Chapter 1
Securities Markets
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Part I
Investment Management
INVESTMENT MANAGEMENT Dr. V. A. AVADHANI M.A. Ph.D., (USA), M.A., LLB., CAIIB. (Retired Adviser in RBI & Former Director of Training Institute in Bombay Stock Exchange, Former Advisor to HSE.)
EIGHTH REVISED EDITION : 2011
MUMBAI NEW DELHI NAGPUR BENGALURU HYDERABAD CHENNAI PUNE LUCKNOW AHMEDABAD ERNAKULAM BHUBANESWAR INDORE KOLKATA GUWAHATI
Chapter 1
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Part I
Investment Management
PREFACE TO THE EIGHTH REVISED EDITION The theory and principles of Investment Management remain unaltered but the backdrop of the operations of investment and the practices and procedures of invesment management change from time to time. The financial markets in which most of the operations take place are a reflection of the economy and its performance. The economic and financial reforms in India are a continuing process and these affect the operations in the financial markets. The changes are to be incorporated in any revision of a book of this nature, which is being used by students of finance whether in MBA or M.com. or any other professional course. This is the rationale of the present revision, which hopefully helps the student update the information relevant to the area. During the recent past and in the present decade from 1999 to 2009, the GDP growth was at a rate of about 8% higher than ever before, with the latest year 2006-7 showing a growth of 9.2%. Nearly 60% of this growth is due to services sector which includes the financial services like banking, insurance, stock broking etc. The financial structure and institutional framework is being stengthened and banking and e-commerce are the highlights of the recent past. Stock and capital markets are booming reflecting the strong economic fundaments and good corporate performance. Foreign funds inflow is increasing particularly during the period 2004 to 2008 when the BSE Sensex has reached a peak of 21,207 in January 2008 and after a low of 7,697 in October 2008, firmed up again to a high of 18,048 in April 2010 and is around 17,000 in May 2010. Globalization trends are perceptible in all spheres of the economy and particulary in the financial markets. These trends along with privatization of the enterprise gave a new boost to the economy and financial markets. The global recession 2008-09 had its impact along with the financial turmoil in Euro-markets due to debt crisis in Greece on the Indian markets. The strong points in the economy are the good monsoons and rapid growth of the manufacturing sector, control of inflation and larger inflow foreign direct and portfolio investments and good buffer of forex reserves. Although the inflation rate reached a level of 10% at one stage, it is being controlled through monetary and fiscal measures. While equity market is bullish, the corporate debt market is being developed by the SEBI and the Goverment Debt market by the RBI. FDI inflows are being encouraged through the policy changes reducing the red tapism, and Govt. regulations, increase in limits for Foreign investments in selected sectors and rise in the ECB limits. The Eleventh Plan aims at accelerating the growth of agriculture to 4% and increasing the GDP growth rate to 10% for which all necessary inputs are being planned. In the fiscal field, the fiscal deficit is being kept low; subsidies are being rationalized and fiscal prudence is being observed. In the monetary and credit field, flexibility in interest rate policy and frequent use of repo rate and CRR has curbed the growth of money supply beyond the required level. CRR was raised many times from 4.5% in 2003 to 7.75% in Jan. 2008 but it stood at 6% in April 2010. Greater autonomy is given to banks in their risk management, credit policy and interest rate policy. The RBI has been curbing the excess liquidity due to foreign inflow and foreign investment and credit creation by the banks through plastic money etc. The call money rates are around the repo and reverse repo rates. Due to the recession in our economy, following the global recession 2009-10, The Reverse Repo was raised to 3.75% and Repo rate to 5.25%. The monetary policy was antiinflationary. While the Rupee is getting strengthened against dollar in the forex market, the RBI. is thinking of allowing the currency futures in the markets. Derivative markets in stock index and a equities are having a larger turnover than in the cash market, reflecting the larger operations of foreign FIs and MFs etc. The RBI is also allowing the rupee to find its own level but is keeping watch on the inflationary expectations. It is in this context that the present book is revised to bring out the impact of these changes and to update the figures and data used in the text. In this task, I acknowledge with thanks the suggestions of the teaching colleages and the co-operation of the Himalaya Publishing House. — DR. V. A. AVADHANI
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PREFACE TO THE FIRST EDITION This book on Investment Management is intended as a textbook for the students of M.Com. and M.B.A. Courses in Finance. Admittedly, there are many books on Finance Management and Investment Management, but what made me write this book is that it covers the syllabus of many Universities for M.Com. and M.B.A. courses, specially designed to help the students with simple presentation, practical illustrations and in the Indian background. With my experience of 32 years in the Reserve Bank of India in economic and financial research, and nearly six years of research and training experience in the Bombay Stock Exchange and Hyderabad Stock Exchange, and teaching the subjects of Finance and Investment in many management institutes, including I.I.M. Calcutta, my background is down to earth practical and my approach is teaching for job orientation. I have trained many sub-brokers to become brokers and hundreds of investors to become wise investors, which all helped me to make theory useful for practical applications. Many professors whom I know have encouraged me to venture into this useful service to the students by presenting the subjects in a practical manner and with an Indian background. In particular, I kept the syllabus for M.Com. and M.B.A. courses of the Osmania University, Andhra University, Kakatiya University and Madras University, among others, before me when I wrote the book. Shri D.P. Pandey of the Himalaya Publishing House has been constantly helping me and giving all encouragement during the course of my writing this book. Any suggestions for improvement may be sent to him and I shall incorporate such suggestions, in the next edition. This book is structured in a manner to be very comprehensive and sweepingly wide so as to accommodate the syllabus of almost all universities, to the extent possible. This book has the mission of serving the student community, in the areas of Commerce, Finance and Management. This book is meant to be highly practical with Indian bias but incorporates the theoretical inputs necessary to satisfy the components of the syllabus of M.Com. and M.B.A., and the practical needs for job orientation of students, in Indian Finance and Investment Companies, Mutual Funds, Merchant Banks, Stock Broker Firms etc. The scheme of the book is divided into six parts: Part I presents the Investment setting and include chapters such as Securities Markets, Savings and Investment Avenues, Tax Planning, Growth Process of the Economy and Financial System in India. Part II deals with Financial Markets and Institutions setting out the details of the New Issues Market, Stock Market, Money Market and Regulations, Trading and Operations in them. Part III sets out the Process of Investment Decision Making. It contains the sources of Information, Inflation, Security Market Analysis, Financial Analysis, Fundamental and Technical Analysis. Part IV discusses the Risk: Return Concepts, including Financial Arithmetic, Credit Rating, Market Indicators, Interest Rate Theories and Structure. Part V sets out the Valuation of Stocks and Bonds, Security Pricing, Valuation of Bonds, Stock Valuation Theorems, Valuation of Contingent Claims, Valuation of Options etc. Part VI deals with the Portfolio Management, Diversification, Risk and Return Analysis, Modern Portfolio Theory, Portfolio Construction, Revision, Monitoring and Evaluation and ends up with a brief treatment of the Mutual Funds and their Schemes. I will be failing in my duty if I do not acknowledge the help of Shri D. P. Pandey in writing this book. I also owe a deep sense of gratitude to my parents who instilled in me the spirit of service to the community, in the faculty that God has given me. — Dr. V. A. AVADHANI
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Part I
Investment Management
CONTENTS PART – I INVESTMENT SETTING
1.
SECURITIES MARKETS
3 - 14
Introduction — What is Securities Market? — What are Securities? — Mobilisation of Savings for Investment — IOUs as Securities — Characteristics of Securities — Primary Issues and Derivative Securities — Schematic Presentation of Emergence of Market — Legal Framework for Securities Markets — Companies Act — Acceptance of Fixed Deposits — Compulsory Repayment of Deposits which have Matured for Repayment — Procedure for Making Application to Company Law Board — Cases in Respect of which Applications to the Company Law Board will not Lie — Facts about Company Deposits — Care to be Exercised while Investing in Fixed Deposits — Problems in Securities Markets.
2.
SAVINGS AND INVESTMENT
15 - 18
How do Savings Emerge? — Why do People Save? — Impact of Inflation — Investment Activity — What is Investment Activity? — Savings and Investments — Objectives of Investors — Investment for Consumption and Business — Investment and Speculation — Investment Opportunities — Financial Investments vs. Physical Investment — Bank Deposits.
3.
Macro aspects of savings and investments
19 - 25
Structure of the Economy — What is Growth Process? — Role of Savings — Other Factors in Development — Financial Intermediation — Links of Real Economic System and Financial System — Savings Rate — Gross and Net Savings — Household Savings — Shifts within Industrial Sector — Lead and Lag Industries — Public Sector Enterprises — Paradox of High Savings and Low Growth — Role of Private Corporate Sector — Conclusions.
4.
Financial System —Intermediation
26- 35
Financial Intermediation — Ratios of Financial Intermediation — Some Financial Indicators — What Constitutes Financial Activity? — RBI and the Financial System — Money Market —Characteristics — Discount and Finance House — Operations of DFHI — Stock Market — Financial Institutions — Savings and Investment — Interest Rate Structure — Capital Market — Unorganised Financial System — Bullion Market.
5.
Investment avenues
36 - 41
Introduction — Financial Position — Classification of Investments — What is Investment — Macro Household Savings and Investment — Modes of Investment — Cash Management — Tax Provision — Specialised Knowledge.
6.
Features of investment avenues
42 - 52
Objectives of Investor — Characteristics of Investment — Risk-Return Relationships — Tax Benefits — Marketability and Liquidity — Safety vs. Riskiness — Need for Tradability — Classes of Instruments — Investment Profile of Average Household — Analysis of Household Sector Savings — Non-Corporate Investments — Corporate Investments — Deposits with Banks — Instruments of Post Offices — Public Provident Fund —
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Tax Planning for Investment 53 - 61 Taxation of Dividend and Interest Income — Brokerage Income and Business Profits — Tax Treatment on Investments — Interest and Dividend: Section 80 L — Tax Rebate under Section 88 — Scheme Elegible for Rebate u.s. 88 — Income Tax and Corporation Taxes — Capital Gains Taxation —Postal Investments — Wealth Tax — Gift Tax — Taxation of NRIs — Taxation of Investment Business in India — Taxation of FFIs in India — Latest Trend — Transaction Costs —Introduction — Objectives — Elements of Costing — Costs in Investment Activity — Transaction Costs — Real and Nominal Costs — Tax and Govt. Charges and Fees — Recent Changes.
PART – II MONEY AND CAPITAL MARKETS AND INSTITUTIONS
8.
Overview of capital market
65 - 71
What is Capital Market? — Structure of the Market — Players in the Market — Stock Market Intermediaries — Instruments of Issue/Trading — New Instruments — SEBI Guidelines — Indian Capital Market — Landmarks and Developments During a Decade — Recent Trends in Capital Markets — A New Order — Genesis of New Order — National Market System — Need for Larger Financial Base — SEBI Reforms of the Secondary Markets.
9.
Institutional structure in capital market
72 - 83
Development and Investment Institutions — UTI & Its Objectives —Activities of UTI — Investment Pattern — Schemes Offered by the UTI — IDBI — Schemes of IDBI Assistance — Sources of Funds — ICICI — IFCI — Functions — I.R.B.I. — Functions — IIBI — Insurance Companies — Life Insurance Corporation (LIC) — General Insurance Corporation (GIC) — Public Sector Mutual Funds — SFCs/SIDCs — SHCIL (Stock Holding Corporation of India Ltd.) — Organisational Structure — Functions — Clearing Services — Depository Services — Support Services — Management Information System — Developmental Services — CRISIL (Credit Rating and Information Services of India Ltd.) — CRISIL Rating and Investor Protection — ICRA — Factors Considered — Ratings — Advantages — CARE — DPCR — FIR.
10. Capital market reforms
84 - 98
Introduction — Narasimham Committee — Free Entry to Capital Market — Liberalisation Measures — New Instruments — SEBI Guidelines — Strengthening of SEBI Powers — Stock Invest — Changes in Listing Guidelines — Guidelines for Takeovers — Relaxation of Some Restrictions — Details for Investor Protection — More Recent Changes in New Issue Market — Changes in Companies Act — Institutional Strengthening — Electronic Trading — Stock Exchange Reforms — Market Makers — BOLT System — Badla Trading — SEBI’s Insider Trading Regulations — Central Depository System — Corporate Membership — Pending Reforms — SEBI norms for Book Building — SEBI Reforms on Stock Exchanges — Take over Code — Record of Take Overs — Critique of Bhagwati Committee’s Report — Pending Reforms in Banking Sector — Second Generation Reforms (Budget 2000-01) — Some Recent Reforms — Banking and Financial Reforms
11. New issues market and problems
99 - 110
Definition — Functions — Methods of Floatation — Offer Through Prospectus — Offer of Sale — Private Placement — Right Issue — Debt versus Equity — Rights of Conversion of Debt into Equity — Preference Shares — Bonus Shares — Cost of Floatation — Underwriting Activity — Abuses in the New Issue Market — Problems of the New Issue Market — Primary Market — Problems — Public Response — Timing of New Issues — Cost of Capital Issues — Wasteful Procedures on Public Issue — Group on Primary Market
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12. Money market and its instruments
111 - 121
Developed and Underdeveloped Markets — Integration and Specialisation — Advantages of Mature Money Market — Sub-Markets — Bill Market in India — Institutional Structure — Characteristics — Discount and Finance House of India (DFHI) — New Money Market Instruments — Classification of Money Market Instruments — Money Market Rates — Commercial Paper (C.P.) — Certificate of Deposits (C.D.) — Participation Certificates — Repos Transactions — Management in Money Market — Securities Trading Corporation of India Ltd. (STCI).
13. The securities and exchange board of india (sebi)
122 - 134
Introduction — Objectives — SEBI Guidelines — Reforms in the New Issues Market — Details of SEBI Guidelines — For Capital Market —SEBI Reforms on Stock Exchanges — Complaints against Members — Grievances Cell — Complaints against Companies — Customers’ Protection Fund — Investors Beware — Specific Goals — Pre-requisites of Investor — Preparing to Invest — Balance Sheet Study — Choice of a Broker — Protection in the New Issues Market — Protection for Fixed Deposits — Guidelines to Investors — Legislative Protection to Investors — CRISIL Rating and Investor Protection.
PART – III SECONDARY MARKETS IN INDIA
14. Securities Trading Regulations
137 - 140
Objectives — Coverage — Recognised Stock Exchanges — Options in Contracts — Regulation of Trading — Restrictions on Transferability.
15. Instruments Of Issue And Trading
141 - 153
Issues of Securities — Government Securities — Corporate Securities — Corporate Debentures — Other Securities — Company Deposits — Commercial Paper — Legal Provisions — Despatch of Share Certificates — Debenture Certificates — Fixed Deposits — Law regarding Dividends — New Companies Bill 1993 — SEBI Guidelines — Equity Shares — Dividend Distribution — Dividend Policy — Other Instruments — Bonus Shares — Rights Shares — Preference Shares — CCP — Government and Semi-Government Bonds — Equity Shares — Public Issue — Cost of Issue Guidelines — New Instruments — Recent Liberalisation of Policy — ADR and GDR Proceeds — Latest Foreign Investment Policy Measures — Relaxation in ECB Norms — Instruments of Foreign Borrowing.
16. Stock Markets In India
154 - 164
History of Stock Exchanges — What is a Stock Exchange? — Byelaws — Regulation of Stock Exchanges — Recognition by Government — Licensed Dealers — Securities Contracts (Regulation) Rules, 1957 — Present Recognised Stock Exchanges — Qualifications for Membership — Organisation — Demutualisation of Stock Exchanges — Advantages of Demutualisation — Disadvantages — Governing Body — Functions of Stock Exchanges — Listed Paid-up Capital — Who Owns the Securities? — Bombay: Stock Exchange — Patel Committee — Regulations on Trading — Investor Protection — Measures to Promote Healthy Stock Markets — Other Reforms — Rolling Settlement System CDSL: Central Depository Services Limited — Globalisation
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17. Otcei, nse and icse
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165 - 182
Securities Exchanges — Structured Markets — OTC Defined — Investor Interests — Practices Abroad — OTC and New Issues Market — OTC and Stock Exchange — Advantages of OTC — Structural Weaknesses in India — Role of OTC — Over-the-Counter Exchange of India (OTCEI) — Objectives of OTCEI — Establishment of OTC — Listing on OTCEI — Investors Benefitted — Market Players — Listing Procedure — Trading on the OTCEI — Conclusion — Problems — OTCEI and Dave Committee Report — DAVE Committee Recommendations — Annexure — National Stock Exchange — National Market System — Characteristics — NSE Operations — Automated Lending and Borrowing Mechanism (ALBM) — Central Depository System — Listing of Securities — Settlement System — The National Securities Depository Limited (NSDL) — What is a Depository? — Rematerialisation — Advantages of the Depository — About the Depository Participants — NSDL’s First Participants — Legal Aspects — Interconnected Stock Exchange — Objective — Computer System — Trader Work Stations — Advantages of ISE.
18. Stock Market Operations And Functions
183 - 191
Introduction — Specified and Non-Specified Groups — Customer’s Orders — Trading Ring — Block Book (or the Sauda Book) — Contract Note — Drawing Up and Bills — Cum and Ex-dividend — Settlement in Specified List — Badla Charges — Factors Influencing Badla Rates — Carry Forward Facilities — Example 1 — Example 2 — Book Closure Badla Financing (BCBF) — Settlement in Non-Specified Shares — After the Badla Day — Kinds of Delivery — Hand Delivery — Spot Delivery — Special Delivery — Delivery for Clearing — Present Position of BADLA — J.S. Varma Committee (July 1997) — Dhanuka Committee Report — Recent Reforms of Stock Exchanges.
19. Trading In The Stock Market
192 - 203
Pattern of Trading — ‘Z’ Group in Bombay Stock Exchange — Trading and Settlement — Speculative Traders vs. Genuine Investors — Types of Speculators — Activities of Brokers — Brokers’ Charges — Delivery/ Payment — Settlement Procedure — Auctions — Clearing Procedure — Regulation — National Market System — Characteristics — Objectives — Study Group Recommendations — Experience in Foreign Countries — National Clearance and Depository System — Present Settlement and Clearance System — National Trade Comparison and Reporting System — Internet Broking — Order Routing System (ORs) — e-Broking — SEBI’s Role — Dynamics of Net Trading in Stocks — Emerging Role of Stock Exchanges.
PART – IV SECURITY ANALYSIS
20. Sources of investment information
207 - 211
Types of Information — Need for Information — Uses of these Data — Conclusion.
21. Inflation and investments
212 - 218
What is Inflation? — Traditional Explanation of Inflation — Demand Pull and Cost Push Inflation — Structural Factors — Inflationary Tendencies — Inflation Indicators — Causes of Inflation — Effects of Inflation — Inflation — A Fallout of Reforms — RBI’s Responsibility — Inflation as a Monetary Phenomenon — Mid-term Appraisal of the VIII Plan — Impact of Govt. Measures — Role of RBI — Credit Control by RBI — Responsibility
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22. Security market analysis
219 - 228
What is Security Analysis? — Origin of Markets — Information Flows — Savings or Money Flows — Factors Influencing the Market Behaviour — Trading — Instruments — Players — Intermediaries — What is Market Analysis? — Valuation — Theoretical Framework — Schematic Presentation of Theory — Investment and Time Value of Money — Present Value Method — D.C.F. (Discounted Cash Flows).
23. Investment decision making
229 - 234
Investment Management Involves Correct Decision Making — What is Investment Management? — Criteria for Investment Decision — Risk and Investment — What is Fundamental Analysis? — Investment Objectives — Cost-Benefit Analysis — Environmental Considerations — Chit Funds and Nidhis — Tax Planning in Investment Management — Execution of Investment Decisions.
24. Financial analysis and interpretation
235 - 239
What is Financial Management? — Components of Financial Statements — Comparison of the Financial Statements — Ratio Analysis — Usefulness of Ratio Analysis — Fund Flow Analysis — Trend Analysis.
25. Balance sheet analysis and blue chips
240 - 249
Annual Reports — Market Price and Corporate Performance — Ana-lysis of Financial Position — Types of Shares in the Market — Growth Shares — Cyclical Shares — Defensive Shares — Discount Shares — Net Financial Results and Profitability — Corporate Performance — How to Locate Emerging Blue Chips? — Established Blue Chips.
26. fundamental analysis
250 - 263
Influence of the Economy — Economy vs. Industry and Company — Industry Analysis— Example of an Industry Analysis — Petro-Chemicals — Company Analysis — Need for Forecast — Guidelines for Investment — Example of Company Analysis — How to Pick Up Growth Shares? — Pharma Industry — Profile of Pharma Industry — Future Outlook — Conclusions.
27. Technical analysis of the market
264 - 275
Importance of Timing in Investment — Basic Tenets of Technical Analysis — Tools of Technical Analysis — Dow Theory — Major Trends — Chartist Method — Breadth of the Market — Volume of Trading — Tripod of Technical Analysis — Principles of Technical Analysis — Charts and Trend Lines — Moving Averages — Advantages of Moving Averages — Criticism of Dow Theory — Charts — Head and Shoulders — Breaking the Neckline — Resistance and Support Lines — Speculative Trading and Technical Analysis — Elliot Wave Theory — Operation of Wave Theory — Oscillators (Rate of Change or ROC).
28. Efficient market theory
276 - 281
Assumptions — Random Walk Theory — Assumptions of Random Walk Theory — Random Walk and Efficient Market Theory — Empirical Tests — Filter Tests — Serial Correlation Tests — Run Tests — Other Tests — Mutual Fund Peformance — Efficient Market Hypothesis — Semi Strong Form — Strong Form of EMH —
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PART – V RISK AND RETURN CONCEPTS AND MEASUREMENT
29. Risk and credit rating
285 - 295
Introduction — Risk and Uncertainty — What Causes the Risks? — Systematic and Unsystematic Risks — Risks are Classified into Major Categories — Examples of Systematic Risks — Examples of Unsystematic Risks — Other Risks — Risks and Returns — Purchasing Power Risk — Problem — Standard Deviation and Variance — Investment Decision-Making — Risk Measurement — Range of Variation — Why Credit Rating? — Rating in USA — What is Credit Rating? — How to Understand Ratings and Rating System? — What Instruments are Rated? — Limitations to Ratings — Key Factors Considered — Risk and Credit Rating — Confidentility of Information — CRISIL — ICRA — CARE —Duff and Phelps — Fitch India Pvt. Ltd.
30. Security market indicators
296 - 307
Introduction — Functions and Activity — Segments of the Markets — Segment of Government Securities — Yield Curve — Indicators — Corporate Securities Section — Main Indicators — Security Price Indices — RBI Index of Industrial Security Prices — BSE Sensitive Index — Scrip Selection — Methods of Compilation — Weightage — Other Adjustments — BSE Sensex Composition — BSE National Index — BSE 200 and Dollex — Daily Current Market Data — Other Indicators — Other Indices — Indexes for other Segments.
31. Interest rates — theory and structure
308 - 321
Introduction — Role of Interest Income — Relative Share of Interest Income — Role of Interest Rates — Theories of Interest Rate — Structure of Interest Rates — Factors Influencing Interest Rates — Interest Rates in India — Bank Rate and Refinance Rates — Money Market Rates — Rates in Gilt-edged Market — Private and Government Bond Rates — Rates of Borrowings and Lendings by Commercial Banks — Interest Rates on Small Savings — Interest Rates on Non-resident Accounts — Export Credit — Level and Structure of Rates — Level of Interest Rates — Structure of Interest Rates — Reforms — Recent Deregulation Measures — The Yield — Current Yield — Redemption Yield — Holding Period Yield (HPY) — Real Yield — Net Yield — Maturity and Yields — Yield Curve.
PART – VI VALUATION OF STOCKS AND BONDS
32. Financial arithmetics
325 - 339
Introduction — Calculation of Returns (Yields) — Yields on Bonds/Fixed Interest Securities — Simple Yield or Interest Calculation — Yields on Equity — Time Value of Money and Securities — Time Preference for Money — Applications — Features of a Bond — Equity Valuation — Fundamentals of Valuation of Securities — Discounting — Bond Prices — Factors Influencing — Formulae — Valuation of Convertible Bonds/Debentures — Why Convertible Financing? — Valuation of Convertibles — Conversion Ratio — Conversion Premium — Valuation of ‘Rights’ — Example of Rights Pricing — Callable Bonds — Detachable and Non-Detachable
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Part I
Investment Management
33. Security pricing
340 - 352
Factors Influencing Valuation — Security Valuation — Constant Growth Model — Book Value — Liquidating Value (Breakdown Value) — Replacement Value — Instrinsic Value vs. Market Price — Equity Valuation — Single-Period Valuation Models — Example — Multi-Period Share Valuation Model — Example — Dividend Capitalisation — Earnings Capitalisation — Use of P/E Ratio — Security Pricing Models — Other Models — Graham’s Approach to Valuation of Equity — Valuation of Securities in India — Example — Free Market Pricing — SEBI Guidelines — Theory of Pricing — Share Valuation Models — Granger Causality Test.
34. Investment analysis and theory
353 - 368
Introduction — Flow of Funds Theory — Price Formation — Capital Assets Pricing Model — Risk and Portfolio — Efficient Market Theory — Random Walk Theory — Trend Walk Theory — Capital Asset Pricing (CAP) Theory — Modern Portfolio Theory — Concept of Beta — Fundamental School — Intrinsic Value and Market Value — Evaluation of Shares — Gordon’s Hypothesis — Gordan Dividend Model — M.M. Hypothesis — Walter’s Formula — Walter Model — Problems — Graham Dodd Model — Discount Model — Malkiel and Cragg Regression Model — Cootner’s Price Value Interaction Model — Random Walk Theory — Random Walk Theory Assumptions — Martingale Models — Capital Market Theory — Security Market Line — CAPM — Tobin “Q” Theory.
35. Valuation of bonds — bond market
369 - 412
Introduction — Bond Market In India — Special Features of Bonds — Interest Rate Structure — Properties of Bonds and Bond Value — Measures of Bond Returns — Calculation of Yield to Maturity (YTM) — Valuation of Bonds — Solved Problems — Accrued Interest — Calculation of Accrued Interest and Value — Discrete Models — Bond Price Theorems — Malkiel Bond Theorems — Risk Premium on Bonds — Yield Curves — Term Structure — Types of Bond Management — Active Strategies — Yield Curve Study — Objectives of Raising Incremental Return — Need for Tax Planning — Sequence of Steps for Bond Issues — Steps in Management of the Issue — General Benchmarks in Making Issues — Valuation of Bonds — Price Risk — Riding the Yield Curve — Duration Measure — Risks to be Covered — Duration and Immunisation — What is Duration? — Use of Duration as a Concept — Macaulay’s Duration (MD) — Duration (Example) — Theorems Emerging from MD — Advantages of M.D. — Uses of Duration — Interest Rate Elasticity and Risk — Modified Duration (by Hicks) — Short Cut Formula for Duration — Immunisation — What is Immunisation? — Immunisation Process — Immunisation Operations — How Immunisation is Effected? — Problems of Immunisation — Bond Holding Strategies — Immunisation —Cash Matching (Dedicated Portfolio) — Price Elasticity — Illustration — Volatility of Bond Prices — Immunisation — Immunisation — (A) Present Value of Bonds: (Total PV = 62.05) — (B) Face Value of Bonds: (Yield is 11%) — Macauly’ Duration — Problems in Bonds.
36. Valuation Of contingent claims and options
413 - 434
Introduction — What is Contingent Claim? — Pricing of Such Claims — Free Market Pricing — What is a Convertible Security? — Valuation of Rights Shares — Preference Shares — CCP — Legal Provisions — Norms for N.C.D. of Non-Convertible Portion of P.C.D. — Conversion Value — Conversion Premium — Pricing of Convertibles — Valuation of Convertibles — Graphical Presentation — Role of Interest Rate — Graphical Depiction — Brigham’s Model on Convertible Bonds — Valuation of Options — Factors Affecting the Option Value — Call and Put Options — Hedge Ratio (Black-Scholes Model) — Hedge Ratio Data — Black-Scholes Formula — What is Black-Scholes Formula? — Implications — Solved Problem (B/S Model)
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PART – VII PORTFOLIO THEORY AND MANAGEMENT
37. Risk and return in portfolio management
437 - 442
What is the Objective? — What is Risk? — How to Minimise the Risks? — What is Beta? — Risk Return Analysis — Degree of Risk and Risk Free Return — Capital Market Instruments — Money Market Instruments — What is a Portfolio? — Definition of Portfolio? — Speculative Instinct — Precautions for Investment — Decomposition of Return.
38. Capital asset pricing model (capm)
443 - 468
CAPM-Assumptions — CML — Security Market Line (SML) —CAPM Analysis — Market Model — Uses and Limitations — Capital Asset Pricing Model — Limitation of CAPM — SML Security Market Line — CAPM — Diversification — Why Diversification — Example on Measurement of Risk — Calculation of Standard Deviation —Example Escorts — Example of Simple Diversification — Markowitz Diversification — CML — SML — CAPM — Asset Pricing Implication of SML — Equilibrium price: (SLM) — Problem on CAPM — Problem on SML.
39. Portfolio analysis 469 - 480 Return on Portfolio — Risk on a Portfolio — Example of Standard Deviation — Regression Equation — Alpha — Beta — Rho or Correlation Coefficient (covariance) — An Example for Covariance and Correlation — Expected Returns — Calculation of Beta — Calculation of Alpha — Calculation of Residual Variance — Calculation of Residual Variance — Method of Calculation of (r) — Variance of IBM — Variance of BSE Index — Covariance of Returns — Correlation Coefficient.
40. Diversification And Techniques of Risk Reduction
481 - 489
What is Diversification?— Principles — Random Diversification — International Diversification — Why International Diversification? — Risks in Foreign Investments — FFI’s Investment in India — NRI Investment in India — A. Personal Investments Scheme — B. Direct Investment Scheme — (C) Portfolio Investment Scheme — Passive International Investment Strategy — Active International Investment Strategy — Return Forecasts — International Investing — Problem — Advantages of Diversification — Naive Diversification — Evans & Archers’ Study.
41. Markowitz model 490 - 508 Assumptions of Markowitz Theory — Markowitz Diversification — Parameters of Markowitz Diversification — Criteria of Dominance — Markowitz Model — Measurement of Risk (Example) — Portfolio Risk — Equation for Portfolio Return — Equation for Portfolio Variance — Arbitrage Pricing Theory — Introduction — Asset Selection in the Above Model — Components of Expected Returns — Empirical Testing of APT Model — Arbitrage Pricing Theory — Problem — Sharpe Model — Optimal Portfolio of Sharpe — Basis for Cut-off Rate — Distribution of Investments.
42. Basics Of Portfolio Management In India
509 - 514
Some Aspects of Portfolio Management — Investment Strategy — Objectives of Investors — Risk and Beta — Modern Portfolio Theory (MPT) — Time Value of Money — Compounding — Discounting — Perpetuity —
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43. Modern portfolio theory
515 - 521
What is Modern Portfolio Theory (MPT) — Basis of Modern Portfolio Theory — B. Cap Theory and Concept of Dominance (Capital assets pricing model) — Dominance Concept — C. Role of Beta — Portfolio Investment Strategy — Asset Allocation — Risk Management Strategy — Duration — Beta — Target Return — Borrowing for Investment — Problems — Portfolio Return Equation is — Portfolio Risk = Standard Deviation of Portfolio.
44. Portfolio management: construction, revision and evaluation
522 - 548
Fact Sheet — Clients’ Data Base — Objectives of Investors — Motives for Investment — Tax Provisions — Capital Gains — Portfolio Construction — Risk-Return Analysis — Time Horizon of Strategy — Types of Risk — Efficient Portfolio — Market Efficiency Theorem — Diversification — Portfolio Management — Elements of Portfolio Management — Execution of Strategy — Monitoring — Building of the Portfolio — Portfolio Revision — Security Pricing and Portfolio Management — Markowitz Model of Portfolio Theory — Risk Analysis — Evaluation of Portfolio Performance — Criteria for Evaluation of Portfolio — Example of Sharpe’s Measure — Treynor’s Measure Evaluation Problem — Comparison — Jensen’s Measure — Jensen’s Model — Evaluation Criteria for Portfolios — Portfolio Performance Evaluation — Jensen’s Performance Measure: (JP) — Returns and Performance Evaluation — Problems — Take Home Problems.
45.
Mutual funds and their schemes
549 - 572
Introduction — Definition — Types of Funds — Unit Trust of India — UTI Schemes for Resident Indians — Off shore Funds — SBI Mutual Fund — India Magnum Fund N.V. — Other Funds — Overall Progress in India — Investment Policy — Steps to Popularise Mutual Funds — Response of NRIs — For All MFs Common Rules — Advantages of Mutual Funds — Progress in Nineties — Regulation of Mutual Funds — Authorisation of Existing Mutual Funds — Money Market Mutual Funds (MMFs) — MMMF’s Regulation — Authorisation of New Mutual Funds — Mutual Funds Present Status — Taxation and M.Fs — Wealth Tax — Gift Tax — Tax Benefit under 1999-2000 — Saga of Fortunes of MFs — Stocklending by Mutual Funds — Latest Trends — Annexure I - RBI Guidelines on Mutual Funds — Annexure II -SEBI.
46.
Disinvestment management
573 - 590
Introduction — What is Disinvestment? — Why Disinvestment? — Role of Disinvestment — Disinvestment Under Adverse Conditions — Disinvestment Motivated by Market Conditions — Types of Disinvestment — Factors Influencing Disinvestment — Role of Fundamental Factors — How to Make Disinvestment Decision? — Objectives — Investment Avenues — Stock Market Disinvestment — Fundamental Analysis — FIIs and the Art of Contrariness — FII Investments in India — Role of Technical Factors — Timing of Disinvestment (Through Technical Analysis) — R.S.I (Relative Strength Index) — Moving Average Convergence and Divergence (MACD) — Disinvestment by Government Sector — Problems of PSU Disinvestment — NAVARATNAS — Central Public Sector Undertakings — Divestment Methods of Government — Open Bidding Process of Divestment — A Proposal on Mutual Fund Route — Banks’ Divestment Scheme
47. Securities Market Report (BSE)
591 - 607
Introduction — Global Comparison — Overview of BSE Market Report — Globalisation Trend — Daily Report Analysis — Sensex Shows 5% Fall on FII Selling — Price Index Snapshots of the Market — Trade Turnover — Advance/Decline Line — Role of Institutional Agencies — Trading Cycle — Record Dates and Book Closure — Circuit Band Hitters — Speculative Positions — Surveillance System — Index Details — BSE Stock Tables — Main Indicators — Face Value — Market Macro Indicators — Badla Statistics — Derivatives Trading.
Chapter 1
Securities Markets
PART — I Investment Setting
Chapter 1: Securities Markets Chapter 2: Savings and Investment Chapter 3: Macro Aspects of Savings and Investments Chapter 4: Financial System – Intermediation Chapter 5: Investment Avenues Chapter 6: Features of Investment Avenues Chapter 7: Tax Planning for Investment
15
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Chapter 1
CHAPTER CHAPTER
11
Securities Markets
17
Securities Markets
Introduction The issue of securities by corporate units in India is as old as the introduction of joint-stock enterprises by the British Government. The 18th and 19th centuries saw the emergence of cotton and jute textiles, tea and other plantation industries in India. Many companies were set up as joint-stock enterprises with liability limited by shares. A vast number of businessmen in major cities purchased these shares and trading started in them early in the 19th century, thanks to their enterprising spirit. In those days, although many of these companies were financed by the issue of shares to the public, they mainly depended on the joint-stock British banks in India and borrowals from abroad. British enterprise and the British Government have thus helped the emergence of the securities markets in India. The corporate securities have come to have a market first. So far as the Government securities are concerned, the British India Government borrowed mostly in London by issue of Sterling consols. Only later in the 19th century the Government issued treasury bills and Government securities in rupees. This led to the emergence of the Government securities market also in India.
What is Securities Market? Securities markets are markets in financial assets or instruments and these are represented as I.O.Us (I owe you) in financial form. These are issued by business organisations, corporate units and the Governments, Central or State. Public sector undertakings also issue these securities. These securities are used to finance their investment and current expenditure. These are thus sources of funds to the issuers. There are different types of business organisations in India, namely, partnership firms, co-operative societies, private and public limited companies and joint and public sector organisations etc. The more frequently organised method is the company, registered under the Indian Companies Act 1956. Under this Act, there are three types of companies: (a) companies limited by guarantee; (b) companies which are private limited companies — limited by shares paid up; and (c) companies which are public limited companies — limited by shares paid up and companies limited by guarantee cannot enter the market. The private limited companies can have 50 members and their shares are not transferable freely. These companies reserve the right to refuse any transfer of shares and as such trading in them is restricted. Due to these inhibitive features, private limited companies do not have easy access to the securities markets. Only public limited companies are largely popular as they can raise funds from the public through the issue of shares. The methods of raising funds used by the corporate sector are to issue securities, either ownership instruments or debt instruments.
What are Securities? Securities are claims on money and are like promissory notes or I.O.U. Securities are a source of funds for companies, Governments and Semi-Government bodies. There are two types of sources of funds namely internal and external and securities emerge when funds are raised from external sources.
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The external sources of funds of the companies are as follows: (A) Long-term Funds (i) Ownership Capital — equity and preference capital, and Non-voting Shares. (ii) Debt Capital — debentures and long-term borrowings in the form of deposits from public or credit limits or term loans or advances from banks and financial institutions, etc. (B) Short-term Funds (i) Borrowings from banks, and other corporates. (ii) Trade credits and suppliers’ credits, etc. Of the above sources, the most popular are those which are tradable and transferable. They have a market and their liquidity is ensured, as in the case of equity shares, preference shares, debentures and bonds. Of these the ownership instruments, particularly the equity shares, are generally the most liquid as they are not only tradable in the securities markets but also enjoy the prospects of capital appreciation, in addition to dividends. The market for these has thus grown much faster than for others.
Mobilisation of Savings for Investment The issue of securities can be looked at from various angles. These may be set out as follows: (i) From the point of view of issuers, these are the sources of finance for long-term capital investment and for working capital. They can thus invest more than their resources; (ii) From the point of view of investors, these are IOUs or promissory notes, giving an income or a return to their investment. They provide a channel to their savings and cater to the asset preferences of the public with varying characteristics of risk, income, maturity, etc.; (iii) From the point of view of the nation, these issues mobilise the savings for investment and capital formation in the country. They promote the growth of output and income by a multiplier leading to a rise in the output by a multiple of the original investment over a period of time; (iv) From the point of view of the financial intermediaries like banks, financial institutions, etc., these issues are a source of income to them for the management of these issues placing them with the public, providing liquidity and marketability to them and by activating idle funds. Thus, the securities markets comprise all the above players, namely, issuers, savers, investors, intermediaries, etc. and the major activity is the moblisation of funds from saving and their channelisation into investment.
IOUs as Securities In the securities markets, the securities dealt with are equity shares, preference shares, debentures and bonds. These securities being financial claims are issued as I.O.U.s or Promissory Notes. In the primary market, the issues are made to the primary or original savers. The other forms of holding debt or borrowings such as public deposits or bank owned IOUs are not securitised and hence not tradable. In certain cases like the P.O. Certificates, bank deposits, LIC policy certificates etc., they are not transferable by endorsement, but they have a primary market as these primary issues are I.O.U.s, used to mobilise the savings of the public. The market for such primary securities is limited to one stage and there is no secondary market for them. The UTI units and the instruments of many mutual funds in India belong to a hybrid category, as these are not securities according to the strict definition of the term under the Indian Companies Act. But as they can be sold back to the issuing institution or sold in the market if they are quoted on the Stock Exchange, they enjoy liquidity. Thus UTI units under the 1964 scheme for example can be repurchased by the UTI, which provides liquidity to these instruments. The master shares of UTI and the stocks of some mutual funds can also be traded as they are quoted on the Stock Exchanges and they are close ended schemes.
Chapter 1
Securities Markets
19
The securities markets emerge out of the two characteristics of financial instruments: (a) mobilising primary savings from the public to serve as sources of funds for the issuing authority; and (b) providing liquidity to these instruments through regular quotations in the financial markets and thus traded. The primary markets exist only if the first condition is satisfied. The secondary market also operates if both the conditions are satisfied. The pattern of corporate financing and the extent of their dependence on the external sources of funds, as opposed to the internally generated cash flows, would thus determine the creation of new securities. The retained earnings are the internally generated funds which have an opportunity cost but whose issue costs are zero. These can be converted into securities by issue of bonus shares to existing share holders. There are, however, issue costs for equity and preference shares, convertible and non-convertible debentures etc. The capital market and stock market do provide the facilities for new issues and conversion of issues into money and vice versa, so that investors are assured of liquidity for their investments so as to induce them to enter these markets.
Characteristics of Securities The major characteristics of securities are their transferability and marketability. These help the process of trading and investment in them. Under the Indian Companies Act, Sections 82 and 111 deal with the transfer of shares. In the case of public limited companies, the objective of the Companies Act as also of the Listing Agreement with the Stock Exchanges is to ensure free and unfettered transfer of shares. Under Section 82 of the Companies Act, shares are treated as any movable property. As any right to property, these are freely transferable. By one amendment in 1985, Section 22(A) of the Securities Contracts (Regulation) Act has denied the right to refuse to transfer shares by a public limited company except on technical grounds. The other grounds on which the transfer can be refused are specifically laid down under the Act and the company has to specify the reasons for such refusal to transfer and reference has to be made to the Company Law Board whose decision to refuse or not to refuse the transfer of shares will be final. Thus the essential characteristic of transferability of shares is well preserved which gives them the market which in turn extends liquidity to these shares. This has led to the emergence of securities markets in India.
Primary Issues and Derivative Securities Primary issues are those issued to the public by the companies, Governments and financial institutions. Derivative issues are those which are based on the original primary issues. There are a number of derivative instruments which are used to generate a market for the primary issues. Thus in many developed markets abroad, there are warrants, options, futures, index linked instruments etc. which have well-established markets and they are based on some primary instruments. In India, options are now permitted and some form of futures trading exists in Group A securities on the stock exchanges as they are permitted to be carried forward from settlement to settlement without taking delivery of shares. Since January 1995, options and futures have been permitted by change in law by the Government and they are now developing under strict control of SEBI, since 2000. More recently, new instruments have been developed in India, namely, warrants, Zero coupon bonds, conversion options, rights options etc. But in many cases these are not well developed and secondary markets for these instruments are under developed and trading does not take place as in the case of listed shares and particularly those on the specified group (Group A) of stock exchanges. Reference is made in the subsequent chapters to many new instruments which are introduced both in the capital market and the money market in India. Besides, the RBI has also recently permitted the securitisation of book debts of banks and financial institutions in the sense that the debit balances on companies’ accounts can be transferred to other banks and financial institutions which are willing to discount them or purchase them at a price but the market in many new instruments is yet to be developed in India.
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Derivatives Markets in India In India, options and futures were allowed as securities to be traded in stock exchanges by necessary changes in the S. C. (R) Act 1956, in the year 1996-97. But actual trading in them did not take place until 2000-2001, due to the need for preparing the members for this new system and for setting up the necessary architecture and infrastructure for trading in derivatives. In June 2000, Index futures and in November 2001, stock futures were started, on NSE and BSE. But the index options were initiated in June 2001 and stock options in July 2001. More importantly interest rate futures were introduced only in June 2003 on the NSE. But the process in interest rate futures and currency futures are yet to take off. The volume of turnover has grown faster on the NSE than on BSE. Secondly, turnover in derivative markets has grown faster than in the cash markets, although the former were started only a decade ago.
Schematic Presentation of Emergence of Market A schematic presentation of the emergence of markets through the flow of cash, credit and savings of the public is made in Charts 1.1 to 1.5. It will be seen from Chart 1.1 that money flows lead to claims on financial assets and physical assets and financial assets in turn when issued as securities result in trading in markets. The money and capital markets are shown separately as short-term and long-term wings of the markets. The components of capital market are shown as primary and secondary markets whose details are explained in terms of instruments traded, institutions involved and operations undertaken in Charts 1.3 and 1.4 respectively. Chart 1.2 explains the savings flows of the household sector into financial assets invested by the household sector, namely, currency, deposits of banks, etc. Chart 1.5 presents the inter-relations of the various institutions and markets, namely, the stock exchange, brokers, banks, financial institutions, etc. Finally, the investor clients and corporate clients and the various services rendered to them by these markets are briefly depicted in this chart as constituting the totality of the markets. The further details of these charts are explained in later chapters.
Chapter 1
Securities Markets
21
Chart 1.1
BROAD CONTOURS OF MONEY FLOWS
Broad Contours of Money Flows MONEY CASH + CREDIT
CREATED BY R.B.I. CASH
CREATED BY BANKS CREDIT
INCOME MINUS EXPENDITURE = SAVINGS
INVESTMENTS
FUTURE CLAIMS ON MONEY
PHYSICAL ASSETS
FINANCIAL ASSETS — INSTRUMENTS
A. SHORT-TERM —DDs, MTs, CHEQUES ETC. CALL MONEY, T.Bs, C.Ps, ETC
B. LONG-TERM — SECURITIES SHARES, DEBENTURES (CAPITAL MARKET) — DEPOSITS, BORROWINGS, ETC.
PRIMARY MARKET
SECONDARY MARKET OR STOCK MARKET TRADING IN OLD SHARES OR SECURITIES
INSTRUMENTS
ASSETS TRADED
NEW ISSUES, ALLOTMENT LETTERS, RIGHTS-BONDS, VOUCHERS, RENUNCIATIONS ETC.
GOVT. SECURITIES, CORPORATE SHARES, DEBENTURES, UNITS, ETC.
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Investment Management
Chart 1.2 SAVINGS FLOWS
Saving Profile of Macro Household
2008-09
TOTAL SAVINGS ESTIMATES (HOUSEHOLD SECTOR)
FINANCIAL ASSETS 48%
PHYSICAL ASSETS 52%
STRUCTURE OF FINANCIAL ASSETS (GROSS SAVINGS IN FINANCAL FORM)
Percentage of Gross Financial Assets Form of Assets
2004-05
1. Currency
2003-04
2006-07
2007-08
2008-09
9.2
10.5
8.6
11.4
12.4
37.1
36.7
55.6
50.4
54.9
0.4
4.9
0.1
1.8
3.6
4. LIC, Insurance, PF and Pension Funds
26.4
27.6
24.2
20.0
29.6
5. Claims on Govt. (Postal Savings, Govt. Securities etc.)
24.0
20.2
5.2
–4.0
–3.1
6. Shares and Debentures & MFs
1.1
0.1
6.3
12.4
2.6
7. Others
1.8
Nil
100
100
100
100
100
2. Deposits of Banks 3. Deposits of Non-Bank Companies
Total
Source: Latest RBI Annual Reports
Chapter 1
Securities Markets
23
Chart 1.3
INSTRUMENTS — PRIMARY MARKET
Primary Market CORPORATE SHARES, DEBENTURES, RIGHTS, ETC., ARE THE INSTRUMENTS BASIS: 1.
ENABLING LEGISLATION, PRACTICES, PROCEDURES
2.
PATTERN OF CORPORATE FINANCING - STRUCTURE
A. INTERNAL FINANCE, RETAINED INCOME B. EXTERNAL SOURCES — METHODS
EQUITY, ORDINARY, PREFERENCE, ETC.
DEBT BORROWINGS FROM BANKS and FIs
DEBENTURES CONVERTIBLE NON-CONVERTIBLE
FOREIGN SOURCES, EQUITY DEBT
PUBLIC DEPOSITS OF VARIOUS MATURITIES
FIs -NABARD - IFCI - SIDBI - LIC - GIC - etc.
UNDERWRITING AGENCY WORK LEAD MANAGING MERCHANT BANKING, etc.
PLANNINGS CONSULTANCY, AGENCY, BROKING etc.
3. PRIMARY MARKET OPERATIONS PROJECT PLANNING, FINANCE PLANNING, CONSULTANCY, FINANCIAL MANAGEMENT, TAX PLANNING, GOVT. REGULATIONS, DEALINGS IN THE PRIMARY MARKET-ISSUES TO THE HOUSEHOLDS, etc. PROSPECTUS, ALLOTMENT, LISTING, etc.
INTERCORPORATE INVESTMENT
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Investment Management
Chart 1.4
STOCK EXCHANGES
Secondary Market SEBI
GOVT. COMPANIES P.S.Us.
SECURITIES APPELLATE AUTHORITY
STOCK EXCHANGES
BROKER JOBBER
DEPTS FUNCTIONS
OWN BUSINESS (WHOLESALE) — JOBBER CLIENT BUSINESS (RETAIL) — BROKERS
CUSTOMERS
INDIVIDUALS, COMPANIES, FIs, MUTUAL FUNDS etc.
TRADING
BID OFFER/PURCHASE & SALE PRICES
SPECIFIED SHARES NON-SPECIFIED SHARES/BONDS, etc.
O.T.C.
OPTIONS & FUTURES
RAISING OF ENABLING CONTRACTS & NOTES CLEARING HOUSE SETTLEMENT DELIVERY PAYMENT etc.
GOVT. SECTOR FINANCING — CENTRAL — STATE LOCAL BODIES AND SEMI-GOVT. ORGANISATIONS GILT-EDGED MARKET, RBI, UNDERWRITERS, PRIMARY DEALERS, BANKS, PF, FIs — BROKERS etc.
CORPORATE SECTOR FINANCING — EQUITIES, PREFERENCE SHARES, DEBENTURES, BONDS etc. REGISTRATION, CONSOLIDATION, SUB-DIVISION FLOW OF INFORMATION ON COMPANY AFFAIRS etc.
Chapter 1
Securities Markets
25
Chart 1.5
INTER - RELATIONS
EXCHANGE AUTHORITY
BROKERS/DEALERS
Inter-relations
BANKERS FINANCE AND DEALING IN GILT-EDGED
GOVT. SEBI
INVESTOR PROTECTION — ENCOURAGEMENT TO FLOW OF SAVINGS + INVESTMENT — FAIR TRADING PRACTICES GRIEVANCES REDRESSAL etc.
F.Is, GIC, LIC MUTUAL FUNDS, BANKS, CHIT FUNDS COMPANIES etc.
FINANCIAL SUPPORT TO BOTH PRIMARY AND SECONDARY MARKETS — INSURANCE COVERAGE — INVESTMENT — PORTFOLIO MANAGEMENT — CONSULTANCY — BROKING BUSINESS, UNDERWRITING etc.
INDIVIDUALS AS CLIENTS
CORPORATE UNITS AS CLIENTS
INVESTMENTS ADVICE & CONSULTANCY PORTFOLIO MANAGEMENT TAX PLANNING
MERCHANT BANKING NEW ISSUES PLANNING PROJECT REPORT FINANCIAL MANAGEMENT ACCOUNTACY & AUDIT
CORPORATE FINANCE STUDY — RATIO ANALYSIS BALANCE SHEET — INCOME-EXPENDITURE ANALYSIS etc.
LEGAL FRAMEWORK FOR SECURITIES MARKETS New Issues Market and Stock Exchange are a part of the Capital Market where the shares, debentures, bonds and other securities of companies and Government are traded. The Stock Exchange provides facilities for exchange of shares into money and vice versa. New Issues Market is the Primary market where the issuers can sell securities, but cannot buy. Stock Exchange is defined as an Association of Member Brokers who assist, facilitate and regulate trading in securities. One can buy and sell in the Stock Exchange or Secondary market. These securities are issued by the Companies under the Companies Act and by the Government under the Indian Public Debt Act, since replaced by the Government Securities Act in 1999. Since the public are not interested in Government Securities due to lower level of interest rates on them, the public awareness of this market is little or negligible. This market is mainly confined to banks, financial institutions etc. The capital market comprises of two components, namely, New Issues Market where companies issue directly securities to the public and the Stock Market or the Secondary Market where the existing securities are bought and sold.
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Investment Management
Trading in old securities is governed by the Securities Contract (Regulation) Act of 1956 and the Securities Contract (Regulation) Rules of 1957. The Act has provided for recognition to the Stock Exchanges and gave wide ranging powers to the Government to control and regulate the Stock Exchanges. It has laid down the types of contracts in securities which can be traded or purchased and sold and for listing of securities of public limited companies, whose shares are being traded. The Act and the Rules made thereunder have provided for qualifications for members, contracts to be traded, trading period, permitted deals, settlement periods, clearance and delivery of shares etc. The actual Rules and Bye-laws of each Stock Exchange have enshrined these rules. The Act is applicable to Public Limited Companies, which are listed on Stock Exchanges and ensure transferability of shares and laid down the conditions under which transferability can be denied to investors.
Companies Act The Companies Act which regulates the activities of the companies from birth to death has provided for the sources of finance for companies and the methods of marketing the public issues which are marketable. These are in the form of ownership category, namely, Equities and Preference shares and Debt capital in the form of convertible and non-convertible debentures, fixed deposits etc. Under the Companies Act, Sections 55 to 68 provided for issue of prospectus, its contents, Registration of Prospectus, civil and criminal liabilities of the Directors for any mis-statements in prospectus etc. The Act has laid down the methods of raising new issues, namely, through prospectus, letter of offer or statement in lieu of prospectus, Rights and Bonus. Section 58 A and B deal with the conditions for acceptance of deposits, repayments of deposits, etc., while companies (acceptance of deposits) Rules of 1975 laid down the period of maturity, interest rates and other conditions. The company deposits are an avenue of investment, but are not tradeable. The details regarding them are dealt with briefly later. Sections 69 to 73 deal with the allotment of new issues to applicants, delivery of certificates and their listing on Stock Exchanges. The allotment is also governed by the guidelines given by the Stock Exchanges as per the listing agreement in the case of listed companies. The basic framework for trading is provided by the Companies Act in the form of: (1) Marketing the shares as movable property under Section 82. (2) Ensuring transferability of shares in respect of public limited companies under Sections 108 - 112. (3) The transfer deed through which share certificates are to be transferred is provided for under Section 108 which was amended to legalise the demat form of transfer since 1999. (4) The validity of the transfer deed under Section 111 is 12 months in the case of listed companies and 24 months in the case of non-listed companies. (5) Section 114 provides for issue of share warrants. So far as investors are concerned, it is desirable that they know the main provisions of the Companies Act, because the issue of prospectus, the contents of it, allotment of new issues, despatch of certificates, transferability etc., are all laid down in it. The rights of shareholders and debentureholders, and different categories of creditors and debtors of companies are set out. The book closure for accounts, presentation of Balance Sheet and Income-Expenditure accounts, payments of dividends etc., are all provided for in this Act. In Particular, Section 82 provides for transferability of shares and Section 73 lays down the conditions for listing of Public Limited Companies. While these sections ensure the marketability of shares of listed public limited companies, trading in them is made possible by the Securities Contracts Regulation Act and the Rules made thereunder. In view of the fact that purchase and sale of shares through recognised Stock Exchanges and through licensed Stock Brokers are only legal, and those are governed by the SC(R) Act, the investors have to be familiar with this Act and the Rules made thereunder. The relations between the Brokers and Investors and in particular, the disputes if any, between them are governed by the Rules and Bye-laws of the Stock Exchanges which are formulated under this Act.
Chapter 1
Securities Markets
27
Acceptance of Fixed Deposits A company cannot accept deposits in excess of 35% of the paid up capital and free reserves. Of this, 25% deposits can be accepted from the public and the rest 10% from shareholders of the company. The minimum period of acceptance of deposits is one year and the maximum period is limited to 3 years. The company is under an obligation to maintain an amount not less than 15% of the company’s deposit liability maturing during the course of the year, in liquid investments such as Government securities, units, deposits with banks etc. The maximum rate of interest that can be offered on deposits is fixed at 11% to 14%. A ceiling on brokerage payable on deposits has been fixed at 1%. The interest earned on fixed deposits of companies does not enjoy any exemption from income tax. Neither does the amount of deposit qualify for any exemption under wealth tax. Under the existing provisions of the Income Tax Act, tax on interest paid/payable is deducted at source if the interest payment exceeds Rs. 2,500 in a financial year unless suitable declaration is furnished by the depositor in regard to the total income of the depositor not exceeding the minimum liable to tax in a financial year. (Form 15(H) under I.T. Act) The acceptance of deposits by non-bank non-financial companies is governed by the Companies (acceptance of deposits) Rules 1975 as amended from time to time. Along with the prescribed application form the terms and conditions of acceptance of deposits are required to be furnished by companies, to the RBI in the case of non-bank finance companies and a copy in case of non-bank non-finance companies. A careful study of either the financial data in the advertisement or the prescribed particulars as available within the application form would generally reveal the working results and the financial position of the company.
Compulsory Repayment of Deposits which have Matured for Repayment The Companies Act, 1956 has been amended by the Companies (Amendement) Act, 1988 with effect from 1.9.1989 so as to provide for compulsory repayment of deposits which have matured for repayment (Section 58(9)]. Under the amended provisions, the Company Law Board has been empowered to take cognizance of non-repayment of any deposit on maturity and to direct repayment of such deposits on such conditions as may be specified by the Company Law Board in its Order. This will help and ensure repayment of public deposits and will create confidence amongst the public.
Procedure for Making Application to Company Law Board The person holding a matured fixed deposit which he has not renewed and which the company has failed to repay, has to make an application in triplicate in Form No.11. The application has to be accompanied by a fee payable by way of bank draft in favour of the Pay & Accounts Officer, Dept. of Company Affairs, New Delhi/Mumbai/Kolkata/Chennai. The Company Law Board has four Regional Benches. The aggrieved depositors may make an application to the Bench of the Company Law Board having jurisdiction according to the Registered Office of the company. The Company Law Board would, after giving a reasonable opportunity of hearing to the company and other persons interested in the matter, make suitable orders for repayment of such deposits. Non-compliance of the order of the Company Law Board is a punishable offence attracting penalty by way of imprisonment upto 3 years and fine of not less than Rs. 50 for every day till such non-compliance continues. Where the deposit which has fallen due for payment remains unpaid the depositor can seek remedy in a civil court, or can file an application for winding up of the company to the court after serving on the company written demand requiring the company to repay the deposit (Section 433, 434 and 439 of the Companies Act may be referred to for the purpose). The SEBI is not permitting such companies to make public issues.
Cases in Respect of which Applications to the Company Law Board will not Lie It is essential to know that under Section 58A of the Companies Act, the power to order repayment of matured deposits can be exercised by the CLB only in respect of deposits accepted Under the Companies (Acceptance of Deposit) Rules 1975 as amended from time to time. In other words, an application to the Company Law Board of repayment of matured deposits shall not lie in the following cases: (i) Deposits made for booking purchases of scooter, car etc.
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Part I
Investment Management
(ii) Deposits accepted by financial companies like, hire-purchase finance company, a housing finance company, an investment company, a loan/mutual benefit financial company, a chit fund company, which are governed by the rules made by the RBI. (iii) Deposits accepted by companies which have been notified as ‘relief undertakings’ under special laws enacted by various State Governments. Court rulings point to the fact that the monetary liabilities of relief undertakings during the notified period stand suspended and any proceedings including the proceedings for compulsory repayment of deposits under Section 58A(9) shall accordingly remain stayed. (iv) Deposits accepted by a sick industrial company covered by the Sick Industrial Companies (Special Provisions) Act, 1985 in respect of which, the Board for Industrial and Financial Reconstruction has specifically, by order suspended the operations of any contract, agreement, settlement, etc. under Section 22(3) of the Act.
Facts about Company Deposits The deposits accepted by a company are not repayable before the date of maturity. It is left to the discretion of a company to allow premature repayment of a deposit. If and when the deposits are prematurely repaid the depositors are entitled to a lower rate of interest than the contracted rate. Most importantly, the company deposits are unsecured and rank pari passu with other unsecured liabilities. Hence, the investor has no recourse to any asset of the company in case of default by a company to repay the deposit on maturity.
Care to be Exercised while Investing in Fixed Deposits Invitation to deposits from public for various schemes of deposits is invariably published in newspapers in the form of a statutory advertisement giving the following details: (i) Terms of acceptance of deposits, rate of interest on different maturities, minimum amount of deposits, cumulative or non-cumulative nature of the deposit, etc. (ii) Brief details of the name of the company, date of its incorporation, business carried on by it, places where the company has offices and names and address of directors. (iii) Details of profits and dividends for the last three years. (iv) Summarised financial position to the company (i.e., assets and liabilities) as appearing in the two latest audited balance sheets, alongwith details of contingent liabilities not provided for. (v) Details regarding maximum amount of deposits which a company can accept. (vi) A specific declaration that deposits accepted are unsecured and would rank pari passu with other unsecured liabilities. (vii) A statement of deposits remaining unpaid.
Problems in Securities Markets Securities markets are highly sensitive to any socio-economic and political factors. As such, the stock market is said to be the window of the economy. A large element of speculation is rampant in these markets and a right dose of regulation is a necessary evil. The sensitivity of external factors has increased after 1992 economic and financial reforms, when liberalisation and globalisation trends began to be perceptible. Lack of professionalisation and broker-banks nexus has led to a number of scams. Even big banks got involved in Scams, in 1991-92 and 2000-01. Corruption and malpractices including mismanagement led to many bank failures, involving the U.T.I. as well. The trust and confidence reposed in the markets by investors were rudely shaken by the failure of U.S. 64 Scheme of UTI, urban corporative banks’ failures and non-refund of deposits by many financial and non-financial companies. The laxity in regulation and in supervision by C.L.B., SEBI and RBI is one obvious reason for increased malpractices in the financial system, shaking the confidence of savers and investors. The failure of global Trust Bank, and scam of Satyam Computers are examples of laxity in supervision.
