these analysts are generally circulated among the top management/investment managers of the employer firms as these reports contain recommendations about which securities to buy, hold or sell. These reports are usually only for internal consumption and are not available in public domain. Independent Research Analysts - They work for research originators or boutique firms separate from full-service investment firms and sell their research to others on a subscription basis. Their clients could be investors, institutions, investment bankers, regulators, stock exchanges, fund managers etc. They also provide customized research reports on the businesses or industries or sectors on specific requests. The purpose of these reports could vary from investment activity to understanding competition landscape to mergers and acquisition etc. Apart from these three main categories, entities such as newspapers, media and consolidators of information also provide research reports. In a nutshell, role of a research analyst is that of a selector - to do a comprehensive study of companies, evaluate their past performance, analyse how a company is expected to perform in the future and make recommendations based on this analysis. 1.2 Primary Responsibilities of a Research Analyst As stated before, Research Analysts’ primary role is to understand and evaluate the growth of industries and companies. Let us briefly look into the aspects which the Research Analysts explore while evaluating industries, companies and/or economies. Understanding economy: British economist John Maynard Keynes (1883–1946) believed that governments could change economic performance of its industries by adjusting tax rates and government spending. Therefore, as growth depends, to a great extent, on the economic environment, it becomes important for analysts to understand the economy. For this, the following are their focus areas: Changes in various macro-economic factors like - National income, Inflation, Interest rate and Unemployment rate Fiscal and Monetary Policies and their impact on the economy Flows from Foreign Direct Investment (FDI) and Foreign Portfolio Investors (FPIs) Savings and investment patterns Global factors that impact the GDP growth based on export and import transactions We shall know more about economic analysis in Chapter5. Understanding industry: Different industries face different challenges and opportunities. Their growth drivers could be significantly different. Accordingly, Research Analysts need to understand thoroughly the regulatory environment prevalent in the industry, business models, competition, operating factors, sensitivity of demand to price changes, consumers’ behaviour etc. We shall explore the methods for Industry analysis using various tools and techniques in Chapter 6. Understanding Companies: Rahul Dravid and Virender Sehwag were both great batsmen, but were two very different players. Their statistics (in terms of strike rate and so on) and their style (defensive and aggressive) are very different from each other. If one asks - who would perform better? Then a deeper analysis of the pitch, game type and the opposition team’s bowling strengths may help us answer the question, although only with probability and not with certainty. Just as in the case of players' statistics and style, companies in the same industry may vary significantly in their approach towards business. Based on their styles, product configuration, business model, customers segment, their financials could also vary dramatically. Accordingly, companies are also studied by analysts in two dimensions - Qualitatively and Quantitatively. Qualitative understanding is more about understanding why a particular business is better when compared to its peers, what are the strengths and weakness of the business model, how qualified and capable the management is and so on. Quantitative understanding would be more mathematical in nature. In this, analysts try to understand the balance sheets and profit and loss statements of last few years, cash flows, assets and liabilities and so on. We shall look at both the approaches (Qualitative and Quantitative) of company analysis in great detail in Chapters 7 and 8 respectively. 1.3 Basic Principles of Interaction with Companies/Clients Though the power of internet gives an analyst the ability to acquire a lot of information, it cannot substitute direct interaction with companies and clients. Personal communication with management helps them to get a better insight in to the vision of the company and its strategy to achieve the desired goals. However, it may also happen that management mislead the analysts by deliberately exaggerating positives about business (painting rosy pictures) to encourage them to write positive stories to influence the market prices positively. Therefore, it is always advisable for analysts to cross verify the claims of the management prior to their recommendations. This communication with management, like any other, requires analysts to have clarity of thoughts and good listening ability but there are a few additional principles that analysts must keep in mind while talking to the management of a company. The following are a few: Pre-meeting Research - While the management is generally open to interview with Research Analysts, they must bear in mind that these opportunities do not come very frequently and therefore must be made full use of whenever they come. Before going to meet a company's management, they must thoroughly learn about the company’s products, industry and competitors. Analysts must be familiar with the financial information of the company, also read previous year’s annual reports to understand the direction of the company and whether the company has been able to achieve the goals it had intended to. Independence and Neutrality of view - During the research, analysts must have an unbiased opinion and should always hold their independence. Their analysis should be based on factual information and not led by personal inclinations. Also, they must make it clear with the management to not reveal any information which is not available in the public domain. Network - Analysts may use their network to acquire more contacts relevant to the research, who would be able to provide meaningful insights into the company’s performance and plans. The person who is responsible for the important activities and understands the heartbeat of the company would be the most relevant contact and this person may not necessarily be from top management. Competitors and other stakeholders of the business such as suppliers, distributors, retailers and customers can also provide meaningful inputs to analysts in the research process. Clarity of questions - As analysts start analysing a company, there would be certain aspects on which they might need more clarity. Time with management would be effectively used if analysts have clear and specific set of questions in mind. It is advisable to go with a questionnaire to have a better understanding of the company's operations and future progress. Once analysts are done with research and research report is prepared, they need to communicate their findings to the clients. There are certain guidelines that an analyst could follow in their communication with clients. They must be realistic in suggesting companies to their clients. Suggestions should be based on facts and figures and not contain an optimistic/pessimistic/biased view on the subject company. Communication, done through written research reports, should be simple, clear and concise. If there is any conflict of interest (e.g. RA holds shares of the subject company), such information should be disclosed beforehand. Assumptions, if any, must be clearly stated in the research reports. Abbreviations/Jargons should either be avoided or explained clearly in simple words. The role of RAs is to collect data/information from different reliable sources, interpret the data/information and convert it into recommendations that their clients can use. While doing so, it is expected that RAs would perform their role with utmost sincerity, honesty and ethics without any bias, following all the rules and regulations as specified by SEBI both in words and spirit. For this, it is also recommended to make use of technology like recording devices while interviewing management and communicating with clients, only after taking their due consent for recording. 1.4 Important Qualities of a Research Analyst The job of research analysts requires quantitative and qualitative skills. An analyst needs to have a high degree of comfort in dealing with numbers to be able to analyse various financial factors, identify trends and see the inter-relationship between different factors. At the same time, he needs to be methodical, have an enquiring mind and be discerning to know where to find relevant information. Ability to understand business models and competitive dynamics in a business is another important quality an analyst must possess. Using these skills, a research analyst comes to the conclusion whether he would be in favour of or against investing in a particular industry or company. Qualities that are desired in a good research analyst are: Good with numbers Good Excel (spread sheet) and other data analytical tools Clarity in financial concepts Ability to read and comprehend financial statements and reports Ability to ask pertinent questions Attention to details Communication Skills – Written and Verbal Sample research reports: https://www.bseindia.com/investors/Research.aspx https://www.nseindia.com/education/content/reports/eq_research_reports.htm Sample Questions 1. What is the role of Research Analyst? a. RAs are only involved in the analysis of data b. RAs are only involved in collection of the data c. RAs help their clients take informed decisions d. RAs help in financial planning of their client 2. Analysis and Decision making, the two imperative parameters involved in are affected by which of the following factors? a. Management Ethics b. Revenues and Costs c. Efficiency of operations d. All of the above 3. Sell side Analyst generally work for money managers like mutual funds, hedge funds, portfolio managers who purchase and sell securities for their own investment accounts or on behalf of their clients. State whether True or False. a. True b. False 4. Which of these Qualities are desired in a good research analyst? a. Knack for numbers and interpretation b. Clarity in financial concepts c. Ability to read and understand financial statement d. All of the above CHAPTER 2: INTRODUCTION TO SECURITIES MARKET LEARNING OBJECTIVES: After studying this chapter, you should know about: Meaning of securities and the functions of securities market Various kinds of products in securities market Structure of securities market Activities of the securities market participants Various securities market transactions Dematerialization and Rematerialisation of securities 2.1 Introduction to Securities and Securities Market Securities are transferrable financial instruments or contracts that show evidence of indebtedness or ownership interest in assets of an incorporated entity. These include equity shares, preference shares, debentures, bonds and other such instruments. These are issued by companies, financial institutions or the government. They are purchased by investors who have money to invest. Security ownership allows investors to convert their savings into financial assets which provide a return. On the other hand, security issuance allows borrowers to raise money at a cost. Thus, the objectives of the issuers and the investors are complementary. Raising fund through issue of securities also allows the investors to transfer their rights / interests to others without impacting the issuers. Thus, securities also provide a mechanism for issuers to raise money for long term while providing an opportunity to the investors to exit. The efficacy of security in allowing movement of capital is achieved through an efficient securities market that allows investors and sellers to buy and sell securities. Securities market brings together a large number of buyers and sellers and thus creates liquidity i.e. makes it easy to buy and sell securities at close to market prices. These markets help 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. Through securities market, a broader universe of savers with surplus to invest is available to the issuers of securities and a universe of wider options is available to savers to invest their money. Broadly stating, Financial Market consists of: Investors/Providers of funds (buyers of securities) Borrowers/Seekers of funds (sellers of securities) Intermediaries (providing the infrastructure to facilitate transfer of funds and securities) Regulatory bodies (responsible for orderly development of the market) The term “securities” has been defined in the Section 2(h) of Securities Contracts (Regulation) Act, 1956(SCRA). The term ‘Securities’ include: 1. 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; 2. Derivative 3. Units or any other instrument issued by any collective investment scheme to the investors in such schemes units 4. 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 5. Units or any other such instrument issued to the investors under any mutual fund scheme Explanation.—For the removal of doubts, it is hereby declared that securities" shall 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);] 6. units or any other instrument issued by any pooled investment vehicle; 7. Any certificate or instrument (by whatever name called), issued to an investor by an 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. 8. Government securities Such other securities as may be declared by the Central Government to be securities and Rights or interest in securities For e.g. Eletronic Gold receipts are declared as securities vide gazette notification dated 24 December 2021. Electronic Gold Receipt” means an electronic receipt issued on the basis of deposit of underlying physical gold in accordance with the regulations made by the Securities and Exchange Board of India under section 31 of the said Act. The investors in the Indian securities market have a wide choice of financial products to choose from depending upon their risk appetite and return expectations. Broadly, the financial products can be categorized as equity, debt and derivative products. We shall learn more about these securities in detail in the next section. 2.2 Product Definitions / Terminology There are many financial instruments issued in the market, each with distinct risk and return characteristics that define its suitability for an investor. In this section, we shall explore the major instruments available in the Indian Securities Market. 2.2.1 Equity Shares Issued by: Companies or Issuers Investors: Institutional (FPI, FII, DII) and Individual (Retail and HNI) Medium: Direct issuance by companies and Stock Exchange Regulator: SEBI, Regulators under the Companies Act Equity shares represent the form of fractional ownership in a business venture. Equity shareholders collectively own the company. They bear the risk and enjoy the rewards of ownership. 2.2.2 Debentures/Bonds/Notes Issued by: Companies, Government, Special Purpose Vehicles (SPVs), Other Issuers Investors: Institutional and Individual Medium: Direct issuance by issuers and Stock Exchange (If listed) Regulator: RBI, SEBI, Regulators under the Companies Act Debentures/Bonds/Notes are instruments for raising long term debt. Debentures are either unsecured or secured (backed by collateral support) in nature. There are variety of debentures/bonds such as fully convertible, non-convertible and partly convertible debentures. These could be in Domestic as well as Foreign currency. Fully convertible debentures are fully convertible into ordinary shares of the issuing company. The terms of conversion are specified at the time of issue itself. Partly convertible debentures (PCDs) are partly convertible into ordinary shares of the issuing company under specified terms and conditions as specified at the time of issue itself. The non- convertible part of these debentures is redeemed as happens in any other vanilla debenture. Non-Convertible Debentures (NCDs) are pure debt instruments without a feature of conversion. The NCDs are repayable/redeemable on maturity. Thus, debentures can be pure debt or quasi-equity, as the case may be (we would discuss about these types in section 2.2.7 in further detail). Further, short-term debt instruments are used to raise debt for periods not exceeding one year. These instruments include Treasury Bills issued by the government, Commercial Papers issued by the companies and Certificate of Deposit issued by the banks. 2.2.2.1 Foreign currency bonds Issued by: Companies, Government, Special Purpose Vehicles (SPVs) Investors: Institutional and Individual Medium: Direct issuance by issuers and Stock Exchange Regulator: Regulators in the respective country of issue Foreign currency bonds are bonds issued by a company in a currency that is different from the currency of its home country. For example, in February 2020, Delhi International Airport Limited (an SPV of GMR Infrastructure Ltd) issued USD bonds. These could also have a feature of conversion into shares if needed, based on preferences of issuers/investors. Companies in emerging markets may prefer to issue bonds in USD or currencies of other economically matured countries as they carry significantly lower interest rates. However, these bonds create significant foreign currency risk to the issuer. In case of the foreign currency (currency of issue of the bond) appreciates against the local currency, the issuer will need higher amount of local currency to repay the loan. 2.2.2.2 External bonds / Masala bonds Issued by: Companies, Government, Special Purpose Vehicles (SPVs) Investors: Institutional and Individual Medium: Direct issuance by issuers and Stock Exchange Regulator: Regulators in the respective country of issue External bonds, also referred as Euro bonds, are bonds issued in a currency that is different from the currency of the country in which it is issued. For example, if a company issues a US dollar denominated bonds in Kuwait, it would be referred as a Euro bond as the currency of the bond (USD) is different from currency of the country in which it is issued (Kuwaiti Dinar). External bonds denominated in Indian rupees (INR) are referred as Masala bonds. These bonds are issued outside of India but are denominated in Indian Rupees. Masala bonds were issued for the first time in November 2014 by International Finance Corporation and was listed in the London Stock Exchange. As against foreign currency bonds, which create currency risk for the issuer, in the case of masala bonds, the currency risk is borne by the investor. Since the bonds are denominated in INR, if INR depreciates against the currency of the country of issue, the amount received by the investor will be less in their local currency terms. 2.2.3 Warrants and Convertible Warrants Issued by: Companies Investors: Institutional and Individual Medium: Direct issuance by companies and Stock Exchange Regulator: SEBI Warrants are options that entitle an investor to buy equity shares of the issuer company after a specified time period at a pre-determined price. Only a few companies in Indian Securities Market have issued warrants till now. 2.2.4 Indices A market index tracks the market movement by using the prices of a specific number of shares chosen as a representative sample. Most leading indices are weighted by market capitalisation to take into account the fact that more the number of shares issued, greater the number of portfolios in which they may be held. Stocks included in an index are also quite liquid, making it possible for investors to replicate the index at a low cost. Narrow indices are usually made up of the most actively traded equity shares in that exchange. Other indices to track sectors or market cap categories are also in use. The most widely tracked indices in India are the NSE’s Nifty 50, S&P BSE Sensex and MSEI’s SX40. The S&P Sensex has been computed as the market cap weighted index of 30 chosen stocks on the BSE. The SX40 is composed of 40 most representative stocks listed on Metropolitan Stock Exchange of India Ltd (MSEIL) and the Nifty 50 is composed of 50 most representative stocks listed on the National Stock Exchange. The shares included in these indices are chosen on the basis of factors such as liquidity, availability of floating stock and size of market capitalization. The composition of stocks in the index is reviewed and modified from time to time to keep the index representative of the underlying market. Some of the other common indices in India are listed below: Nifty Next 50 Nifty 100 Nifty 500 S&P BSE 100 S&P BSE 500 S&P BSE MidCap S&P BSE SmallCap There are also sector indices for banking, information technology, pharma, fast-moving consumer goods and such other sectors, created by the exchanges to enable tracking specific sectors. The major uses of indices are: The index can give a comparison of returns on investments in stock markets as opposed to asset classes such as gold or debt. For the comparison of performance with an active equity fund/portfolio, a stock market index can be the Benchmark. The performance of the economy or any sector of the economy in a country is indicated by the index. Real time market sentiments are indicated by indices. Indices act as an underlying for Index Funds, Index Futures and Options. 2.2.5 Mutual Fund Units Issued by: Mutual Funds Investors: Institutional and Individual Medium: Direct issuance by mutual funds and Stock Exchange Regulator: SEBI Mutual Funds (MFs) are investment vehicles that pool together the money contributed by investors which the fund invests in a portfolio of securities that reflect the common investment objectives of the investors. Each investor’s share is represented by the units issued by the fund. The value of the units, called the Net Asset Value (NAV), changes continuously to reflect changes in the value of the portfolio held by the fund. MF schemes can be classified as open-ended or close-ended. An open-ended scheme offers the investors an option to buy units from the fund at any time and sell the units back to the fund at any time. These schemes do not have any fixed maturity period. The units can be bought and sold anytime at the NAV linked prices. The unit capital of closed-ended funds is fixed and they sell a specific number of units. Units of closed- ended funds can be bought or sold in the Stock Market where they are mandatorily listed. 2.2.6 Exchange Traded Funds (ETFs) Issued by: Mutual Funds Investors: Institutional and Individual Medium: Direct issuance by mutual funds and Stock Exchange Regulator: SEBI, Exchange Traded Fund (ETF) is an investment vehicle that invests funds pooled by investors to track an index, a commodity (e.g Gold) or a basket of assets. It is similar to an index fund in the sense that its portfolio reflects the index it tracks. But, unlike an index fund, the units of the ETF are listed and traded in demat form on a stock exchange and their price changes continuously to reflect changes in the index or commodity prices. ETFs provide the diversification benefits of an index fund as well as the facility to sell or buy at real- time prices, even one unit of the fund. Since an ETF is a passively managed portfolio, its expense ratios are typically lower than that of a mutual fund scheme. 2.2.7 Hybrids/Structured Products 2.2.7.1 Preference Shares: Preference shares, as their name indicates, are a special kind of equity shares which have preference over common/ordinary equity shares at the time of dividend and at the time of repayment of capital in the event of winding up of the company. They have some features of equity and some features of debt instruments. Preference shares resemble equity as preference shareholders are called shareholders of the company (not creditors), payment to them is termed as dividend and the same is paid from the Profit after Tax and dividend payment is not an obligation unlike interest. However, unlike common equity shares, preference shares do not carry voting rights or a right over the residual assets of the company, in case of winding up. Preference shares resemble debt instruments because they offer pre-determined rate of dividend and this dividend is payable before any dividend is paid on common equity. Further, in case of winding up of the company, preference shareholders get paid before common equity holders. In other words, these shareholders have preference over the common equity holders at the time of distribution of both earnings and assets. There are variety of preference shares – cumulative (unpaid dividend is carried forward), non- cumulative (unpaid dividend lapses), convertible partly or fully etc. 2.2.7.2 Convertible Debentures & Bonds: Convertible debentures are debt instruments that can be converted into equity shares of the company at a future date. This security also has features of both debt and equity. It pays periodic coupon/interest just like any other debt instrument till conversion. And, at a pre-defined time, this debt instrument may get converted into equity shares. These debentures may be of different kinds: Fully convertible debentures (FCD) - where the entire face value of the debenture is converted into equity shares Partly convertible debentures (PCD) - where a portion of the debenture is converted into equity. The non-convertible portion continues to remain as debentures, earns interest income and gets repaid on redemption Optionally convertible debentures (OCDs) - OCDs are convertible into equity shares at the discretion of the debenture holders, who may choose to convert them into equity, or continue to hold the instrument as debt depending on their desire and the terms of conversion. The issuer specifies the details of the conversion at the time of making the issue itself. These will generally include: Date on which or before which the conversion may be made Ratio of conversion i.e. the number of shares that the investor will be eligible to get for each debenture Price at which the shares will be allotted to the investor on conversion. Usually, this is at a discount to the market price Proportion of the debenture that will be converted into equity shares (in case of partially convertible debentures) The advantage to the issuer of convertible debenture lies in the fact that convertible debentures usually have a lower coupon rate than pure debt instruments. This is because the yield to the investor in such debenture is not from the coupon alone but also the possibility of capital appreciation in the investment once the debentures are converted into equity shares. Moreover, the issuer does not have to repay the debt on maturity since shares are issued in lieu of repayment. The disadvantage to this is that stakes of the existing shareholders get diluted when fresh shares are issued on conversion. As more shareholders come in, the proportionate holding of existing shareholders fall. The investors in a convertible debenture have the advantage of equity and debt features. They earn coupon income in the initial stage, usually when the company’s project is in its nascent stage. And, once the debenture is converted into shares, they may benefit from the appreciation in the value of the shares. 2.2.7.3 Indian Depository Receipts (IDRs), Global Depository Receipts (GDRs) and American Depository Receipts (ADRs): Depository receipts (DRs) are financial instruments that represent shares of a foreign company. These depositary receipts trade in the local market (in which it is issued) and are denominated in local currency. The process of issuing a depositary receipt is as follows: (i) A company or an investor delivers a specific quantity of equity shares to a bank (ii) The bank places the security in its custodian account in the country where the company is domiciled (iii) The bank then issues a certificate (depositary receipt) against such shares to investors in the overseas market. If the issuing company is the one that delivers the securities and initiates the process, it is referred as sponsored depositary receipts and they can be listed in the exchanges of the country in which the DRs are issues. Companies that want their DRs to be listed should apply for listing and should comply with all the listing requirements. On the other hand, if the shares are delivered by an investor they are referred as unsponsored depositary receipts. Typically, unsponsored DRs are not allowed to be traded in the stock exchanges. They can be traded only in OTC markets. They also have less regulatory requirement. DRs may feature two-way fungibility, subject to regulatory provisions of the countries involved. This means that shares can be bought in the local market and converted into DRs to be traded in the foreign market. Similarly, DRs can be bought and converted into the underlying shares which are traded on the domestic stock exchange. Indian companies are permitted to raise foreign currency resources in the form of issue of ordinary equity shares through depository receipts. Foreign companies are also allowed to raise equity capital from India through IDRs. SEBI has laid down the guidelines to be followed by companies for IDRs. These include the limit on the money raised by a company in India, one year lock-in on the conversion of IDRs into shares, the availability of IDRs to only resident Indian investors, etc. Several stock exchanges around the world allow trading in depositary receipts of a foreign company. These depository receipts can be specific to a country or it can be traded across multiple countries (as in case of GDRs). Some of the country specific depositary receipts include: American Depositary Receipts (ADRs): These depositary receipts issued and traded in U.S.A that are issued by a non-US company. ADRs are one of the most popular depositary receipts and many companies across the world have issued ADRs. Some of the Indian companies that have issued ADR include Infosys, Wipro, ICICI Bank and HDFC Bank. The American exchanges have allowed ADR since the early part of 20th century and thus it is one of the most evolved markets. Indian Depositary Receipts (IDR): DR issued and traded in the Indian market by a non-Indian company is referred as IDR. Depositary receipts of Standard Chartered Bank are traded in the Indian stock market in the form of IDR. Hong Kong Depositary Receipts (HKDR): In the same lines as the above two, HKDRs refers to depositary receipt issued by a non- Hong Kong company that are traded in the Hong Kong market. Global Depositary Receipts (GDRs): These refer to depositary receipts that are allowed to be traded in more than one country. Typically, GDRs are preferred to be issued in the European Union member states as commonality of the regulations makes it easy for the issuing companies to comply with regulation across the region. The company, whose shares are traded as DRs, gets a wider investor base from the international markets. Investors in international markets get to invest in shares of the company that they may otherwise have been unable to do because of several restrictions or administrative issues. Investors get to invest in international stocks through domestic exchanges with their existing brokers and local currency. Holding DRs give investors the right to dividends and capital appreciation from the underlying shares, but no voting rights. However, issue of voting rights to DR holders is under consideration of SEBI at present. 2.2.7.4 Foreign Currency Convertible Bonds (FCCBs): FCCBs or Foreign Currency Convertible Bonds are foreign currency (usually dollar) denominated convertible debt papers issued by companies in international markets. These instruments are to be understood the way convertibles are with only difference that they are generally optionally convertible and issued offshore in different denomination under guidelines as defined by Reserve Bank of India (RBI) from time to time. The payment of interest and repayment of principal (if happens) on these bonds is in foreign currency. However, once conversion of instrument happens in equity, dividend is paid in Indian Rupees with conversion obligation (currency risk) lying with the investors. FCCBs are regulated by RBI notifications under the Foreign Exchange Management Act (FEMA). The Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism), 1993 lays down the guidelines for such issues. 2.2.7.5 Equity Linked Debentures (ELDs): Equity Linked Debentures (ELDs) are floating rate debt instruments whose interest is based on the returns of the underlying equity asset such as Nifty 50, S&P Sensex, individual stocks or any customized basket of individual stocks. The issuer of bond invests a pre-determined part of the principal amount collected in fixed income securities like bonds, which provide principal protection while the balance is used to buy options which provide the exposure to returns of equity. Thus, these instruments are generally structured in a way to give full capital protection with a provision for equity participation to the investors. Capital Protection should not be read as non-existence of credit risk (risk of default by issuer). These instruments still carry credit risk and accordingly rated by credit rating agencies. 2.2.7.6 Commodity Linked Debentures (CLDs): Just like ELDs, CLDs are floating rate debt instruments whose interest is based on the returns of the underlying commodity asset. While the returns can be linked to any commodity, most of these papers globally are linked to precious metals – Gold and Silver. Like ELDs, the advantage of CLDs is that they provide the investor an opportunity to earn return from the commodity markets while protecting their initial capital. 2.2.7.7 Mortgage Backed Securities (MBS) and Asset Backed Securities (ABS): MBS and ABS are debt instruments issued by institutions against the receivables and cash flows from financial assets such as home loans (MBS), auto loans, rent receivable, credit card receivables and others. The cash flows accruing from these assets are used to meet the interest and principal repayment obligations on the bonds issued. The issuer is able to create liquidity in an otherwise illiquid asset by securitizing them. The instruments are credit rated and may be listed on stock exchanges. Financial Innovation is a continuous process and new products keep hitting financial markets on day to day basis. 2.2.7.8 REITs/InvITs Real Estate Investment Trust (REITs) and Infrastructure Investment Trusts (InvITs) are investment vehicles that pool money from various investors and invest in revenue generating real estate projects and infrastructure projects, respectively. As the name indicates, these vehicles are formed as a trust. They issue units to the investors to raise money. They enjoy favourable tax treatment as long as they meet the necessary regulatory requirements. Regulations stipulate the minimum amount of the assets that have to be held in the form of revenue generating assets. In the case of REITs, 80% of the asset should be held in the form of real estate asset. Similarly, for InvITs, regulation stipulates that 90% of the unit capital should be invested in revenue generating infrastructure projects. These assets can be held directly or through a special purpose vehicle (SPV). In the case of both, REITs and InvITs, the trust has to distribute at least 90% of the distributable surplus cash flow to the unit holders. 2.2.8 Commodities Commodities are basic materials or goods that are largely homogenous in nature. These goods are interchangeable with other goods of the same type. Thus, a bar of gold is a commodity while a jewellery made of the gold is not a commodity. This is because an investor would be indifferent to different bars of gold as long as their quantity and quality remain same. However, in the case of jewels, the buyer may prefer one design over another even though their weight and quality may be the same. Commodities may be hard or soft. Hard commodities are essentially natural resources that are mined or extracted. This includes all types of metals and crude oil. Soft commodities on the other hand refer to commodities that are grown i.e. agricultural products. Soft commodities include grains and pulses. Commodities are largely traded goods that are meant for use in production of goods or for consumption. Since inflation and prices of commodities are directly related, investing in commodity can help protect real value of investment. However, most of the commodities involve huge storage cost and are thus not suitable investments. Having said that, there are certain avenues available to invest in commodities. 2.2.8.1 Precious metals Precious metals such as gold and silver are viewed as an investment that can help preserve real value of money. Unlike many other commodities that have short life, these precious metals have very long life. Further, storage cost on these metals is very small compared to their values. These characteristics make precious metal a viable investment option. 2.2.8.2 Commodity ETFs Commodity ETF is an exchange traded fund that invests the pooled investment in a range of physical commodities. Investors can invest in commodity ETF by buying the units of the fund. The value of the units largely moves in line with the net asset value of the fund, which, in turn, moves in line with the commodity prices. Since the storage is handled by the fund, the investors do not have any storage obligation. Although commodity ETFs can be created for any set of commodities, Gold ETFs are the most common commodity ETF products as they are easy to store and manage for the fund. 2.2.8.3 Managed futures contract Futures contract is a contract to buy or sell an asset at specified future date at a specific price. Since the price of the contract is pre-determined, the buyer of the contract tends to gain if the price of the product increases in future (the reverse is also true). Thus, an investor can gain out of price rise without buying the product. Managed futures contract refers to a portfolio of futures contract that are actively managed by professionals. Instead of buying the actual underlying asset, the investment managers take position in the futures contract. Investors can thus invest in commodities through managed commodity futures contract. 2.2.8.4 Warehouse receipts Warehouse receipt is a document that shows proof of ownership of goods that are stored in a warehouse. Most of these warehouse receipts are negotiable. Thus, the title to the underlying goods can be transferred by simply transferring the receipts. 2.3 Structure of Securities Market The market in which securities are issued, purchased by investors, and subsequently transferred among investors is called the securities market. The securities market has two interdependent and inseparable segments: 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 the 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. We shall look at each of the markets in detail in the next section. Ways to Issue Securities 2.3.1 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. 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. SEBI regulation also specifies the proportion of shares to be allocated to different classes of shareholders. According to it, in an eligible issue, at least 35% of shares should be allocated to retail investors (investors investing less than or equal to Rs.2,00,000 in the issue) while utmost 50% can be allocated to qualified institutional investors. Other investors can be issued the balance. In 2009, SEBI also introduced the concept of anchor investor. 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. Anchor investors can be allocated up to 60% of the portion allocated to QIBs. Bidding for them opens one day before the IPO open for public subscription. However, the allocation price for anchor investors can be lower than the final issue price determined through the book building process. The volume and value of anchor subscriptions serve as an indicator of the quality of the offer. Follow on 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 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 follow-on public offer. A follow-on public offer 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. Private Placement - It refers to issuing large quantity of shares to a select set of investors. According to Companies Act 2013, the number of investors to whom shares are issued under private placement should not exceed fifty. Private placements can be in the form of qualified institutional placements (QIP) or preferential allotment. Qualified Institutional Placements (QIPs)- Qualified Institutional 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. Preferential Issue-Preferential issue means an issue of specified securities by a listed issuer to any select person or group of persons on a private placement basis and does not include an offer of specified securities made through a public issue, rights issue, bonus issue, employee stock option scheme, employee stock purchase scheme or qualified institutions placement or an issue of sweat equity shares or depository receipts issued in a country outside India or foreign securities. The issuer is required to comply with various provisions defined by SEBI, which inter-alia includes pricing, disclosures in the notice, lock-in, in addition to the requirements specified in the Companies Act. The requirements of SEBI’s regulations with respect to a public issue do 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. Rights and Bonus Issues - Securities are issued to existing shareholders of the company as on a specific cut-off date, enabling them to buy more securities at a specific price (in case of rights) or without any consideration (in case of bonus). Both rights and bonus shares are offered in a particular ratio to the number of securities held by investors as on the record date. An investor who has been awarded right shares has three options: (i) Exercise the right (ii) Transfer the right to another investor or (iii) Let the rights lapse i.e. do nothing. On the other hand, in case of bonus, additional shares are conferred on to the existing shareholders (without any consideration) in lieu of dividends. Companies can issue bonus shares only if they have sufficient amount of retained earnings. When a bonus issue is made an amount equivalent to the value of the shares issued should be transferred from retained earnings to share capital. 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. Sweat Equity – Under Sec.54 of Companies Act, 2013, a company may issue shares to its employees, promoters, technocrats, or others as reward for their contribution to the company. These shares are referred as sweat equity. The purpose of issuing the share is to motivate employees and top management or any other recipient to work in the interest of the company. It helps reduce the agency risk arising on account of separation of management and ownership. Although, the main purpose of sweat equity is not to raise capital, the transaction does involve issuing new shares. Employee Stock Option Scheme (ESOPs) – ESOPs are instruments given by a company to its employees that give them an option to buy the shares of the company at pre-determined price after a period of time (referred as vesting period). Typically, the vesting period is more than one year and companies may stipulate additional conditions for vesting. Like sweat equity, the objective of issuing ESOPs is to motivate employees to work in the interest of the company. The employees gain only if company’s share price rise above the exercise price of the option. The company will have to issue shares if the employee chooses to exercise the option. 2.3.2 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/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 and the issuers do not come into the picture. Secondary market can be broadly divided into two segments: Over-The-Counter Market (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. 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 exchanges. The trades executed on the exchange are settled through the 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) market or the Exchange Traded Market. Stock exchanges in India feature an electronic order-matching system that facilities efficient and speedy 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. And, settlement is the next step of settling obligations by delivering shares (by the seller) and paying money (by the buyer) 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 brokers are made available to the Clearing house by the Stock exchange. The Clearing House gives an obligation report to Brokers 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 counter party risk is substantially reduced for the investors. 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, Peak 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. 2.4 Various Market Participants and Their Activities Market Participants in Securities Market include buyers, seller and various intermediaries between the buyers and sellers. Some of these entities are defined in brief here: 2.4.1 Market Intermediaries Stock Exchanges -Stock Exchanges provide a trading platform where buyers and sellers can 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 (like 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 /clearing houses, 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 - 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. Authorised Person - Authorised person is any person (individual, partnership firm, LLP or body corporate), who is appointed by a stock broker or trading member as an agent to reach out to the investors scattered across the country. A stock broker may appoint one or more authorised person(s) after obtaining specific prior approval from the stock exchange concerned for each such person. The approval as well as the appointment of authorized person(s) is for a specific segment of the exchange. SEBI had earlier allowed spread of sub-brokership as well as Authorised Person’s network to expand the brokers’ network. However, SEBI Board in its meeting held on June 21, 2018 decided that sub- brokers as an intermediary shall cease to exist with effect from April 01, 2019. All existing sub-brokers would migrate to become Authorised Persons (APs) or Trading Members, if the sub-brokers meet the eligibility criteria prescribed under Stock Exchange bye-laws and SEBI Regulations and by complying with these Regulations. Custodians - A Custodian is an entity that is charged 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 counter party 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. They are single point 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. 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. 2.4.2 Institutional Participants An investor is the backbone of the securities market in any economy as the one lending surplus resources to companies for their productive activities. Investors in securities market can be broadly classified into Retail Investors and Institutional Investors. Institutional Investors comprise domestic financial institutions, Banks, Insurance Companies, Mutual Funds and Foreign Portfolio Investors. Some of them are defined here in brief: 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 regulator - Securities and Exchange Board of India (SEBI) to participate in the Indian Securities Market. P-Note Participants - Participatory Notes (P-Notes or PNs) are instruments issued by SEBI registered foreign portfolio investors to overseas investors, who wish to invest in the Indian stock markets without registering themselves with the market regulator - Securities and Exchange Board of India. P- Notes provide access of Indian securities to these investors. 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. Each investor owns units, which represent a portion of the holdings of the fund. Diversification of investments is an important aspect of Mutual Funds investing. It helps in reducing the risk in investment for the investor. As a result, the investor is less likely to lose money on all the investments at the same time. Insurance Companies - Insurance companies' core business is to ensure 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. 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 run by a financial intermediary for the company and its employees, although some larger corporations operate their pension funds in-house. Pension funds control relatively large amount of capital and are some of the largest institutional investors. Venture Capital Funds - A venture capital fund refers to a pooled investment vehicle like mutual fund but with mandate to invest money in enterprises that are in the early stage of development but with the potential of long-term growth. The longer gestation period and higher risk of failure make it difficult for such companies to access conventional sources of finance, such as banks and the capital markets. Venture capitalists bring managerial and technical expertise as well along with capital to their investee companies. Private Equity Firms - Private equity is a term used to define funding available to companies in the early stages of growth, expansion or buy-outs. Investee companies may be privately held or publicly traded companies. The term private equity includes venture capital firms. The money in the fund is contributed by investors, called limited partners, and invested and managed by the general partner(s). Some of the private equity funds are specialized funds with competence in a particular industry, stage of the company, or targeted deals such as funding buyouts. Hedge Funds - A hedge fund is an investment vehicle that pools capital from a number of investors and invests that across the assets, across the products and across the geographies. These fund managers generally have very wide mandate to generate return on the invested capital. They hunt for opportunities to make money for their investors wherever possible. In that sense, actually, term hedge fund is misnomer as these funds may not necessarily be hedged. Alternative Investment Funds - These are privately pooled investment schemes that invest in various asset classes such as real estate, private companies, commodities and such other alternative investment assets. The term alternative typically include all other assets excluding listed equities, fixed income instruments, fixed deposits or collective investment scheme or investment platforms such as mutual funds, NPS, insurance plan that invests in these assets. In India, alternative investment funds (AIFs) are defined in Regulation 2(1) (b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. It refers to any privately pooled investment fund, (whether from Indian or foreign sources), in the form of a trust or a company or a body corporate or a Limited Liability Partnership (LLP) which are not presently covered by any Regulation of SEBI governing fund management (like, Regulations governing Mutual Fund or Collective Investment Scheme) nor coming under the direct regulation of any other sectoral regulators in India - IRDAI, PFRDA, RBI etc. SEBI categorizes AIFs into three categories: Category I AIF: These refer to AIFs which invest 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. These include venture capital funds (including angel funds), SME Funds, social venture funds, infrastructure funds, etc. Category III AIF: These refer to those that use complex investment strategies including use of leverage and derivatives. Hedge funds, PIPE Funds, etc. are registered as Category III AIFs. Category II AIF: AIFs which do not fall in Category I and III and which do not undertake leverage or borrowing (other than to meet day-to-day operational requirements) are categorized under Category II AIFs. Various types of funds such as real estate funds, private equity funds, funds for distressed assets, etc. are registered as Category II AIFs. 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 inv
