Table of Contents I.

Macroeconomics
1. Aggregate Demand.........................................................................................................................4
2. Methods of measuring GDP? ..........................................................................................................4
a.) Expenditure method: ..........................................................................................................4
b.) Income method: ..................................................................................................................5
c.) Production method: ................................................................................................................5
3. Gross National Income (GNI) ..........................................................................................................5
4. Inflation .........................................................................................................................................5
4.1 CPI ...........................................................................................................................................6
4.2 WPI ..........................................................................................................................................6
4.3 Cost Push and Demand Pull Inflation .........................................................................................6
4.3.1 Cost-Push Inflation .............................................................................................................7
4.3.2 Demand-Pull Inflation ........................................................................................................8
5. Deflation ....................................................................................................................................9
6. Monetary Policy .........................................................................................................................9
7. Money Supply .......................................................................................................................... 11
8. Fiscal Policy .............................................................................................................................. 13
8.1 Expansionary Fiscal Policy ....................................................................................................... 13
8.2 Contractionary Fiscal Policy..................................................................................................... 13
8.3 Tools of Fiscal Policy ............................................................................................................... 14
8.3.1 Changes in government spending Governance .................................................................. 14
8.3.2 Changes in taxation .......................................................................................................... 14
8.3.3 Automatic Stabilizers........................................................................................................ 14
8.4 Fiscal Policy and the Multiplier ................................................................................................ 14
8.5 The Budget Balance ................................................................................................................ 15
8.7 Government Budgets .............................................................................................................. 15
8.8 Deficits Versus Debt ................................................................................................................ 15
8.9 Types of Deficits ..................................................................................................................... 15
8.10 Should the Budget Be Balanced? ........................................................................................... 16
8.11 Problems Posed by Rising Government Debt ......................................................................... 16

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Table of Contents II. Bond Basics
1. Bond Characteristics ................................................................................................................. 17
2. Types of Bonds ......................................................................................................................... 17
2.1 Based on the issuer: ................................................................................................................ 17
2.2 Variations in bonds based on features: .................................................................................... 17
3. Relationship between bond price and Interest Rates ................................................................. 18
5.1 Slope of the Yield Curve .......................................................................................................... 19
5.1.1 Normal Yield Curve .......................................................................................................... 19
5.1.2 Flat Yield Curve ................................................................................................................ 19
5.1.3 Inverted Yield Curve ......................................................................................................... 20
5.2 Yield data (for the week ended September 9, 2016) ................................................................. 21

Table of Contents III. Capital Markets

1. Primary Markets ....................................................................................................................... 22
2. Secondary Markets ................................................................................................................... 23
2.1 Stock Exchange ....................................................................................................................... 23
2.2 Products dealt ........................................................................................................................ 24
2.2.1 Equity: ............................................................................................................................. 24
2.2.2 Fixed Income.................................................................................................................... 25
2.3 SEBI and its role ...................................................................................................................... 26
2.4 Trading ................................................................................................................................... 26
2.4.1 Screen Based Trading ........................................................................................................... 26
2.4.2 NEAT ................................................................................................................................... 27
2.4.3 BOLT.................................................................................................................................... 27
2.4.4 Placing orders with the broker ............................................................................................. 27
2.5 Circuit Breaker ........................................................................................................................ 28
2.6 Settlement ............................................................................................................................. 28
2.6.1 Rolling Settlement ............................................................................................................... 28
2.6.2 Pay-in and Pay-out ............................................................................................................... 29
2.6.3 BSEs Trading and Settlement Cycle ...................................................................................... 29
2.7 Market Index and Index Construction...................................................................................... 30

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 2.8 Calculating Indices .................................................................................................................. 30
3. Capital Market Instruments ...................................................................................................... 33
3.1 Deep Discount Bonds .............................................................................................................. 33
3.2 Equity Shares with Detachable Warrants ................................................................................. 33
3.3 Fully Convertible Debentures with Interest.............................................................................. 33
3.4 Equity Preference Shares ........................................................................................................ 34
3.5 Sweat Equity Shares................................................................................................................ 34
3.6 Disaster Bonds ........................................................................................................................ 34
3.7 Mortgage Backed Securities (MBS) .......................................................................................... 34
3.8 Global Depository Receipts/ American Depository Receipts ..................................................... 35
3.9 Foreign Currency Convertible Bonds (FCCBs)............................................................................ 36
3. 10 Derivatives........................................................................................................................... 37
3.10.1 Futures .......................................................................................................................... 37
3.10.2 Options .......................................................................................................................... 38
3.11 Participatory Notes ............................................................................................................... 38
3.12 Hedge Fund .......................................................................................................................... 39
3.13 Fund of Funds ....................................................................................................................... 39
4. Call Money Market ................................................................................................................... 39
4.1 Need for call money market .................................................................................................... 39
4.2 Money market instruments..................................................................................................... 40
4.2.1 T-Bills .................................................................................................................................. 41
4.2.2 Commercial paper................................................................................................................ 41
4.2.3 Certificate of deposits (CD) ................................................................................................... 42
4.2.4 Repurchase agreements (Repo) ............................................................................................ 42
4.2.5 Bankers Acceptance: ............................................................................................................ 43
5. Derivatives Market ................................................................................................................... 43

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 I. MACROECONOMICS

1. Aggregate Demand
The total amount of goods and services demanded in the economy at a given overall price
level and in a given time period. It is represented by the aggregate-demand curve, which
describes the relationship between price levels and the quantity of output that firms are
willing to provide. Normally there is a negative relationship between aggregate demand and
the price level. It is also known as "total spending".
Aggregate demand is the demand for the gross domestic product (GDP) of a country, and is
represented by this formula:
Aggregate Demand (AD) = C + I + G + (X-M)
C = Consumers' expenditures on goods and services
I = Investment spending by companies on capital goods
G = Government expenditures on publicly provided goods and services
X = Exports of goods and services
M = Imports of goods and services.

2. Methods of measuring GDP?

GDP is the market value of all the finished goods and services produced within a country's
borders in a specific time period. Three methods of measuring GDP are as follows:
a.) Expenditure method: The expenditure estimate is based on the value of total expenditure
on goods and services, excluding intermediate goods and services, produced in the
domestic economy during a given period. Thus expenditure approach reflects the value of
spending by corporations, consumers, overseas purchasers and government on goods and
services. The primary data for this measure come from expenditure surveys of households
and businesses, as well as from data on government expenditure.
GDP as examined using the Expenditure Approach is reported as the sum of four
components. The formula for determining GDP is: C + I + G + (X - M) = GDP
Where,
C = Personal Consumption Expenditures
I = Gross Private Fixed Investment
G = Government Expenditures and Investment
X = Net Exports
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 M = Net Imports
b.) Income method: The income estimate measures the incomes earned by individuals (for
example, wages) and corporations (for example, profits) directly from the production of
outputs (goods and services). The main data for this approach to measuring GDP come
from the Quarterly Operating Profits, Average Weekly Earnings and employer surveys,
along with administrative data from HM Revenue & Customs.
c.) Production method: The production estimate is based on the value of final output in the
economy less the inputs used up in the production process. Final outputs include products
such as cars, while intermediate goods are inputs used in the production of another good
or service, such as car tires, electricity and advertising. As the value of the final good (the
cars price) reflects both the value of its inputs (the tires) and the engineering expertise of
the manufacturer, adding the final output of the tire manufacturer to final output of the
car manufacturer together would overestimate GDP. To avoid this double counting, the
value-added at each stage of production is calculated and aggregated. This is known as
gross value added (GVA), which is further adjusted for taxes and subsidies on products to
create a GDP estimate.

3. Gross National Income (GNI)

Gross national income (GNI) is defined as the sum of value added by all producers who are
residents in a nation, plus any product taxes (minus subsidies) not included in output,
plus income received from abroad such as employee compensation and property income. GNI
measures income received by a country both domestically and from overseas. In this respect,
GNI is quite similar to Gross National Product (GNP), which measures output from the citizens
and companies of a particular nation, regardless of whether they are located within its
boundaries or overseas.

4. Inflation
To calculate inflation, the number of goods that are representative of the economy are put
together into what is referred to as a "market basket." The cost of this basket is then
compared over time. This results in a price index, which is the cost of the market basket today
as a percentage of the cost of that identical basket in the starting year.
There are two main price indexes that measure inflation:

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4.1 CPI
CPI uses a "basket of goods" approach that aims to compare a consistent base of products
from year to year, focusing on products that are bought and used by consumers on a daily
basis. The CPI measures price change from the perspective of the retail buyer. It is the real
index for the common people. It reflects the actual inflation that is borne by the
individual. CPI is designed to measure changes over time in the level of retail prices of
selected goods and services on which consumers of a defined group spend their incomes.
Till January 2012, in India CPI was calculated based on
1. Industrial Workers (IW) (base 2001),
2. Agricultural Labourer (AL) (base 1986-87) and
3. Rural Labourer (RL) (base 1986-87)
4. Urban Non-Manual Employees (UNME) (base 1984-85)
However, these did not encompass all the segments of the population and thus, did not
reflect the true picture of the price behaviour in the country as a whole.
Thus, now Central Statistics Office (CSO) of the Ministry of Statistics and Programme
Implementation has started compiling a new series of CPI for the
1. CPI for the entire urban population - CPI (Urban)
2. CPI for the entire rural population - CPI (Rural)
3. Consolidated CPI for Urban + Rural will also be compiled based on above two CPIs
These would reflect the changes in the price level of various goods and services consumed
by the urban and rural population. These new indices are now compiled at State / UT and all
India levels.

4.2 WPI
It is an index that measures and tracks the changes in price of goods in the stages before the
retail level. Wholesale price indexes (WPIs) report monthly to show the average price
changes of goods sold in bulk, and they are a group of the indicators that follow growth in
the economy.

4.3 Cost Push and Demand Pull Inflation

Inflation is a sustained increase in the general price level leading to a fall in the purchasing
power of money. Inflationary pressures can come from domestic and external sources and
from both the supply and demand side of the economy.

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4.3.1 Cost-Push Inflation
Aggregate supply is the total volume of
goods and services produced by an
economy at a given price level. When
there is a decrease in the aggregate
supply of goods and services stemming
from an increase in the cost of
production, we have cost-push inflation.
Cost-push inflation basically means that
prices have been "pushed up" by
increases in costs of any of the four
factors of production (labor, capital, land or entrepreneurship) when companies are already
running at full production capacity. With higher production costs and productivity
maximized, companies cannot maintain profit margins by producing the same amounts of
goods and services. As a result, the increased costs are passed on to consumers, causing a
rise in the general price level (inflation).
Cost-push inflation occurs when businesses respond to rising costs, by increasing their
prices to protect profit margins. There are many reasons why costs might rise:

1. Component costs: e.g. an increase in the prices of raw materials and components. This
might be because of a rise in global commodity prices such as oil, gas copper and
agricultural products used in food processing a good recent example is the surge in the
world price of wheat.

2. Rising labour costs - caused by wage increases that exceed improvements in

productivity. Wage and salary costs often rise when unemployment is low (creating
labour shortages) and when people expect inflation so they bid for higher pay in order
to protect their real incomes.

3. Higher indirect taxes imposed by the government for example a rise in the duty on
alcohol, cigarettes and petrol/diesel or a rise in the standard rate of Value Added Tax.
Depending on the price elasticity of demand and supply, suppliers may pass on the
burden of the tax onto consumers.

4. A fall in the exchange rate this can cause cost push inflation because it normally leads
to an increase in the prices of imported products. For example during 2007-08 the pound

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 fell heavily against the Euro leading to a jump in the prices of imported materials from
Euro Zone countries.

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply
curve. The fall in SRAS causes a contraction of GDP together with a rise in the level of prices.
One of the risks of cost-push inflation is that it can lead to stagflation.

4.3.2 Demand-Pull Inflation

Demand-pull inflation occurs when
there is an increase in aggregate
demand, categorized by the four
sections of the macro economy:
households, businesses, governments
and foreign buyers. When these four
sectors concurrently want to purchase
more output than the economy can
produce, they compete to purchase
limited amounts of goods and services.
Buyers in essence "bid prices up", again, causing inflation. This excessive demand, also
referred to as "too much money chasing too few goods", usually occurs in an expanding
economy.

Possible causes of demand pull inflation

1. A depreciation of the exchange rate which makes exports more competitive in overseas
markets leading to an injection of fresh demand into the circular flow and a rise in
national and demand for factor resources there may also be a positive multiplier effect
on the level of demand and output arising from the initial boost to export sales.
2. Higher demand from a government (fiscal) stimulus e.g. via a reduction in direct or
indirect taxation or higher government spending and borrowing. If direct taxes are
reduced, consumers will have more disposable income causing demand to rise. Higher
government spending and increased borrowing feeds through directly into extra
demand in the circular flow.
3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much
demand for example in raising demand for loans or in causing rise in house price
inflation.

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 4. Faster economic growth in other countries providing a boost to UK exports overseas.
5. Improved business confidence which prompts firms to raise prices and achieve better
profit margins

Demand pull inflation is most likely to occur when an economy is becoming stretched and
is said to be danger of over-heating. This is often seen towards the end of a boom when
output is expanding beyond the economys usual capacity to supply, the result being higher
prices and also a larger trade deficit.

5. Deflation
It is a general decline in prices, often caused by a reduction in the supply of money or credit.
Deflation can be caused also by a decrease in government, personal or investment spending.
The opposite of inflation, deflation has the side effect of increased unemployment since there
is a lower level of demand in the economy, which can lead to an economic depression. Central
banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the
excessive drop in prices to a minimum.

6. Monetary Policy
Monetary policy is the macroeconomic policy laid down by the central bank. It involves
management of money supply and interest rate and is the demand side economic policy used
by the government of a country to achieve macroeconomic objectives like inflation,
consumption, growth and liquidity.
In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of
money in order to meet the requirements of different sectors of the economy and to increase
the pace of economic growth.
The RBI implements the monetary policy through open market operations, bank rate policy,
reserve system, credit control policy and through many other instruments. Using any of these
instruments will lead to changes in the interest rate, or the money supply in the economy.
Monetary policy can be expansionary and contractionary in nature. Increasing money supply
and reducing interest rates indicate an expansionary policy. The reverse of this is a
contractionary monetary policy.
For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the
RBI is dependent on the monetary policy. By purchasing bonds through open market
operations, the RBI introduces money in the system and reduces the interest rate.

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Statutory Liquidity Ratio (21.5%): The minimum percentage of deposits that the bank has to
maintain in form of gold, cash or other approved securities. Every bank is required to maintain
at the close of business every day, a minimum proportion of their Net Demand and Time
Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities.
The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio
(SLR). RBI is empowered to increase this ratio up to 40%. An increase in SLR also restricts the
banks leverage position to pump more money into the economy.
Cash Reserve Ratio (4%): Banks in India need to hold a certain proportion of their deposits in
the form of cash. Higher the ratio (i.e. CRR), the lower is the amount that banks will be able
to use for lending and investment. This power of RBI to reduce the lendable amount by
increasing the CRR makes it an instrument in the hands of a central bank through which it can
control the amount that banks lend. Thus, it is a tool used by RBI to control liquidity in the
banking system.
Repo rate (6.5%): Repo (Repurchase) rate is the rate at which the RBI lends shot-term money
to the banks against securities. When the repo rate increases borrowing from RBI becomes
more expensive. Therefore, RBI wants to make it more expensive for the banks to borrow
money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow
money, it reduces the repo rate
Reverse Repo rate (6%): Reverse Repo rate is the rate at which banks park their short-term
excess liquidity with the RBI. The banks use this tool when they feel that they are stuck with
excess funds and are not able to invest anywhere for reasonable returns. An increase in the
reverse repo rate means that the RBI is ready to borrow money from the banks at a higher
rate of interest. As a result, banks would prefer to keep more and more surplus funds with
RBI.
Marginal Standing Facility (7%): MSF rate is the rate at which banks borrow funds overnight
from the Reserve Bank of India (RBI) against approved government securities. This came into
effect in May 2011. Under the Marginal Standing Facility (MSF), currently banks avail funds
from the RBI on overnight basis against their excess statutory liquidity ratio (SLR) holdings.
Additionally, they can also avail funds on overnight basis below the stipulated SLR up to 2.5%
of their respective Net Demand and Time Liabilities (NDTL) outstanding at the end of second
preceding fortnight.

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7. Money Supply
In economics, the money supply or money stock is the total amount of monetary
assets available in an economy at a specific time. Money supply includes currency in
circulation and demand deposits (generally savings and current accounts in the commercial
banks).
That relation between money and prices is historically associated with the quantity theory of
money. There is strong empirical evidence of a direct relation between money-supply growth
and long-term price inflation, at least for rapid increases in the amount of money in the
economy. That is, a country such as Zimbabwe which saw rapid increases in its money supply
also saw rapid increases in prices (hyperinflation). This is one reason for the reliance
on monetary policy as a means of controlling inflation.
The nature of this causal chain is the subject of contention. Some heterodox economists argue
that the money supply is endogenous (determined by the workings of the economy, not by
the central bank) and that the sources of inflation must be found in the distributional structure
of the economy.
In addition, those economists seeing the central bank's control over the money supply as
feeble say that there are two weak links between the growth of the money supply and the
inflation rate. First, in the aftermath of a recession, when many resources are underutilized,
an increase in the money supply can cause a sustained increase in real production instead of
inflation. Second, if the velocity of money, i.e., the ratio between nominal GDP and money
supply changes, an increase in the money supply could have either no effect, an exaggerated
effect, or an unpredictable effect on the growth of nominal GDP.
The Reserve Bank of India defines the monetary aggregates as:
Reserve Money (M0): Currency in circulation + Bankers deposits with the RBI + Other
deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial
sector + RBIs claims on banks + RBIs net foreign assets + Governments currency
liabilities to the public RBIs net non-monetary liabilities.
M1: Currency with the public + Deposit money of the public (Demand deposits with the
banking system + Other deposits with the RBI).
M2: M1 + Savings deposits with Post office savings banks.
M3: M1+ Time deposits with the banking system = Net bank credit to the Government +
Bank credit to the commercial sector + Net foreign exchange assets of the banking sector
+ Governments currency liabilities to the public Net non-monetary liabilities of the
banking sector (Other than Time Deposits).
M4: M3 + All deposits with post office savings banks (excluding National Savings
Certificates).

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Central banks around the world control the money supply using various tools at their disposal.
The tools are broadly classified as below:
1. A change in reserve requirements
The reserve ratio is the percentage of reserves a bank is required to hold against deposits.
A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of
money. An increase in the ratio will have the opposite effect.
2. A change in the discount rate
The discount rate is the interest rate that the central bank charges commercial banks that
need to borrow additional reserves. It is an administered interest rate set by the Fed, not
a market rate; therefore, much of its importance stems from the signal the central bank
is sending to the financial markets. As a result, short-term market interest rates tend to
follow its movement. If the central bank wants to give banks more reserves, it can reduce
the interest rate that it charges, thereby tempting banks to borrow more. Alternatively,
it can soak up reserves by raising its rate and persuading the banks to reduce borrowing.
3. Open-market operations
Open-market operations consist of the buying and selling of government securities by the
central bank. If the bank buys back issued securities (such as Treasury bills) from large
banks and securities dealers, it increases the money supply in the hands of the public.
Conversely, the money supply decreases when the bank sells a security. In the case of an
open-market purchase of securities by the central bank, it is more realistic for the seller
of the securities to receive a check drawn on the bank itself. When the seller deposits it
in his or her bank, the bank is automatically granted an increased reserve balance with
the central bank. Thus, the new reserves can be used to support additional loans. Through
this process, the money supply increases. The monetary expansion following an open-
market operation involves adjustments by banks and the public. The bank in which the
original check from the Fed is deposited now has a reserve ratio that may be too high. In
other words, its reserves and deposits have gone up by the same amount; therefore, its
ratio of reserves to deposits has risen. To reduce this ratio of reserves to deposits, it
chooses to expand loans.
When the bank makes an additional loan, the person receiving the loan gets a bank
deposit. At this stage, when the bank makes a loan, the money supply rises by more than
the amount of the open-market operation. This multiple expansion of the money supply
is called the money multiplier.

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8. Fiscal Policy
Fiscal policy is the use of taxes, government transfers, or government purchases of goods and
services to shift the aggregate demand curve.
Discretionary Fiscal Policy: government takes deliberate actions through legislation to
alter spending or taxation policies
Inflation: The rate at which the general level of prices for goods and services is rising, and,
subsequently, purchasing power is falling.
Deflation: A general decline in prices, often caused by a reduction in the supply of money
or credit. Deflation can be caused also by a decrease in government, personal or investment
spending. The opposite of inflation.
Disinflation: A slowing in the rate of price inflation. Disinflation is used to describe
instances when the inflation rate has reduced marginally over the short term. Although it is
used to describe periods of slowing inflation, disinflation should not be confused with
deflation.
Hyper-Inflation: Extremely rapid or out of control inflation. Hyperinflation is a situation
where the price increases are so out of control that the concept of inflation is meaningless.
Stagflation: A condition of slow economic growth and relatively high unemployment - a
time of stagnation - accompanied by a rise in prices, or inflation

8.1 Expansionary Fiscal Policy

When the economy is in recession, government wants to increase Aggregate Demand (AD)

Tax cut: increases consumers disposable income

Increases Aggregate Demand as long as consumers dont increase savings or spending
on imports
Increase in government spending: directly shifts the Aggregate Demand curve

8.2 Contractionary Fiscal Policy

When economy is suffering from inflation, government wants to decrease Aggregate
Demand

Tax increase: decreases disposable income of consumers

Aggregate Demand curve shifts left, both inflation and GDP decrease
Decrease in government spending: directly shifts the Aggregate Demand curve left

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8.3 Tools of Fiscal Policy

8.3.1 Changes in government spending Governance

Can increase spending in normal budgetary programs (health, education, welfare,
etc.)
Can increase spending on infrastructure (underlying economic foundation of
goods and services that allows a society to function e.g. build roads, schools,
communication systems)
Added advantage of increasing capital goods in economy which can shift AS in the
future

8.3.2 Changes in taxation

Raise or lower personal and corporate income taxes and/or sales and excise taxes
Alter tax exemptions or tax credits
Provide special tax incentives for investment (Capital Cost Allowance)

8.3.3 Automatic Stabilizers

Exist and act on Aggregate Demand before a recession or inflationary trend takes
hold
Employment insurance and welfare: increased payments during times of
economic downturns
Help to maintain incomes during recessions (maintain spending)
Either slows the leftward shift of Aggregate Demand or shifts curve right
Progressive tax: as incomes rise, taxes rise
Slows down increases in consumption
Stops Aggregate Demand curve from shifting too quickly to the right

8.4 Fiscal Policy and the Multiplier

Fiscal policy has a multiplier effect on the economy
Expansionary fiscal policy leads to an increase in real GDP larger than the initial rise in
aggregate spending caused by the policy. The government spends an additional $4 Billion
through discretionary fiscal policy. The total effect on GDP will be larger than $4 Billion
The multiplier effect refers to the additional shifts in aggregate demand that result when
expansionary fiscal policy increases income and thereby increases consumer spending
Conversely, contractionary fiscal policy leads to a fall in real GDP larger than the initial
reduction in aggregate spending caused by the policy

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8.5 The Budget Balance
Other things equal, discretionary expansionary fiscal policiesincreased government
purchases of goods and services, higher government transfers, or lower taxesreduce the
budget balance for that year
That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit
bigger
Conversely, contractionary fiscal policiessmaller government purchases of goods and
services, smaller government transfers, or higher taxesincrease the budget balance for
that year, making a budget surplus bigger or a budget deficit smaller
Some of the fluctuations in the budget balance are due to the effects of the business cycle
In order to separate the effects of the business cycle from the effects of discretionary fiscal
policy, governments estimate the cyclically adjusted budget balance, an estimate of the
budget balance if the economy were at potential output

8.7 Government Budgets

Deficit budget: government spends more than it receives in tax revenue (must borrow
money to cover shortfall)
Surplus budget: government collects more in taxes than it spends
Balanced budget: government spends amount equal to collected tax revenue

8.8 Deficits Versus Debt

A deficit is the difference between the amount of money a government spends and the
amount it receives in taxes over a given period
A debt is the sum of money a government owes at a particular point in time
Deficits and debt are linked, because government debt grows when governments run
deficits. But they arent the same thing, and they can even tell different stories

8.9 Types of Deficits

Cyclical deficit: part of deficit incurred in trying to pull an economy out of recession
(spending on infrastructure, jobs retraining, etc.)
Structural deficit: part of deficit that exists even when economy is operating at full
employment
Full employment budget: intervene only when economy falls below its full-employment
targets no structural deficits

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8.10 Should the Budget Be Balanced?
Most economists dont believe the government should be forced to run a balanced
budget every year because this would undermine the role of taxes and transfers as
automatic stabilizers
Yet policy makers concerned about excessive deficits sometimes feel that rigid rules
prohibitingor at least setting an upper limit ondeficits are necessary

8.11 Problems Posed by Rising Government Debt

Public debt may crowd out investment spending, which reduces long-run economic
growth.
And in extreme cases, rising debt may lead to government default, resulting in economic
and financial turmoil.
Cant a government that has trouble borrowing just print money to pay its bills?
Yes, it can, but this leads to another problem: inflation

16
 II. BOND BASICS

1. Bond Characteristics
A bond is a fixed income security with the following characteristics:
1. Face value/Par value: The face value (also known as the par value or principal) is
the amount of money a holder will get back once a bond matures. The par value is not
the price of the bond (the bonds price fluctuates throughout its life). When a bond
trades at a price above the face value, it is said to be selling at a premium. When a bond
sells below face value, it is said to be selling at a discount.
2. Coupon: The coupon is the amount the bondholder will receive as interest
payments. The coupon is expressed as a percentage of the par value. If a bond pays a
coupon of 10% and its par value is $1,000, then it'll pay $100 of interest a year.
3. Maturity: The maturity date is the date in the future on which the investor's
principal will be repaid
4. Yield: the return provided by a fixed income investment = Coupon/ Bond purchase
price
5. Yield to Maturity: total return you will receive if you hold the bond to maturity

2. Types of Bonds

2.1 Based on the issuer:

1. Government Bonds: Issued by the Government of a particular country
2. Municipal Bonds: Issued by local governments
3. Corporate Bonds: Issued by Corporates

2.2 Variations in bonds based on features:

1. Convertible Bonds: which the holder can convert into stock
2. Callable Bonds: which allow the company to redeem an issue prior to maturity
3. Put Bonds: which allows the holder to force the issuer to repurchase the security at
specified dates before maturity
4. Zero Coupon Bonds: This is a type of bond that makes no coupon payments but
instead is issued at a considerable discount to par value. For example, a zero-coupon
bond with a $1,000 par value and 10 years to maturity trading at $600; you'd be paying
$600 today for a bond that will be worth $1,000 in 10 years

17
3. Relationship between bond price and Interest Rates
Interest rates and bond prices have an inverse relationship. When interest rates fall, bond
prices usually rise and when interest rates rise, bond prices usually fall.
Example: An investor buys a new bond for $1,000 that has a 6% interest payment (yield)
earning $60 in interest each year. (This interest payment is generally referred to as a
coupon.) If interest rates increase by 1%, new bonds will provide a 7% interest payment,
paying investors $70 annually. Because investors will now be able to buy a bond with a
higher interest payment (higher yield), not as many people will want to buy the 6% bonds.
This decline in demand will cause the value of the 6% bond to fall.

4. Bond Valuation

The value of a bond at any time is simply the present value of the remaining cash flows.
Consider a bond having a coupon of 10% and 3 years remaining to maturity. The face
value/par value of the bond is Rs.1000. The bond gives has a yield to maturity of 12.5%.

Then the value of the bond may be calculated as:

Cash Flow in Year 1: 10% of 1000 = Rs 100. PV of cash flow = 100/ (1.125) = Rs.88.88
Cash Flow in Year 2: Rs.100. PV of cash flow = 100/ (1.125) ^2 = Rs.79.01
Cash Flow in Year 3: Rs.1100 (as the principal of Rs.1000 is also paid back).
PV of cash flow = Rs.1100/ (1.125) ^3 = Rs.772.65
Bond Value = 88.88+79.01+772.65 = Rs. 940.46
As the YTM is greater than the coupon rate the bond is trading at a discount i.e. the price
of the bond is less than its par value. If YTM is lesser than coupon rate then the bond will
trade at a premium i.e the current value will be greater than the par value.

For a Zero Coupon bond:

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5. Yield curve analysis
The yield curve is a favourite market indicator of analysts and investors around the world.
Lets look at how we can use the yield curve to analyse current market conditions and
project future market conditions.

5.1 Slope of the Yield Curve

The slope of the yield curve provides analysts and investors with the important
information they are looking for. Typically, you will see one of the following three slopes
on your yield curve:
Normal yield curve
Flat yield curve
Inverted yield curve

5.1.1 Normal Yield Curve

A normal yield curve tells us that investors believe the Federal Reserve is going to be
raising interest rates in the future. Typically, the Federal Reserve only has to raise
interest rates when the economy is expanding and the Fed is worried about inflation.
Therefore, a normal yield curve often precedes an economic upturn.

5.1.2 Flat Yield Curve

A flat yield tells us that investors believe the Federal Reserve is going to be cutting
interest rates. Typically, the Federal Reserve only has to cut interest rates when the
economy is contracting and the Fed is trying to stimulate growth. Therefore, a flat
yield curve is often a sign of an economic slowdown.

19
5.1.3 Inverted Yield Curve
An inverted yield curve tells us that investors believe the Federal Reserve is going to
be dramatically cutting interest rates. Typically, the Federal Reserve has to
dramatically cut interest rates during a recession. Therefore, an inverted yield curve
is often a sign that the economy is in, or is headed for, a recession.

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 5.2 Yield data (for the week ended September 9, 2016)
The table below shows the latest yields per the maturities. If you plot this on the graph,
it will be an upward slopping (or normal) yield curve.

Date 1 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr

09/01/16 0.27 0.33 0.47 0.60 0.78 0.91 1.18 1.44 1.57 1.90 2.23

09/02/16 0.25 0.33 0.45 0.59 0.80 0.92 1.20 1.47 1.60 1.95 2.28

09/06/16 0.24 0.32 0.45 0.56 0.74 0.86 1.13 1.40 1.55 1.90 2.24

09/07/16 0.25 0.34 0.49 0.57 0.74 0.86 1.12 1.39 1.54 1.89 2.23

09/08/16 0.26 0.35 0.50 0.57 0.78 0.91 1.19 1.46 1.61 1.98 2.32

09/09/16 0.24 0.35 0.51 0.58 0.79 0.93 1.23 1.51 1.67 2.05 2.39

Friday Sep 9, 2016

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 III. CAPITAL MARKETS
Types of Markets Primary and Secondary

1. Primary Markets
It is a market that issues new securities on an exchange. It is used by Companies,
governments and other groups obtain financing through debt or equity based securities.
The primary markets are where investors can get first crack at a new security issuance.
The issuing company or group receives cash proceeds from the sale, which is then used
to fund operations or expand the business. Primary markets are facilitated by
underwriting groups, which consist of investment banks that will set a beginning price
range for a given security and then oversee its sale directly to investors.
IPOIt is the first sale of stock by a private company to the public. IPOs are often issued
by smaller, younger companies seeking the capital to expand, but can also be done by
large privately owned companies looking to become publicly traded.
In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it
determine what type of security to issue (common or preferred), the best offering price
and the time to bring it to market. For further information -
http://www.sebi.gov.in/faq/pubissuefaq.pdf
Prospectus- A formal legal document, which is required by and filed with the SEBI that
provides details about an investment offering for sale to the public. A prospectus should
contain the facts that an investor needs to make an informed investment decision.
Book Building- SEBI guidelines defines Book Building as "a process undertaken by which
a demand for the securities proposed to be issued by a body corporate is elicited and
built-up and the price for such securities is assessed for the determination of the quantum
of such securities to be issued by means of a notice, circular, advertisement, document
or information memoranda or offer document".
Book Building is basically a process used in Initial Public Offer (IPO) for efficient price
discovery. It is a mechanism where, during the period for which the IPO is open, bids are
collected from investors at various prices, which are above or equal to the floor price. The
offer price is determined after the bid closing date.
As per SEBI guidelines, an issuer company can issue securities to the public though
prospectus in the following manner:
100% of the net offer to the public through book building process

22
 75% of the net offer to the public through book building process and 25% at the
price determined through book building. The Fixed Price portion is conducted like
a normal public issue after the Book Built portion, during which the issue price is
determined.
The concept of Book Building is relatively new in India. However it is a common
practice in most developed countries.

2. Secondary Markets
This is the market wherein the trading of securities is done. Secondary market consists of
both equity as well as debt markets.
Securities issued by a company for the first time are offered to the public in the primary
market. Once the IPO is done and the stock is listed, they are traded in the secondary
market. The main difference between the two is that in the primary market, an investor
gets securities directly from the company through IPOs, while in the secondary market,
one purchases securities from other investors willing to sell the same.
Equity shares, bonds, preference shares, treasury bills, debentures, etc. are some of the
key products available in a secondary market. SEBI is the regulator of the same.
For the general investor, the secondary market provides an efficient platform for trading
of his securities. For the management of the company, Secondary equity markets serve
as a monitoring and control conduitby facilitating value-enhancing control activities,
enabling implementation of incentive-based management contracts, and aggregating
information (via price discovery) that guides management decisions.

2.1 Stock Exchange

The stock exchanges in India, under the overall supervision of the regulatory authority,
the Securities and Exchange Board of India (SEBI), provide a trading platform, where
buyers and sellers can meet to transact in securities. Even though there are 21 SEBI
recognized stock exchanges in India, majority of the trading activity happens through BSE
and NSE. The trading platform provided by BSE and NSE is an electronic one and there is
no need for buyers and sellers to meet at a physical location to trade. They can trade
through the computerized trading screens available with the BSE/NSE trading members
or the internet based trading facility provided by the trading members of BSE/NSE.

Demutualisation of stock exchanges

Demutualisation refers to the legal structure of an exchange whereby the ownership, the
management and the trading rights at the exchange are segregated from one another.

23
 Difference between a demutualised exchange and mutual exchange
In a mutual exchange, the three functions of ownership, management and trading are
concentrated into a single Group. Here, the broker members of the exchange are both
the owners and the traders on the exchange and they further manage the exchange as
well. This at times can lead to conflicts of interest in decision making. A demutualised
exchange, on the other hand, has all these three functions clearly segregated, i.e. the
ownership, management and trading are in separate hands.

2.2 Products dealt

Following are the main financial products/instruments dealt in the secondary market:

2.2.1 Equity: The ownership interest in a company of holders of its common and preferred
stock. The various kinds of equity shares are as follows:-

a) Equity Shares: An equity share, commonly referred to as ordinary share also

represents the form of fractional ownership in which a shareholder, as a fractional
owner, undertakes the maximum entrepreneurial risk associated with a business
venture. The holders of such shares are members of the company and have voting
rights.

Rights Issue / Rights Shares: The issue of new securities to existing shareholders
at a ratio to those already held.

Bonus Shares: Shares issued by the companies to their shareholders free of cost
by capitalization of accumulated reserves from the profits earned in the earlier
years.

Preferred Stock / Preference shares: Owners of these kinds of shares are entitled
to a fixed dividend or dividend calculated at a fixed rate to be paid regularly before
dividend can be paid in respect of equity share. They also enjoy priority over the
equity shareholders in payment of surplus. But in the event of liquidation, their
claims rank below the claims of the companys creditors, bondholders / debenture
holders.

Cumulative Preference Shares: A type of preference shares on which dividend

accumulates if remains unpaid. All arrears of preference dividend have to be paid
out before paying dividend on equity shares.

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 Cumulative Convertible Preference Shares: A type of preference shares where
the dividend payable on the same accumulates, if not paid. After a specified date,
these shares will be converted into equity capital of the company.

Participating Preference Share: The right of certain preference shareholders to

participate in profits after a specified fixed dividend contracted for is paid.
Participation right is linked with the quantum of dividend paid on the equity shares
over and above a particular specified level.

2.2.2 Fixed Income

Government securities (G-Secs): These are sovereign (credit risk-free) coupon

bearing instruments which are issued by the Reserve Bank of India on behalf of
Government of India, in lieu of the Central Government's market borrowing
programme. These securities have a fixed coupon that is paid on specific dates on
half-yearly basis. These securities are available in wide range of maturity dates.

Debentures: Bonds issued by a company bearing a fixed rate of interest usually

payable half yearly on specific dates and principal amount repayable on particular
date on redemption of the debentures. Debentures are normally secured /
charged against the asset of the company in favour of debenture holder.

Bond: A negotiable certificate evidencing indebtedness. It is normally unsecured.

A debt security is generally issued by a company, municipality or government
agency. A bond investor lends money to the issuer and in exchange, the issuer
promises to repay the loan amount on a specified maturity date. The issuer usually
pays the bond holder periodic interest payments over the life of the loan.

Zero Coupon Bond: Bond issued at a discount and repaid at a face value. No
periodic interest is paid. The difference between the issue price and redemption
price represents the return to the holder. The buyer of these bonds receives only
one payment, at the maturity of the bond.

Convertible Bond: A bond giving the investor the option to convert the bond into
equity at a fixed conversion price.

Commercial Paper: A short term promise to repay a fixed amount that is placed
on the market either directly or through a specialized intermediary. It is usually
issued by companies with a high credit standing in the form of a promissory note
redeemable at par to the holder on maturity and therefore, doesnt require any

25
 guarantee. Commercial paper is a money market instrument issued normally for
tenure of 90 days.

Treasury Bills: Short-term (91 days, 182 days, 364 days) bearer discount security
issued by the Government as a means of financing its cash requirements.

2.3 SEBI and its role

The Securities and Exchange Board of India (SEBI) is the regulatory authority in India
established under Section 3 of SEBI Act, 1992. SEBI Act, 1992 provides for establishment
of Securities and Exchange Board of India (SEBI) with statutory powers for (a) protecting
the interests of investors in securities (b) promoting the development of the securities
market and (c) regulating the securities market. Its regulatory jurisdiction extends over
corporates in the issuance of capital and transfer of securities, in addition to all
intermediaries and persons associated with securities market. SEBI has been obligated
to perform the aforesaid functions by such measures as it thinks fit. In particular, it has
powers for:
Regulating the business in stock exchanges and any other securities markets
Registering and regulating the working of stock brokers, subbrokers etc.
Promoting and regulating self-regulatory organizations
Prohibiting fraudulent and unfair trade practices
Calling for information from, undertaking inspection, conducting inquiries and
audits of the stock exchanges, intermediaries, self-regulatory organizations, mutual
funds and other persons associated with the securities market.

2.4 Trading

2.4.1 Screen Based Trading

The trading on stock exchanges in India used to take place through open outcry
without use of information technology for immediate matching or recording of
trades. This was time consuming and inefficient. This imposed limits on trading
volumes and efficiency. In order to provide efficiency, liquidity and transparency, NSE
introduced a nationwide, on line, fully automated screen based trading system (SBTS)
where a member can punch into the computer the quantities of a security and the
price at which he would like to transact, and the transaction is executed as soon as a
matching sale or buy order from a counter party is found.

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 2.4.2 NEAT
NSE is the first exchange in the world to use satellite communication technology for
trading. Its trading system, called National Exchange for Automated Trading (NEAT),
is a state of-the-art client server based application. At the server end all trading
information is stored in an in-memory database to achieve minimum response time
and maximum system availability for users. For all trades entered into NEAT system,
there is uniform response time of less than one second.

2.4.3 BOLT
BSE On-Line Trading System, popularly known as the BOLT System took its genesis in
the year 1994, as part of the four-phase computerization program to create an
automated trading environment. BOLT system aimed at converting the Open Outcry
System of trading to a Screen-based trading system (SBT). In BOLT system buy and
sell orders entered by the Trading Members are known as "Bid" and "Offers",
respectively.

2.4.4 Placing orders with the broker

You may go to the brokers office or place an order on the phone/internet or as
defined in the Model Agreement, which every client needs to enter into with his or
her broker.
Session Timings

Session Time Action

Order Addition/Modification/Cancellation
Random stoppage between 7th and 8th minute
9:00am -
Order Entry Period Dissemination of Indicative Price, Cumulative
9:07/08am
buy & sale Quantity & Indicative Index
Uniform price band of 20% is applicable

Order Matching & No Order Addition/Modification/Cancellation

9:08am -
Confirmation Opening price determination, order matching
9.12am
Period and trade confirmation & trade confirmation

9:12am - To facilitate transition between pre open and

Buffer Period
9:15am continuous trading session

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 Continuous Trading Session 9:15am 3:30pm Trades occur continuously as orders
match at time/price priority

2.5 Circuit Breaker

The index-based market-wide circuit breaker system applies at 3 stages of the index
movement, either way viz. at 10%, 15% and 20%. These circuit breakers when triggered
bring about a coordinated trading halt in all equity and equity derivative markets
nationwide. The market-wide circuit breakers are triggered by movement of either the
BSE Sensex or the NSE CNX Nifty, whichever is breached earlier.
The market shall re-open, after index based market-wide circuit filter breach, with a pre-
open call auction session. The extent of duration of the market halt and pre-open session
is as given below:
Trigger Market halt Pre-open call auction
Trigger time
limit duration session post market halt

Before 1:00 pm. 45 Minutes 15 Minutes

10% At or after 1:00 pm upto 2.30 pm 15 Minutes 15 Minutes
At or after 2.30 pm No halt Not applicable
Before 1 pm 1 hour 45 minutes 15 Minutes
At or after 1:00 pm before 2:00 pm 45 Minutes 15 Minutes
15%
Remainder of the
On or after 2:00 pm Not applicable
day
Remainder of the
20% Any time during market hours Not applicable
day

2.6 Settlement

2.6.1 Rolling Settlement

Under rolling settlements, unlike in the "account period settlements", the trades
done on a particular day are settled after a given number of business days instead of
settling all trades done during an "account period' of a week or fortnight. Under
rolling settlement all open positions at the end of the day mandatorily result in
payment/ delivery n days later. Currently trades in rolling settlement are settled on
T+2 basis where T is the trade day. For example, a trade executed on Monday is
mandatorily settled by Wednesday (considering two working days from the trade day

28
 - excluding Saturdays, Sundays, bank and Exchange trading holidays). The funds and
securities pay-in and pay-out are carried out on T+2 days.

2.6.2 Pay-in and Pay-out

Pay-in day is the day when the securities sold are delivered to the exchange by the
sellers and funds for the securities purchased are made available to the exchange by
the buyers.
Pay-out day is the day the securities purchased are delivered to the buyers and the
funds for the securities sold are given to the sellers by the exchange.
At present the pay-in and pay-out happens on the 2nd working day after the trade is
executed on the stock exchange.

2.6.3 BSEs Trading and Settlement Cycle

Day Activity

Trading on BOLT and daily downloading of statements showing details of

transactions and margins at the end of each trading day.
T Downloading of provisional securities and funds obligation statements by Trading
Members
Give-up* entry by the Trading Members/ confirmation by the custodians

Trading Members can modify the unconfirmed give up entry upto 11:00 a.m.
Confirmation of give up data by the Custodians upto 1:00 p.m.
T+1
Downloading of final securities and funds obligation statements by Trading
Members / custodians

Pay-in/Payout: Pay-in of funds and demat securities by 11:00 a.m. The Trading
Members to ensure availability of funds in their designated Clearing Bank account
and securities in their demat Pool/Principal Accounts by 10:30 a.m. In case of
delivery of securities in physical form, the Trading Members have to deliver the
T+2 securities to the Clearing House in special closed pouches along with the relevant
details like distinctive numbers, scrip code, quantity, etc., on a floppy between
9.30 a.m. to 10:30 a.m.
Pay-out of funds and securities by 1:30 p.m.
Auction on BOLT between 2.00 p.m. to 2.45 p.m.

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 Auction Report Downloads to Trading Members between 3.00 p.m. to 3.15
p.m.

T+3 Auction pay-in and pay-out of funds and securities after 11.00 a.m.

2.7 Market Index and Index Construction

Market Index is defined as an aggregate value produced by combining several stocks or other
investment vehicles together and expressing their total values against a base value from a
specific date. Market indexes are intended to represent an entire stock market and thus
track the market's changes over time.
Index values are useful for investors to track changes in market values over long periods of
time. There are indices for almost every conceivable sector of the economy and stock
market. Many investors are familiar with these indices through index funds and exchange-
traded funds whose investment objectives are to track the performance of a particular
index.
Some examples of major market indices are:
BSE Sensex, Dow Jones Industrial Average (DJIA), NYSE Composite Index, S&P 500 Composite
Stock Price Index

2.8 Calculating Indices

Generally, calculating an index is fairly easy. Anyone can create an index to track the overall
stock market or specific sectors within the market. Some consist of a large number of stocks,
while others are quite limited. If the index weight of each share is equal, calculate the
average prices of stocks to arrive at the index value. If, however, stocks have different
weights -- for example, a weighting determined by the market value of each company -- you
need to multiply the price of each stock by its index weight and sum up the results.
The process becomes a bit more complicated if some of the stocks "split," meaning each old
share is replaced by several new shares, or there are dividend payments. To accurately
assess the impact of such events, you will need to adjust the prices before averaging them.
Different methods are used to calculate a market index's value, such as price-weighting,
market-value-weighting and capitalization-weighting, that each have their own set of pros
and cons. A variety of these methods are prevalent today, and the mathematical intricacies
of each ultimately determine their true usefulness.

30
METHOD ADOPTED FOR SENSEX CACULATION
The method adopted for calculating Sensex is the market capitalisation weighted method in
which weights are assigned according to the size of the company. Larger the size, higher the
weightage.
The base year of Sensex is 1978-79 and the base index value is set to 100 for that period.
WHY IS THE BASE VALUE SET TO 100 POINTS?
The total value of shares in the market at the time of index construction is assumed to be
100 in terms of points. This is for the purpose of ease of calculation and to logically
represent the change in terms of percentage. So, next day, if the market capitalization moves
up 10%, the index also moves 10% to 110.
HOW ARE THE STOCKS SELECTED?
The stocks are selected based on a lot of qualitative and quantitative criterias. You can view
the listing criteria here.
HOW IS THE INDEX CONSTRUCTED?
The construction technique of index is quite easy to understand if we assume that there is
only one stock in the market. In that case, the base value is set to 100 and lets assume that
the stock is currently trading at 200. Tomorrow the price hits 260 (30% increase in price) so,
the index will move from 100 to 130 to indicate that 30% growth. Now lets assume that on
day 3, the stock finishes at 208. Thats a 20% fall from 260. So, to indicate that fall, the Sensex
will be corrected from 130 to 104(20%fall).
As our second step to understand the index calculation, let us try to extend the same logic
to two stocks A and B. A is trading at 200 and lets assume that the second stock B is
trading at 150. Since the Sensex follows the market capitalization weighted method, we have
to find the market capitalization (or size of the company- in terms of price) of the two
companies and proportionate weightage will have to be given in the calculation.
How do we compute size of the company- in terms of price?
Thats simple. Just multiply the total number of shares of the company by the market
price. This figure is technically called market capitalization.
Back to our example-
We assume that company A has 100,000 shares outstanding and B has 200,000 shares
outstanding. Hence, the total market capitalization is (200 x 100000 + 150 x 200000) Rs 500
lakhs. This will be equivalent to 100 points.
Lets assume that tomorrow, the price of A hits 260 (30% increase in price) and the price of
B hits 135. (10% drop in price). The market capitalization will have to be reworked. It would
be 260 x 100,000 + 135 x 200,000 = 530 lakhs. That means, due to the changes in price, the

31
market capitalization has moved from 500 lakhs to 530 indicating a 6% increase. Hence, the
index would move from 100 to 106 to indicate the net effect.
This logic is extended to many selected stocks and this calculation process is done every
minute and thats how the index moves!
CALCULATION OF SENSEX
What was said was the general method to construct indices. Since, the Sensex consists of 30
large companies and since its shares may be held by the government or promoters etc, for
the purpose of calculating market capitalization only the free float market value is
considered, instead of the total number of shares.
What is free float?
Thats the total number of shares available for the public to trade in the market. It excludes
shares held by promoters, governments or trusts, FDIs etc.
To find the free float market value, the total value of the company (total shares x market
price) is further multiplied by a free float market value factor, which is nothing but the
percentage of free float shares of a particular company.
So logically, the company which has more public holding will have the highest free float
factor in the Sensex. This equalizes everything.
Example- lets assume that the market value of a company is Rs 100,000 Crore and it has
100 Crore shares having a value of Rs 1,000 each but only 20% of it are available to the public
for trade. The free float factor would be 20/100 or 0.20 and the free float market value would
be .20 x 100,000 = 20,000 Crores.
NOW, LETS SE HOW THE SENSEX MOVES.
Sensex value = Current free-float market value of constituents stocks/Index Divisor
So, the numerator is available straight from the BSE site. Its the total of free float factors of
30 stocks x market capitalization.
NOW, THE DENOMINATOR
The index divisor is nothing but the present level of index.
So, now, we have all the figures.
Lets assume that the free-float market capitalisation is Rs 10,00,000 Crore. At that point,
the Sensex is at 12500. What would be the value of Sensex if the free-float market
capitalization is Rs 11,50,000 Crore?

..The answer is 14,375.

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3. Capital Market Instruments
A capital market is a market for securities (debt or equity), where business enterprises
and Government can raise long-term funds. It is defined as a market in which money is
provided for periods longer than a year, as the raising of short-term funds takes place on
other markets (e.g., the Money market). The capital market is characterized by a large
variety of financial instruments: equity and preference shares, fully convertible
debentures (FCDs), non-convertible debentures (NCDs) and partly convertible debentures
(PCDs) currently dominate the capital market, however new instruments are being
introduced such as debentures bundled with warrants, participating preference shares,
zero-coupon bonds, secured premium notes, etc.

3.1 Deep Discount Bonds

It is a bond that sells at a significant discount from its par value and has no coupon
rate or lower coupon rate than the prevailing rates of fixed-income securities with a
similar risk profile. They are designed to meet the long term funds requirements of
the issuer and investors who are not looking for immediate return and can be sold
with a long maturity of 25-30 years at a deep discount on the face value of
debentures.

Example-IDBI deep discount bonds for Rs 1 lac repayable after 25 years were sold at a
discount price of Rs. 2,700.

3.2 Equity Shares with Detachable Warrants

A warrant is a security issued by company entitling the holder to buy a given number
of shares of stock at a stipulated price during a specified period. These warrants are
separately registered with the stock exchanges and traded separately. Warrants are
frequently attached to bonds or preferred stock as a sweetener, allowing the issuer
to pay lower interest rates or dividends.

Example - Essar Gujarat, Ranbaxy, Reliance issue this type of instrument.

3.3 Fully Convertible Debentures with Interest

This is a debt instrument that is fully converted over a specified period into equity
shares. The conversion can be in one or several phases. When the instrument is a pure
debt instrument, interest is paid to the investor. After conversion, interest payments
cease on the portion that is converted. If project finance is raised through an FCD issue,
the investor can earn interest even when the project is under implementation. Once

33
 the project is operational, the investor can participate in the profits through share price
appreciation and dividend payments

3.4 Equity Preference Shares

They are fully convertible cumulative preference shares. This instrument is divided into
2 parts namely Part A & Part B. Part A is convertible into equity shares automatically
compulsorily on date of allotment without any application by the allottee. Part B is
redeemed at par or converted into equity after a lock in period at the option of the
investor, at a price 30% lower than the average market price.

3.5 Sweat Equity Shares

The phrase `sweat equity' refers to equity shares given to the company's employees
on favorable terms, in recognition of their work. Sweat equity usually takes the form
of giving options to employees to buy shares of the company, so they become part
owners and participate in the profits, apart from earning salary. This gives a boost to
the sentiments of employees and motivates them to work harder towards the goals of
the company. The Companies Act defines `sweat equity shares' as equity shares issued
by the company to employees or directors at a discount or for consideration other than
cash for providing knowhow or making available rights in the nature of intellectual
property rights or value additions, by whatever name called.

3.6 Disaster Bonds

Also known as Catastrophe or CAT Bonds, Disaster Bond is a high-yield debt instrument
that is usually linked to Insurance and meant to raise money in case of a catastrophe.
It has a special condition that states that if the issuer (insurance or Reinsurance
Company) suffers a loss from a particular pre-defined catastrophe, then the issuer's
obligation to pay interest and/or repay the principal is either deferred or completely
forgiven.

Example- Mexico sold $290 million in catastrophe bonds, becoming the first country to
use a World Bank program that passes the cost of natural disasters to investors.

Goldman Sachs Group Inc. and Swiss Reinsurance Co. managed the bond sale, which
will pay investors unless an earthquake or hurricane triggers a transfer of the funds to
the Mexican government.

3.7 Mortgage Backed Securities (MBS)

MBS is a type of asset-backed security, basically a debt obligation that represents a
claim on the cash flows from mortgage loans, most commonly on residential property.

34
 Mortgage backed securities represent claims and derive their ultimate values from the
principal and payments on the loans in the pool. These payments can be further broken
down into different classes of securities, depending on the riskiness of different
mortgages as they are classified under the MBS.

Mortgage originators to refill their investments

New instruments to collect funds from the market, very economic and more effective

Conversion of assets into funds

Financial companies save on the costs of maintenance of the assets and other costs
related to assets, reducing overheads and increasing profit ratio.

Kinds of Mortgage Backed Securities:

Commercial mortgage backed securities: backed by mortgages on commercial

property

Collateralized mortgage obligation: a more complex MBS in which the mortgages are
ordered into tranches by some quality (such as repayment time), with each tranche
sold as a separate security

Stripped mortgage backed securities: Each mortgage payment is partly used to pay
down the loan's principal and partly used to pay the interest on it

Residential mortgage backed securities: backed by mortgages on residential property

3.8 Global Depository Receipts/ American Depository Receipts

A negotiable certificate held in the bank of one country (depository) representing a
specific number of shares of a stock traded on an exchange of another country. GDR
facilitate trade of shares, and are commonly used to invest in companies from
developing or emerging markets. GDR prices are often close to values of related shares,
but they are traded and settled independently of the underlying share. Listing on a
foreign stock exchange requires compliance with the policies of those stock exchanges.
Many times, the policies of the foreign exchanges are much more stringent than the
policies of domestic stock exchange. However a company may get listed on these stock
exchanges indirectly using ADRs and GDRs. If the depository receipt is traded in the
United States of America (USA), it is called an American Depository Receipt, or an ADR.
If the depository receipt is traded in a country other than USA, it is called a Global
Depository Receipt, or a GDR. But the ADRs and GDRs are an excellent means of

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 investment for NRIs and foreign nationals wanting to invest in India. By buying these,
they can invest directly in Indian companies without going through the hassle of
understanding the rules and working of the Indian financial market since ADRs and
GDRs are traded like any other stock, NRIs and foreigners can buy these using their
regular equity trading accounts!

Example - HDFC Bank, ICICI Bank, Infosys have issued both ADR and GDR

3.9 Foreign Currency Convertible Bonds (FCCBs)

A convertible bond is a mix between a debt and equity instrument. It is a bond having
regular coupon and principal payments, but these bonds also give the bondholder the
option to convert the bond into stock. FCCB is issued in a currency different than the
issuer's domestic currency.

The investors receive the safety of guaranteed payments on the bond and are also able
to take advantage of any large price appreciation in the company's stock. Due to the
equity side of the bond, which adds value, the coupon payments on the bond are lower
for the company, thereby reducing its debt-financing costs.

Advantages

Some companies, banks, governments, and other sovereign entities may decide
to issue bonds in foreign currencies because, as it may appear to be more stable and
predictable than their domestic currency
Gives issuers the ability to access investment capital available in foreign markets
Companies can use the process to break into foreign markets
The bond acts like both a debt and equity instrument. Like bonds it makes regular
coupon and principal payments, but these bonds also give the bondholder the option
to convert the bond into stock
It is a low cost debt as the interest rates given to FCC Bonds are normally 30-50
percent lower than the market rate because of its equity component
Conversion of bonds into stocks takes place at a premium price to market price.
Conversion price is fixed when the bond is issued. So, lower dilution of the company
stocks

Advantages to investors

Safety of guaranteed payments on the bond

Can take advantage of any large price appreciation in the companys stock

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 Redeemable at maturity if not converted
Easily marketable as investors enjoys option of conversion in to equity if resulting
to capital appreciation

Disadvantages

Exchange risk is more in FCCBs as interest on bond would be payable in foreign

currency. Thus companies with low debt equity ratios, large forex earnings potential
only opted for FCCBs
FCCBs means creation of more debt and a FOREX outgo in terms of interest which
is in foreign exchange
In case of convertible bond the interest rate is low (around 3 to 4%) but there is
exchange risk on interest as well as principal if the bonds are not converted in to equity
If the stock price plummets, investors will not go for conversion but redemption.
So, companies have to refinance to fulfill the redemption promise which can hit
earnings
It remains a debt in the balance sheet until conversion

3. 10 Derivatives
A derivative is a financial instrument whose characteristics and value depend upon the
characteristics and value of some underlying asset typically commodity, bond, equity,
currency, index, event etc. Advanced investors sometimes purchase or sell derivatives
to manage the risk associated with the underlying security, to protect against
fluctuations in value, or to profit from periods of inactivity or decline. Derivatives are
often leveraged, such that a small movement in the underlying value can cause a large
difference in the value of the derivative.

Derivatives are usually broadly categorized by:

The relationship between the underlying and the derivative (e.g. forward, option,
swap)

The type of underlying (e.g. equity derivatives, foreign exchange derivatives and credit
derivatives)

The market in which they trade (e.g., exchange traded or over-the-counter)

3.10.1 Futures
It is a financial contract obligating the buyer to purchase an asset, (or the seller
to sell an asset), such as a physical commodity or a financial instrument, at a

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 predetermined future date and price. Futures contracts detail the quality and
quantity of the underlying asset; they are standardized to facilitate trading on a
futures exchange. Some futures contracts may call for physical delivery of the
asset, while others are settled in cash. The futures markets are characterized by
the ability to use very high leverage relative to stock markets. Some of the most
popular assets on which futures contracts are available are equity stocks, indices,
commodities and currency.

3.10.2 Options
It is a financial derivative that represents a contract sold by one party (option
writer) to another party (option holder). The contract offers the buyer the right,
but not the obligation, to buy (call) or sell (put) a security or other financial asset
at an agreed-upon price (the strike price) during a certain period of time or on a
specific date (exercise date). A call option gives the buyer, the right to buy the
asset at a given price. This 'given price' is called 'strike price'. It should be noted
that while the holder of the call option has a right to demand sale of asset from
the seller, the seller has only the obligation and not the right.

For Example: If the buyer wants to buy the asset, the seller has to sell it. He does
not have a right. Similarly a 'put' option gives the buyer a right to sell the asset at
the 'strike price' to the buyer. Here the buyer has the right to sell and the seller
has the obligation to buy. So in any options contract, the right to exercise the
option is vested with the buyer of the contract. The seller of the contract has only
the obligation and no right. As the seller of the contract bears the obligation, he
is paid a price called as 'premium'. Therefore the price that is paid for buying an
option contract is called as premium.

The primary difference between options and futures is that options give the
holder the right to buy or sell the underlying asset at expiration, while the holder
of a futures contract is obligated to fulfill the terms of his/her contract.

3.11 Participatory Notes

They are also referred to as "P-Notes" Financial instruments used by investors or
hedge funds that are not registered with the Securities and Exchange Board of India
to invest in Indian securities. Indian-based brokerages buy India-based securities and
then issue participatory notes to foreign investors. Any dividends or capital gains
collected from the underlying securities go back to the investors. These are issued by
FIIs to entities that want to invest in the Indian stock market but do not want to

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 register themselves with the SEBI. RBI, which had sought a ban on PNs, believes that
it is tough to establish the beneficial ownership or the identity of ultimate investors.

3.12 Hedge Fund

A hedge fund is an investment fund open to a limited range of investors that
undertakes a wider range of investment and trading activities in both domestic and
international markets, and that, in general, pays a performance fee to its investment
manager. Every hedge fund has its own investment strategy that determines the type
of investments and the methods of investment it undertakes. Hedge funds, as a class,
invest in a broad range of investments including shares, debt and commodities. As the
name implies, hedge funds often seek to hedge some of the risks inherent in their
investments using a variety of methods, with a goal to generate high returns through
aggressive investment strategies, most notably short selling, leverage, program
trading, swaps, arbitrage and derivatives. Legally, hedge funds are most often set up
as private investment partnerships that are open to a limited number of investors and
require a very large initial minimum investment. Investments in hedge funds are
illiquid as they often require investors keep their money in the fund for at least one
year.

3.13 Fund of Funds

A "fund of funds" (FoF) is an investment strategy of holding a portfolio of other
investment funds rather than investing directly in shares, bonds or other securities.
This type of investing is often referred to as multi-manager investment. A fund of
funds allows investors to achieve a broad diversification and an appropriate asset
allocation with investments in a variety of fund categories that are all wrapped up into
one fund.

4. Call Money Market

It is a short-term money market, which allows for large financial institutions, such as
banks, mutual funds and corporations to borrow and lend money at interbank rates. The
loans are of short term duration, varying from 1 to 14 days.

4.1 Need for call money market

Banks usually participate in this market for the following reasons:

To adjust for the temporary mismatches in funds

To meet sudden demand of funds arising out of large inflows

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 To lend surplus funds in the market for short term
To borrow money for meeting mandatory reserve requirements of CRR and SLR

4.2 Money market instruments

Classification of Financial instruments:

Instruments

Equity based Debt based

Debt
Securities

Capital Money
Market market

Certificate of Commercial Repurchase

Bonds Debentures G-Secs T-Bills
deposits Paper Agreements

The money market provides very short-term funds to corporations, municipalities and
national governments. Money market securities are debt issues with maturities of
one year or less. Money market instruments give businesses, financial institutions and
governments a means to finance their short-term cash requirements. Three important
characteristics are:

Liquidity - Since they are securities with short-term maturities of a year or less, money
market instruments are extremely liquid.

Safety - They also provide a relatively high degree of safety because their issuers have
the highest credit ratings.

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 Discount Pricing- A third characteristic they have in common is that they are issued at
discount to their face value.

Money Market Instruments

Short term instruments

Wholesale market dominated by institutional investors. High Volume

Regulated by Central Bank (RBI)

Less than 1 year

4.2.1 T-Bills
Treasury bills are the most marketable money market security. Their popularity is
mainly due to their simplicity. Essentially, T-bills are a way for the central
governments to raise money from the public. T-bills are short-term securities that
mature in one year or less from their issue date. T-bills are purchased for a price that
is less than their par (face) value; when they mature, the government pays the holder
the full par value. Effectively, the interest is the difference between the purchase
price of the security and what you get at maturity. The only downside to T-bills is that
they wont give a great return because Treasuries are exceptionally safe. Corporate
Bonds, CODs and money market funds will often give higher rates of interest.

Issued by RBI to meet out short term funds requirements of GOI.

Maturity 91, 182 and 364 days
Issued at discount and Redeemed at par
Zero Coupon
Issued in multiples of Rs.25000

4.2.2 Commercial paper

Commercial paper is an unsecured short-term loan issued by a corporation, typically
for financing accounts receivable and inventories. It is usually issued at a discount,
reflecting current market interest rates. Maturities on commercial paper are usually
no longer than nine months, with maturities of between one and two months being
the average.

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 For the most part, commercial paper is a very safe investment because the financial
situation of a company can easily be predicted over a few months. Furthermore,
typically only companies with high credit ratings and credit worthiness issue
commercial paper.

Maturity 7 days to 1 years

Minimum rating A2 (as defined by SEBI)
Denomination 5 lakh or multiple
No need to be registered with the SEBI
Individuals, banking companies, other corporate bodies, FIIs etc. can invest in CPs
Issued at a discount to face value
Traded OTC in secondary market

4.2.3 Certificate of deposits (CD)

A CD is a time deposit with a bank. CDs are generally issued by commercial banks
but they can be bought through brokerages. They bear a specific maturity date (from
three months to five years), a specified interest rate, and can be issued in any
denomination, much like bonds. Like all time deposits, the funds may not be
withdrawn on demand like those in a checking account.
CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk
for a bank but, overall, the likelihood that a large bank will go broke is pretty slim. Of
course, the amount of interest you earn depends on a number of other factors such
as the current interest rate environment, how much money you invest, the length of
time and the particular bank you choose.

Promissory note issued by a bank

They can be withdrawn with advanced notice and/or by having a penalty
assessed.
Safe investment, but low interest rates
Multiples of 1 lakh
Can be issued to individuals, corporations, companies (including banks and PDs),
trusts, funds, associations, etc.
Traditional CD- fixed interest rate over a specific period of time
Zero-coupon CD - It does not pay out annual interest, and instead re-invests the
payments earn interest on a higher total deposit

4.2.4 Repurchase agreements (Repo)

Repo is used by those who deal in government securities as a form of overnight
borrowing. A dealer or other holder of government securities (usually T-bills) sells

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 the securities to a lender and agrees to repurchase them at an agreed future date at
an agreed price. They are usually very short-term, from overnight to 30 days or more.
This short-term maturity and government backing means repos provide lenders with
extremely low risk. Repos are popular because they can virtually eliminate credit
problems.

Variations on standard repos:

Reverse Repo - The reverse repo is the complete opposite of a repo. In this case,
a dealer buys government securities from an investor and then sells them back at a
later date for a higher price
Term Repo - exactly the same as a repo except the term of the loan is greater
than 30 days

4.2.5 Bankers Acceptance:

Bankers' acceptance (BA) is a short-term credit investment created by a non-
financial firm and guaranteed by a bank to make payment. Acceptances are traded
at discounts from face value in the secondary market. For corporations, a BA acts as
a negotiable time draft for financing imports, exports or other transactions in goods.
This is especially useful when the creditworthiness of a foreign trade partner is
unknown. One advantage of a banker's acceptance is that it does not need to be held
until maturity, and can be sold off in the secondary markets where investors and
institutions constantly trade BAs.

5. Derivatives Market
Derivatives markets are markets that are based upon another market, which is known as
the underlying market. Derivatives markets can be based upon almost any underlying
market, including individual stock markets (e.g. the stock of company XYZ), stock indices
(e.g. the Nasdaq 100 stock index), and currency markets (i.e. the forex markets)

Derivatives markets take many different forms, some of which are traded in the usual
manner (i.e. the same as their underlying market), but some of which are traded quite
differently (i.e. not the same as their underlying market). The following are the most often
traded types of derivatives markets:

Futures Markets
Options Markets

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 Warrants Markets
Contract For Difference (CFD) Markets
Spread Betting

5.1 Moneyness of the Option

Moneyness is a term describing the relationship between the strike price of an option
and the current trading price of its underlying security. In options trading, terms such
as in-the-money, out-of-the-money and at-the-money describe the moneyness of
options.

In The Money

A call option is in-the-money when its strike price is below the current trading price
of the underlying asset. A put option is in-the-money when its strike price is above the
current trading price of the underlying asset. In-the-money options are generally
more expensive as their premiums consist of significant intrinsic value on top of their
time value.

Out of the Money

Calls are out-of-the-money when their strike price is above the market price of the
underlying asset. Puts are out-of-the-money when their strike price is below the
market price of the underlying asset. Out-of-the-money options have zero intrinsic
value. Their entire premium is composed of only time value. Out-of-the-money
options are cheaper than in-the-money options as they possess greater likelihood of
expiring worthless.

At The Money

An at-the-money option is a call or put option that has a strike price that is equal to
the market price of the underlying asset. Like OTM options, ATM options possess no
intrinsic value and contain only time value, which is greatly influenced by the volatility
of the underlying security and the passage of time. Often, it is not easy to find an
option with a strike price that is exactly equal to the market price of the underlying.
Hence, close-to-the-money or near-the-money options are bought or sold instead.

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