FOUNDATION COURSE IN CAPTIAL

MARKETS
 TABLE OF CONTENTS

FINANCIAL INSTRUMENTS....................................................................3
RAISING CAPITAL....................................................................................................................................3
SECURITY..................................................................................................................................................3
DEBT...........................................................................................................................................................3
Bond........................................................................................................................................................3
Principal and Interest.............................................................................................................................3
Corporate bond......................................................................................................................................3
Municipal bond (Munis).........................................................................................................................3
Treasury Securities.................................................................................................................................3
Zero coupon bonds.................................................................................................................................3
Commercial paper..................................................................................................................................3
EQUITY......................................................................................................................................................3
Common stock........................................................................................................................................3
Stock Terminology..................................................................................................................................3
Preferred Stock.......................................................................................................................................3
HYBRIDS....................................................................................................................................................3
Convertible bonds...................................................................................................................................3
Warrants.................................................................................................................................................3
DERIVATIVES............................................................................................................................................3
Forward contract....................................................................................................................................3
Futures contract......................................................................................................................................3
Options...................................................................................................................................................3
Types of Options.....................................................................................................................................3
Swaps......................................................................................................................................................3

FINANCIAL MARKETS.............................................................................3
TYPES OF FINANCIAL MARKETS........................................................................................................3
Primary Markets.....................................................................................................................................3
Secondary markets..................................................................................................................................3
THE DIFFERENT FINANCIAL MARKETS.............................................................................................3
Capital markets......................................................................................................................................3
Stock markets..........................................................................................................................................3
Bond markets..........................................................................................................................................3
Foreign exchange market.......................................................................................................................3
Money market.........................................................................................................................................3
REGULATION OF CAPITAL MARKETS.............................................................................................................3
FINANCIAL MARKET SYSTEMS...........................................................................................................3
Trading Systems......................................................................................................................................3
Exchange systems...................................................................................................................................3
Portfolio Management Systems..............................................................................................................3
Accounting Systems................................................................................................................................3

INSTITUTIONAL ASSET MANAGEMENT............................................3

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 FINANCIAL INSTRUMENTS

RAISING CAPITAL
Corporations need capital to finance business operations. They raise money by issuing
Securities in the form of Equity and Debt. Equity represents ownership of the company
and takes the form of stock. Debt is funded by issuing Bonds, Debentures and various
certificates. The use of debt is also referred to as Leverage Financing. The ratio of
debt/equity shows a potential investor the extent of a company’s leverage. Investors
choose between debt and equity securities based on their investment objectives. Income
is the main objective for a debt investor. This income is paid in the form of Interest,
usually as semi-annual payments. Capital Appreciation (the increase in the value of a
security over time) is only a secondary consideration for debt investors. Conversely,
equity investors are primarily seeking Growth, or capital appreciation. Income is usually
of lesser importance, and is received in the form of Dividends. Debt is considered senior
to equity (i.e.) the interest on debt is paid before dividends on stock. It also means that if
the company ceases to do business and liquidate its assets, that the debt holders have a
senior claim to those assets.

SECURITY
Security is a financial instrument that signifies ownership in a company (a stock), a
creditor relationship with a corporation or government agency (a bond), or rights to
ownership (an option).
Financial instruments can be classified into:
 Debt
 Equity
 Hybrids
 Derivatives

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DEBT
Debt is money owed by one person or firm to another. Bonds, loans, and commercial
paper are all examples of debt.

Bond
An investor loans money to an entity (company or government) that needs funds for a
specified period of time at a specified interest rate. In exchange for the money, the entity
will issue a certificate, or bond, that states the interest rate (coupon rate) to be paid and
repayment date (maturity date). Interest on bonds is usually paid every six months
(semiannually). Bonds are issued in three basic physical forms: Bearer Bonds, Registered
As to Principal Only and Fully Registered Bonds. Bearer bonds are like cash since the
bearer of the bond is presumed to be the owner. These bonds are Unregistered because
the owner’s name does not appear on the bond, and there is no record of who is entitled to
receive the interest payments. Attached to the bond are Coupons. The bearer clips the
coupons every six months and presents these coupons to the paying agent to receive their
interest. Then, at the bond’s Maturity, the bearer presents the bond with the last coupon
attached to the paying agent, and receives their principal and last interest payment. Bonds
that are registered as to principal only have the owner’s name on the bond certificate, but
since the interest is not registered these bonds still have coupons attached. Bonds that are
issued today are most likely to be issued fully registered as to both interest and principal.
The transfer agent now sends interest payments to owners of record on the interest
Payable Date. Book Entry bonds are still fully registered, but there is no physical
certificate and the transfer agent keeps track of ownership. U.S. Government Negotiable
securities (i.e. Treasury Bills, Notes and Bonds) are issued book entry, with no certificate.
The customer’s Confirmation serves as proof of ownership.

Principal and Interest

Bondholders are primarily seeking income in the form of a semi-annual coupon payment.
The annual rate of return (also called Coupon, Fixed, Stated or Nominal Yield) is noted on
the bond certificate and is fixed. The factors that influence the bond's initial coupon rate

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are prevailing economic conditions (e.g., market interest rates) and the issuer's credit
rating (the higher the credit rating, the lower the coupon). Bonds that are In Default are
not paying interest. The principal or par or Face amount of the bond is what the investor
has loaned to the issuer. The relative "safety" of the principal depends on the issuer’s
credit rating and the type of bond that was issued.

Corporate bond
A bond issued by a corporation. Corporations generally issue three types of bonds:
Secured Bonds, Unsecured Bonds (Debentures), and Subordinated Debentures. All
corporate bonds are backed by the full faith and credit of the issuer, but a secured bond is
further backed by specific assets that act as collateral for the bond. In contrast, unsecured
bonds are backed by the general assets of the corporation only. There are three basic
types of Secured Bonds: Mortgage Bonds are secured by real estate owned by the issuer
Equipment Trust Certificates are secured by equipment owned and used in the issuers
business Collateral Trust Bonds are secured by a portfolio of non-issuer securities.
(Usually U.S. Government securities) Secured Bonds are considered to be Senior Debt
Securities, and have a senior creditor status; they are the first to be paid principal or
interest and are thus the safest of an issuer’s securities. Unsecured Bonds include
debentures and subordinated debentures. Debentures have a general creditor status and
will be paid only after all secured creditors have been satisfied. Subordinated debentures
have a subordinate creditor status and will be paid after all senior and general creditors
have first been satisfied.

Case Study
 Enron set up power plant at Dabhol, India
 The cost of the project (Phase 1) was USD 920 Million
 Funding
o Equity USD 285 mio
o Bank of America/ABN Amro USD 150 mio
o IDBI & Indian Banks USD 95 mio
o US Govt – OPIC USD 100 mio

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 o US Exim Bank USD 290 mio
 Enron US declared bankruptcy in 2002
 Enron India’s assets are mortgaged to various banks as above.
 Due to interest payments and depreciation, assets are worth considerably less than
USD 920 mio.
 Who will get their money back? And how much?

Municipal bond (Munis)

A bond issued by a municipality. These are generally tax free, but the interest rate is
usually lower than a taxable bond.

Treasury Securities
Treasury bills, notes, and bonds are marketable securities the U.S. government sells in
order to pay off maturing debt and raise the cash needed to run the federal government.
When an investor buys one of these securities, he/she is lending money to the U.S.
government.

Treasury bills are short-term obligations issued for one year or less. They are sold at a
discount from face value and don't pay interest before maturity. The interest is the
difference between the purchase price of the bill and the amount that is paid to the
investor at maturity (face value) or at the time of sale prior to maturity.

Treasury notes and bonds bear a stated interest rate, and the owner receives semi-
annual interest payments. Treasury notes have a term of more than one year, but not
more than 10 years.

Treasury bonds are issued by the U.S. Government. These are considered safe
investments because they are backed by the taxing authority of the U.S. government, and
the interest on Treasury bonds is not subject to state income tax. T-bonds have maturities
greater than ten years, while notes and bills have lower maturities. Individually, they

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sometimes are called "Tbills," "T-notes," and "T-bonds." They can be bought and sold in
the secondary market at prevailing market prices.

Savings Bonds are bonds issued by the Department of the Treasury, but they aren't are
not marketable and the owner of a Savings Bond cannot transfer his security to someone
else.

Zero coupon bonds

Zeros generate no periodic interest payments but they are issued at a discount from face
value. The return is realized at maturity. Zeros sell at deep discounts from face value.
The difference between the purchase price of the zero and its face value when redeemed
is the investor's return. Zeros can be purchased from private brokers and dealers, but not
from the Federal Reserve or any government agency. The higher rate of return the bond
offers, the more risky the investment. There have been instances of companies failing to
pay back the bond (default), so, to entice investors, most corporate bonds will offer a
higher return than a government bond. It is important for investors to research a bond just
as they would a stock or mutual fund. The bond rating will help in deciphering the default
risk.

Commercial paper
An unsecured, short-term loan issued by a corporation, typically for financing accounts
receivable and inventories. It is usually issued at a discount to face value, reflecting
prevailing market interest rates. It is issued in the form of promissory notes, and sold by
financial organizations as an alternative to borrowing from banks or other institutions.
The paper is usually sold to other companies which invest in short-term money market
instruments. Since commercial paper maturities don't exceed nine months and proceeds
typically are used only for current transactions, the notes are exempt from registration as
securities with the United States Securities and Exchange Commission. Financial
companies account for nearly 75 percent of the commercial paper outstanding in the
market. There are two methods of marketing commercial paper. The issuer can sell the
paper directly to the buyer or sell the paper to a dealer firm, which re-sells the paper in
the market. The dealer market for commercial paper involves large securities firms and

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subsidiaries of bank holding companies. Direct issuers of commercial paper usually are
financial companies which have frequent and sizable borrowing needs, and find it more
economical to place paper without the use of an intermediary. On average, direct issuers
save a dealer fee of 1/8 of a percentage point. This savings compensates for the cost of
maintaining a permanent sales staff to market the paper. Interest rates on commercial
paper often are lower than bank lending rates, and the differential, when large enough,
provides an advantage which makes issuing commercial paper an attractive alternative to
bank credit. Commercial paper maturities range from 1 day to 270 days, but most
commonly is issued for less than 30 days. Paper usually is issued in denominations of
$100,000 or more, although some companies issue smaller denominations. Credit rating
agencies like Standard & Poor rate the CPs. Ratings are reviewed frequently and are
determined by the issuer's financial condition, bank lines of credit and timeliness of
repayment. Unrated or lower rated paper also is sold in the market. Investors in the
commercial paper market include private pension funds, money market mutual funds,
governmental units, bank trust departments, foreign banks and investment companies.
There is limited secondary market activity in commercial paper, since issuers can closely
match the maturity of the paper to the investors' needs. If the investor needs ready cash,
the dealer or issuer usually will buy back the paper prior to maturity.

EQUITY
Equity (Stock) is a security, representing an ownership interest. Equity refers to the value
of the funds contributed by the owners (the stockholders) plus the retained earnings (or
losses).

Common stock
Common stock represents an ownership interest in a company. Owners of stock also have
Limited Liability (i.e.) the maximum a shareholder can lose is their original investment.
Most of the stock traded in the markets today is common. An individual with a majority
shareholding or controlling interest controls a company's decisions and can appoint
anyone he/she wishes to the board of directors or to the management team. Corporations
seeking capital sell it to investors through a Primary Offering or an Initial Public

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Offering (IPO). Before shares can be offered, or sold to the general public, they must first
be registered with the Securities and Exchange Commission (SEC). Once the shares have
been sold to investors, the shareholders are usually free to sell or trade their stock shares
in the Secondary Markets (such as the New York Stock Exchange – NYSE). From time to
time, the Issuer may choose to repurchase the stock they previously issued. Such
repurchased stock shares are referred to as Treasury Stock, and the shares that remain
trading in the secondary market are referred to as Shares Outstanding. Treasury Stock
does not have voting rights and is not entitled to any declared dividends. Corporations
may use Treasury Stock to pay a stock dividend, to offer to employees.

Stock Terminology
Public Offering Price (POP) – The price at which shares are offered to the public in a
Primary Offering. This price is fixed and must be maintained when Underwriters sell to
customers. Current Market Price – The price determined by Supply and Demand in the
Secondary Markets. Book Value – The theoretical liquidation value of a stock based on
the company's Balance Sheet Par Value – An arbitrary price used to account for the
shares in the firm’s balance sheet. This value is meaningless for common shareholders,
but is important to owners of Preferred Stock.

Example
When Cognizant Technology Solutions came out with its Initial Public Offering on
NASDAQ in June 1998, the Public Offering Price (POP) was set at $10 per share. The
stock was split twice, 2-for-1 in March-2000 and 3-for-1 again in April 2003. As of Dec
6, 2003, the Current Market Price stood at $46.26. However, if the stock-splits are taken
into consideration the actual market price would stand at 6 times the Current Market
Price at whopping $253.56!!

Preferred Stock
Preference shares carry a stated dividend and they do not usually have voting rights.
Preferred shareholders have priority over common stockholders on earnings and assets in
the event of liquidation. Preferred stock is issued with a fixed rate of return that is either a
percent of par (always assumed to be $100) or a dollar amount. Although preferred stock

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is equity and represents ownership, preferred stock investors are primarily seeking
income. The market price of income seeking securities (such as preferred stock and debt
securities) fluctuates as market interest rates change. Price and yield are inversely related.
There are several different types of preferred stock including Straight, Cumulative,
Convertible, Callable, Participating and Variable. With straight preferred, the preference
is for the current year’s dividend only. Cumulative preferred is senior to straight preferred
and has a first preference for any dividends missed in previous periods.

Convertible preferred stock can be converted into shares of common stock either at a
fixed price or a fixed number of shares. It is essentially a mix of debt and equity, and
most often used as a means for a risky company to obtain capital when neither debt nor
equity works. It offers considerable opportunity for capital appreciation.

Non-convertible preferred stock remains outstanding in perpetuity and trades like

stocks. Utilities represent the best example of nonconvertible preferred stock issuers.

American Depository Receipts (ADR)

The purpose of an ADR is to facilitate the domestic trading of a foreign stock. An ADR is
a receipt for a specified number of foreign shares owned by an American bank. ADRs
trade like shares, either on a U.S. Exchange or Over the Counter. The owner of an ADR
has voting rights and also has the right to receive any declared dividends. An example
would be Infosys ADRs that are traded in NASDAQ.

HYBRIDS
Hybrids are securities, which combine the characteristics of equity and debt.

Convertible bonds
Convertible Bonds are instruments that can be converted into a specified number of
shares of stock after a specified number of days. However, till the time of conversion the
bonds continue to pay coupons.

Case Study

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Tata Motors Ltd. (previously know as TELCO) recently issued convertible bond
aggregating to $100 million in the Luxemburg Stock Exchange. The effective interest rate
paid on the issue was just 4% which was much lower than what it would have to pay if it
raised the money in India, where it is based out of. The company would use this money to
pay-back existing loans borrowed at much higher interest rates.

 Why doesn’t every company raise money abroad if it has to pay lower interest
rates? Will there is
 Will there be any effect on existing Tata Motors share-holders due to the
convertible issue? If ‘Yes’, when will this be?

Warrants
Warrants are call options – variants of equity. They are usually offered as bonus or
sweetener, attached to another security and sold as a Unit. For example, a company is
planning to issue bonds, but the market dictates a 9% interest payment. The issuer does
not want to pay 9%, so they “sweeten” the bonds by adding warrants that give the holder
the right to buy the issuers stock at a given price over a given period of time. Warrants
can be traded, exercised, or expire worthless.

DERIVATIVES
A derivative is a product whose value is derived from the value of an underlying asset,
index or reference rate. The underlying asset can be equity, foreign exchange, commodity
or any other item. For example, if the settlement price of a derivative is based on the
stock price, which changes on a daily basis, then the derivative risks are also changing on
a daily basis. Hence derivative risks and positions must be monitored constantly.

Forward contract
A forward contract is an agreement to buy or sell an asset (of a specified quantity) at a
certain future time for a certain price. No cash is exchanged when the contract is entered
into.

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Futures contract
A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price. Index futures are all futures contracts where the
underlying is the stock index and helps a trader to take a view on the market as a whole.

Hedging involves protecting an existing asset position from future adverse price
movements. In order to hedge a position, a market player needs to take an equal and
opposite position in the futures market to the one held in the cash market.

Arbitrage: An arbitrageur is basically risk averse. He enters into those contracts were he
can earn risk less profits. When markets are imperfect, buying in one market and
simultaneously selling in other market gives risk less profit. Arbitrageurs are always in
the look out for such imperfections.

Options
An option is a contract, which gives the buyer the right, but not the obligation to buy or
sell shares of the underlying security at a specific price on or before a specific date. There
are two kinds of options: Call Options and Put Options.

Call Options are options to buy a stock at a specific price on or before a certain date.
Call options usually increase in value as the value of the underlying instrument rises. The
price paid, called the option premium, secures the investor the right to buy that certain
stock at a specified price. (Strike price) If he/she decides not to use the option to buy the
stock, the only cost is the option premium. For call options, the option is said to be in-the-
money if the share price is above the strike price.

Example
The Infosys stock price as of Dec 6th, 2003 stood at Rs.5062. The cost of the Dec 24th,
2003 expiring Call option with Strike Price of Rs.5200 on the Infosys Stock was Rs.90.

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This would mean that to break-even the person buying the Call Option on the Infosys
stock, the stock price would have to cross Rs.5290 as of Dec 24th, 2003!!

Put Options are options to sell a stock at a specific price on or before a certain date. With
a Put Option, the investor can "insure" a stock by fixing a selling price. If stock prices
fall, the investor can exercise the option and sell it at its "insured" price level. If stock
prices go up, there is no need to use the insurance, and the only cost is the premium. A
put option is in-the-money when the share price is below the strike price. The amount by
which an option is in-the-money is referred to as intrinsic value. The primary function of
listed options is to allow investors ways to manage risk. Their price is determined by
factors like the underlying stock price, strike price, time remaining until expiration (time
value), and volatility. Because of all these factors, determining the premium of an option
is
complicated.

Types of Options
There are two main types of options:
 American options can be exercised at any time between the date of purchase and
the expiration date. Most exchange-traded options are of this type.
 European options can only be exercised at the end of their life.

Long-Term Options are options with holding period of one or more years, and they are
called LEAPS (Long-Term Equity Anticipation Securities). By providing opportunities to
control and manage risk or even speculate, they are virtually identical to regular options.
LEAPS, however, provide these opportunities for much longer periods of time. LEAPS
are available on most widely held issues.

Exotic Options: The simple calls and puts are referred to as "plain vanilla" options.
Nonstandard options are called exotic options, which either are variations on the payoff
profiles of the plain vanilla options or are wholly different products with "optionality"
embedded in them.

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Open Interest is the number of options contracts that are open; these are contracts that
have not expired nor been exercised.

Swaps
Swaps are the exchange of cash flows or one security for another to change the maturity
(bonds) or quality of issues (stocks or bonds), or because investment objectives have
changed. For example, one firm may have a lower fixed interest rate, while another has
access to a lower floating interest rate. These firms could swap to take advantage of the
lower rates.

Currency Swap involves the exchange of principal and interest in one currency for the
same in another currency.

Case Study
 The World Bank borrows funds internationally and loans those funds to
developing countries. It charges its borrowers a cost plus rate and hence needs to
borrow at the lowest cost.
 In 1981 the US interest rate was at 17 percent, an extremely high rate due to the
anti inflation tight monetary policy of the Fed. In West Germany the
corresponding rate was 12 percent and Switzerland 8 percent.
 IBM enjoyed a very good reputation in Switzerland, perceived as one of the best
managed US companies. In contrast, the World Bank suffered from bad image
since it had used several times the Swiss market to finance risky third world
countries. Hence, World Bank had to pay an extra 20 basis points (0.2%)
compared to IBM
 In addition, the problem for the World Bank was that the Swiss government
imposed a limit on the amount World Bank could borrow in Switzerland. The
World Bank had borrowed its allowed limit in Switzerland and West Germany
 At the same time, the World Bank, with an AAA rating, was a well established
name in the US and could get a lower financing rate (compared to IBM) in the US

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 Dollar bond market because of the backing of the US, German, Japanese and
other governments. It would have to pay the Treasury rate + 40 basis points.
 IBM had large amounts of Swiss franc and German deutsche mark debt and thus
had debt payments to pay in Swiss francs and deutsche marks.
 World Bank borrowed dollars in the U.S. market and swapped the dollar
repayment obligation with IBM in exchange for taking over IBM's SFR and DEM
loans.
 It became very advantageous for IBM and the World Bank to borrow in the
market in which their comparative advantage was the greatest and swap their
respective fixed-rate funding.

Forward Swap agreements are created through the synthesis of two different swaps,
differing in duration, for the purpose of fulfilling the specific timeframe needs of an
investor. Sometimes swaps don't perfectly match the needs of investors wishing to hedge
certain risks. For example, if an investor wants to hedge for a five-year duration
beginning one year from today, they can enter into both a one-year and six-year swap,
creating the forward swap that meets the requirements for their portfolio.

Swaptions - An option to enter into an interest rate swap. The contract gives the buyer
the option to execute an interest rate swap on a future date, thereby locking in financing
costs at a specified fixed rate of interest. The seller of the swaption, usually a commercial
or investment bank, assumes the risk of interest rate changes, in exchange for payment of
a swap premium.

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 FINANCIAL MARKETS

What are financial markets?

A financial transaction is one where a financial asset or instrument, such as cash, check,
stock, bond, etc are bought and sold. Financial Market is a place where the buyers and
sellers for the financial instruments come together and financial transactions take place.

TYPES OF FINANCIAL MARKETS

Primary Markets
Primary market is one where new financial instruments are issued for the first time. They
provide a standard institutionalized process to raise money. The public offerings are done
through a prospectus. A prospectus is a document that gives detailed information about
the company, their prospective plans, potential risks associated with the business plans
and the financial instrument.

Secondary markets
Secondary Market is a place where primary market instruments, once issued, are bought
and sold. An investor may wish to sell the financial asset and encash the investment after
some time or the investor may wish to invest more, buy more of the same asset instead,
the decision influenced by a variety of possible reasons. They provide the investor with
an easy way to buy or sell.

THE DIFFERENT FINANCIAL MARKETS

A financial market is known by the type of financial asset or instrument traded in it. So
there are as many types of financial markets as there are of instruments. Typical examples
of financial markets are:
 Stock market
 Bond (or fixed income) market
 Money market

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  Foreign exchange (Forex or FX for short) market (also called the currency
market). Stock and bond markets constitute the capital markets. Another big
financial market is the derivatives market.

Capital markets
Why businesses need capital?
All businesses need capital, to invest money upfront to produce and deliver the goods and
services. Office space, plant and machinery, network, servers and PCs, people, marketing,
licenses etc. are just some of the common items in which a company needs to invest
before the business can take off. Even after the business takes off, the cash or money
generated from sales may not be sufficient to finance expansion of capacity,
infrastructure, and products / services range or to diversify or expand geographically.
Some financial services companies need to raise additional capital periodically in order to
satisfy capital adequacy norms.

What is the role of Capital Markets?

For businesses to thrive and grow, presence of vibrant and efficient capital markets is
extremely important. Capital markets have following functions:
1. Channeling funds from “savings pool” to “investment pool” - channeling funds from
“those who have money” to “those who need funds for business purpose”.
2. Providing liquidity to investors - i.e. making it easy for investors, to buy and sell
financial assets or instruments. Capital markets achieve this in a number of ways and it is
particularly important for institutional investors who trade in large quantities. Illiquid
markets do not allow them to trade large quantities because the orders may simply not get
executed completely or may cause drastic fluctuations in price.
3. Providing multitude of investment options to investors – this is important because the
risk profile, investment criteria and preferences may differ for each investor. Unless there
are many investment options, the capital markets may fail to attract them, thus affecting
the supply of capital.
4. Providing efficient price discovery mechanism – efficient because the price is
determined by the market forces, i.e. it is a result of transparent negotiations among all

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buyers and sellers in the market at any point. So the market price can be considered as a
fair price for that instrument.

Stock markets
Stock markets are the best known among all financial markets because of large
participation of the “retail investors”. The important stock exchanges are as follows:
 New York Stock Exchange (NYSE)
 National Association of Securities Dealers Automated Quotations (NASDAQ)
 London Stock Exchange (LSE)
 Bombay Stock Exchange (BSE),
 National Stock Exchange of India (NSE)

Stock Exchanges provide a system that accepts orders from both buyers and sellers in all
shares that are traded on that particular exchange. Exchanges then follow a mechanism to
automatically match these trades based on the quoted price, time, quantity, and the order
type, thus resulting in trades. The market information is transparent and available real-
time to all, making the trading efficient and reliable. Earlier, before the proliferation of
computers and networks, the trading usually took place in an area called a “Trading
Ring” or a “Pit” where all brokers would shout their quotes and find the “counter-party”.
The trading ring is now replaced in most exchanges by advanced computerized and
networked systems that allow online trading, so the members can log in from anywhere
to carry out trading. For example, BOLT of BSE and SuperDOT of NYSE.

What determines the share price and how does it change?

The share price is determined by the market forces, i.e. the demand and supply of shares
at each price. The demand and supply vary primarily as the perceived value of the stock
for different investors varies. Investor will consider buying the stock if the market price is
less than the perceived value of the stock according to that investor and will consider
selling if it is higher. A large number of factors have a bearing on the perceived value.
Some of them are:

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  Performance of the company
 Performance of the industry to which it belongs
 State of the country’s economy where it operates as well as the global economy
 Market sentiment or mood relating to the stock and on the market as a whole

Apart from these, many other factors, including performance of other financial markets,
affect the demand and supply.

Bond markets
As the name suggests, bonds are issued and traded in these markets. Government bonds
constitute the bulk of the bonds issued and traded in these markets. Bond markets are also
sometimes called Fixed Income markets. While some of the bonds are traded in
exchanges, most of the bond trading is conducted over-the-counter (OTC), i.e. by direct
negotiations between dealers. Lately there have been efforts to create computer-based
market place for certain type of bonds.

Participants in the Bond Market

Since Government is the biggest issuer of bonds, the central bank of the country such as
Federal Reserve in US and Reserve Bank of India in India, is the biggest player in the
bond market. Like stock markets, one needs to be an authorized dealer of Govt.
securities, to subscribe to the bond issues. Typically, the Govt. bond issues are made by
way of auctions, where the dealers bid for the bonds and the price is fixed based on the
bids received. The dealers then sell these bonds in the secondary market or directly to
third parties, typically institutions and companies.

If the interest rate is fixed for each bond, why do the bond prices fluctuate?
Bond prices fluctuate because the interest rates as well as the perceptions of investors on
the direction of interest rates change. Remember, bond pays interest at a fixed coupon
rate determined at the time of issue, irrespective of the prevailing market interest rate.
Market interest rates are benchmark interest rates, such as Treasury bill rates, which are
subject to change because of various factors such as inflation, monetary policy change,

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etc. So when the prevailing market interest rates change, price of the bond (and not the
coupon) adjusts, so that the effective yield for a buyer at the time (if the bond is held to
maturity) matches the market interest rate on other bonds of equal tenure and credit rating
(risk). So when the market interest rates go up, prices of bonds fall and vice-versa. Thus,
since price of bonds changes when market interest rate changes, all bonds have an
interest rate risk. If the market interest rates shoot up, then the bond price is affected
negatively and an investor who bought the bond at a high price (when interest rates were
low) stands to lose money or at least makes lesser returns than expected, unless the bond
is held to maturity.

Example
Bond Price calculation can be summed by an easy formula:
where B represents the price of the bond and CFk represents the kth cash flow which is
made up of coupon payments. The Cash Flow (CF) for the last year includes both the
coupon payment and the Principal.

 What would be the bond price for a 3-Year, Rs.100 principal, bond when the
interest rate is 10% and the Coupon payments are Rs.5 annually?
 Would the bond price increase/decrease if the coupon is reduced? What would be
happen to bond price if the interest rates came down?

Foreign exchange market

Foreign exchange markets are where the foreign currencies are bought and sold. For
example, importers need foreign currency to pay for their imports. Government needs
foreign currency to pay for its imports such as defense equipment and to repay loans
taken in foreign currency. Foreign exchange rates express the value of one currency in
terms of another. They involve a fixed currency, which is the currency being priced and a
variable currency, the currency used to express the price of the fixed currency. For
example, the price of a US Dollar can be expressed in different currencies as: USD (US
Dollar) 1 = Indian Rupee (INR) 46, USD 1 = Great Britain Pound (GBP) 0.6125, USD 1
= Euro 0.8780 etc. In this example, USD is the fixed currency and INR, GBP, Euro are

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the variable currencies. US Dollar, British Sterling (Pound), Euro and Japanese Yen are
the most traded currencies worldwide, since maximum business transactions are carried
out in these currencies. The exchange rate at any time depends upon the demand – supply
equation for the different currencies, which in turn depends upon the relative strength of
the economies with respect to the other major economies and trading partners.

Participants
Only authorized foreign exchange dealers can participate in the foreign exchange market.
Any individual or company, who needs to sell or buy foreign currency, does so through
an authorized dealer. Currency trading is conducted in the over-the-counter (OTC)
market.

The role of the Central Bank in the foreign exchange market

The central bank regulates the markets to ensure its smooth functioning. The degree of
regulation depends on the economic policies of the country. The central bank may also
buy or sell their currency to meet unusual demand – supply mismatches in the markets.
The foreign exchange rate and transactions are closely monitored because the fluctuations
in forex markets affects the profitability of imports and exports of domestic companies as
well as profitability of investments made by foreign companies in that country.
Regulators try to ensure that the fluctuations are not caused by any factor other than the
market forces.

Example
The Bank of Japan plays the role of central bank in Japan. It strictly monitors the
exchange rates to ensure that the importers/exporters are not hurt due to any exchange
rate fluctuations. Still, the USD/JPY, which is the second most traded currency pair in the
world, maintains a long-standing reputation of sharp increases in short-term volatilities.

Money market
Money market is for short term financial instruments, usually a day to less than a year.
The most common instrument is a “repo”, short for repurchase agreement. A repo is a

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contract in which the seller of securities, such as Treasury Bills, agrees to buy them back
at a specified time and price. Treasury bills of very short tenure, commercial paper,
certificates of deposits etc. are also considered as money market instruments. Since the
tenure of the money market instruments is very short, they are generally considered safe.
In fact they are also called cash instruments. Repos especially, since they are backed by a
Govt. security, are considered virtually the safest instrument. Therefore the interest rates
on repos are the lowest among all financial instruments. Money market instruments are
typically used by banks, institutions and companies to park extra cash for a short period
or to meet the regulatory reserve requirements. For short-term cash requirements, money
market instruments are the best way to borrow.

Participants
Whereas in stock market the typical minimum investment is equivalent of the price of 1
share, the minimum investment in bond and money markets runs into hundreds of
thousands of Rupees or Dollars. Hence the money market participants are mostly banks,
institutions, companies and the central bank. There are no formal exchanges for money
market instruments and most of the trading takes place using proprietary systems or
shared trading platforms connecting the
participants.

Regulation of capital markets

There are many reasons why the financial markets are regulated by governments:
 Since the capital markets are central to a thriving economy, Governments need to
ensure their smooth functioning.
 Governments also need to protect small or retail investors’ interests to ensure
there is participation by a large number of investors, leading to more efficient
capital markets.
 Governments need to ensure that the companies or issuers declare all necessary
information that may affect the security prices and that the information is readily
and easily available to all participants at the same time.

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Typically the government designates one or more agencies as regulator(s) and
supervisor(s) for the financial markets. Thus India has Securities and Exchange Board of
India (SEBI) and the US has Securities and Exchange Commission (SEC). These
regulatory bodies formulate rules and norms for each activity and each category of
participant. For example,
 Eligibility norms for a company to be allowed to issue stock or bonds,
 Rules regarding the amount of information that must be made available to
prospective investors,
 Rules regarding the issue process,
 Rules regarding periodic declaration of financial statements, etc. Regulators also
monitor the capital market activity continuously to ensure that any breach of laws
or rules does not go unnoticed. To help this function, all members and issuers
have to submit certain periodic reports to the regulator disclosing all relevant
details on the transactions undertaken.

FINANCIAL MARKET SYSTEMS

The demands of the capital market transactions, the need for tracking and managing risks,
the pressure to reduce total transaction costs and the obligation to meet compliance
requirements make it imperative that the functions be automated using advanced
computer systems. Some of the major types of systems in capital market firms are briefly
described below.

Trading Systems
The volume of transactions in capital markets demands advanced systems to ensure speed
and reliability. Due to proliferation of Internet technology, the trading systems are also
now accessible online allowing even more participants from any part of the world to
transact, helping to increase efficiency and liquidity. The trading systems can be divided
into front-end order entry and backend order processing systems. Order entry systems
also offer functions such as order tracking, calculation of profit and loss based on real-
time price movements and various tools to calculate and display risk to the value of

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investments due to price movement and other factors. Back-office systems validate
orders, route them to the exchange(s), receive messages and notifications from the
exchanges, interface with external agencies such as clearing firm, generate management,
investor and compliance reports, keep track of member account balances etc.

Exchange systems
The core exchange system is the trading platform that accepts orders from members,
displays the price quotes and trades, matches buy and sell orders dynamically to fill as
many orders as possible and sends status messages and trade notifications to the parties
involved in each trade. In addition, exchanges need systems to monitor the transactions,
generate reports on transactions, keep track of member accounts, etc.

Portfolio Management Systems

These systems allow the investment managers to choose the instruments to invest in,
based on the requirements or inputs such as amount to be invested, expected returns,
duration (or tenure) of investment, risk tolerance etc. and analysis of price and other data
on the instruments and issuers. The term “portfolio” refers to the basket of investments
owned by an invest or. A portfolio of investments allows one to diversify risks over a
limited number of instruments and issuers.

Accounting Systems
The accounting systems take care of present value calculations, profit & loss etc.- of
investments and funds and not the financial accounts of the firms.

SUMMARY
 Financial markets facilitate financial transactions, i.e. exchange of financial assets
such stocks, bonds, etc.
 Financial markets bring buyers and sellers in a financial instrument together, thus
reducing transaction costs, channeling funds, improving liquidity and provide a
transparent price discovery mechanism.

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  Each financial market is segmented into a Primary market, where new instruments
are issued and a Secondary market, where the previously issued instruments are
bought and sold by investors.
 Stock markets, bond markets, money markets, foreign exchange markets and
derivatives markets are prominent examples of financial markets.
 Shares (stock) of a company are issued and traded in the stock markets.
 Bond markets are where bonds such as treasury bonds, treasury notes, corporate
bonds, etc. are traded.
 Money markets, like bonds markets, are also fixed income markets. Instruments
traded in money markets have very short tenure.
 Foreign exchange markets trade in currencies.
 Derivatives markets trade derivatives, which are complex financial instruments,
whose returns are based upon the returns from some other financial asset called as
the underlying asset.
 Price of any financial instrument depends basically on demand and supply, which
in turn depend upon multiple different factors for different markets.
 Each financial instrument has a differing level of inherent risk associated with it.
Money market instruments are considered the safest due to their very short tenure.
 Regulators play a very important role in the development and viability of financial
markets. Regulators try to ensure that the markets function in a smooth,
transparent manner, that there is sufficient and timely disclosure of information,
that the interest of small investors is not compromised by the large investors, and
so on, which is critical for overall vibrancy, efficiency and growth of the market
and the economy.

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 INSTITUTIONAL ASSET MANAGEMENT

Institutional money managers are independent financial advisory firms organized and
licensed under the Security and Exchange Commission or Banking Laws' oversight
agency of the country. Institutional Asset Management service can be both Advisory or
Fund handling and investing on behalf of the customer. Institutional money managers are
distinguished by the fact that:
 They are under greater regulatory scrutiny from both state and federal authorities
 They provide exclusive service to their clientele who are typically institutions
having portfolios in excess of several million dollars.
 They are very selective in the clientele they service and first do an independent
analysis of that client's financial needs, goals, objectives, and risk tolerance.
 They charge competitive fees due to the fact that their clients entrust millions of
dollars to them for investing. Accordingly they are under greater scrutiny to
provide attractive performance returns.

All major international banks offer asset management services. Some key players
include:

 Morgan Stanley
 Bankers Trust
 Boston Partners
 Pacific Investment Management Co. (PIMCO)

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