1

Introduction

The mobility and usage of assets determine the economic environment of a nation. Conducive economic environment attracts investment, which in turn influences the development of the economy. One of the essential criteria for the assessment of economic development is the quality and quantity of assets in a nation at a specific time. Real assets comprise the physical and intangible items available to a society. Physical assets are used to generate activity and result in positive or negative contribution to the owner of the asset. Intangible assets also result in a positive or negative contribution to the owner, but are different in that they do not have a physical shape or form. In fact, intangible assets help physical assets in generating activity. Intangible assets can be said to be behind the scene with respect to productive activities. Besides real assets, the economy is supported by another group of assets called financial assets. The major component of the financial assets is cash, also called money. Financial assets help the physical assets to generate activity. Some examples of financial assets besides cash are deposits, debt instruments, shares, and foreign currency reserves.

Assets in any economy can thus be broadly grouped into physical, financial, and intangible assets, based on their distinct characteristics. The asset classification is given in Figure 1.1. Physical assets can be classified into fixed assets and working capital assets, based on the length of their life. Fixed assets, such as land, building, machinery, and other infrastructure facilities, are utilised by the society over a long period of time when compared with working capital assets. Movable/circulating capital assets are produced and consumed by the society within a financial year. Examples of movable/circulating capital assets include materials, merchandise, durable goods, jewellery (gold), and similar items. Intangible assets are goodwill, patents, copyrights, and royalties.

In a macro sense, financial assets are regulated by the government of an economy. Financial assets smoothen the trade and transactions of an economy and give the society a standard measure of valuation. Money or cash is the basic financial asset created by the government of an economy. The extent of flow of this financial asset has to be regulated in an economy for the demand for and supply of funds to match.

At the macro level, financial assets also represent the current/future value of physical and intangible assets. The current/ future value of financial assets depends on the current/future return expectations from these financial instruments. All the financial assets in an economy represent a real asset either in the present context or in the context of the future. Their dependence on real assets requires the financial assets to be valued differently. The distinctive value determination of financial instruments also requires a specific market to patronise them.

PROPERTIES OF FINANCIAL ASSETS

Financial assets have specific properties that distinguish them from physical and intangible assets. These properties are monetary value, divisibility, convertibility, reversibility, liquidity, and cash flow.

Currency: Financial assets are exchange documents with an attached value. Their values are denominated in currency units determined by the government of an economy. A note or a coin representing cash/ money is a financial asset/instrument with an attached face value and is represented in terms of the currency unit of a country. A ten-rupee note or a one hundred-rupee note is a financial instrument in India that can be exchanged for its attached value for any other asset.

Divisibility: Financial instruments are divisible into smaller units. The total value is represented in terms of divisions that can be handled in a trade. The capital of a firm is collected through financial instruments that are issued in a unit format (shares). Each unit represents a face value of the total capital. The divisibility characteristic of financial assets enables all players, small or big, to participate in the market.

Convertibility: Financial assets are convertible into any other type of asset. For instance, a borrowing can be converted into capital. A firm might issue, in the first place, a debt instrument, which is to be repaid after a specific time duration, say, three years. At the end of the third year, the firm could give the owner of the debt instrument an option to convert it into a share of the company. This characteristic of convertibility gives flexibility to financial instruments. Financial instruments need not necessarily be converted into another form of financial asset; they can also be converted into any other type of asset. The convertibility characteristic also enables trading of financial assets.

Reversibility: This implies that a financial instrument can be exchanged for any other asset and, logically, the so formed asset may be transferred back into the original financial instrument. A firm can deposit currency in a bank and accept a deposit certificate that can be used to earn a rate of return. When the need for currency arises, the bank deposit can be withdrawn in the form of currency again and used as an exchange instrument to buy any other type of asset through which productive activity can be carried on. Thus cash or money has the characteristic of reversibility. Similarly, the shares issued by a company in exchange of cash can be bought back by the company and the cash can be repaid to the holder of the share in turn.

Liquidity: This is the immediate need value of the financial instrument. The characteristic of reversibility of the financial instrument also helps in its liquidity. Liquidity implies that the present need for other forms of assets prevails over holding the financial instrument. The immediate need of meeting hospital expenses, for example, would be possible if the asset is held in a financial form rather than in physical form. The financial asset can be exchanged for currency with another market participant who does not have an immediate cash need, but expects future benefits.

Cash flow: The holding of the financial instrument results in a stream of cash flows that are the benefits accruing to the holder of the financial instrument. For example, a deposit with a bank gives an inflow of interest to the deposit holder. Shares give the holder dividend or bonus. The extent of benefit derived from various financial instruments differs since their real returns are derived from their investment in other physical or intangible assets. A financial instrument by itself does not create a cash flow. Currency kept idle does not result in a flow of benefits, while currency invested in a physical activity gives the holder cash flow benefits/losses.

FINANCIAL MARKETS

The above mentioned characteristics of financial instruments led to the emergence of financial markets. Specific financial markets have evolved to cater to the unique needs of the financial instruments introduced in that market. For example, the American stock market came into existence for the unique purpose of providing liquidity to the rail stocks. Sometimes, an existing market catered to the requirements of the financial instruments. The National Stock Exchange, India, set up as a financial market to cater to the corporate securities market, also trades Government securities. When an existing market was unable to cope with the unique characteristics of the instruments, a new financial market evolved. The establishment of the commodities markets, especially the Chicago Board of Option Trading, is an illustration of a new market for catering to the specific needs of a commodity exchange.

A financial market is a place/system where financial instruments are exchanged. Such markets enhance the unique characteristics of the financial instruments. Financial markets can be classified on the basis of the nature of instruments exchanged in the economy. The instruments can be broadly divided into claim instruments and currency instruments. Claim instruments are subdivided into those that are fixed claims and those instruments that get a residual or equity claim. Fixed claim markets that have very short durations, that is, less than a year are traded in the money market while the fixed claims that have a maturity of more than a year and equity claim instruments are traded in the capital markets. Money markets are also referred to as a wholesale financial market while capital markets are referred to as retail markets since the size of the transactions in the money market is quite large when compared to that in the capital markets. The trading of currency instruments among different countries is conducted through the foreign exchange market. The subdivisions of the major markets are shown in Figure 1.2.

Securities Market

Securities are financial instruments that have been created to represent a legal obligation to pay a sum in future in return for the current receipt of value. Securities thus represent the cash or cash equivalent received from another person. The creation of a security is situation and need specific, and many innovative instruments have been floated in the market. The existence of such financial instruments is, however, within the legal regulations governing the market in which they are floated. The securities market, hence, is place-sensitive. The immediate classification of the securities market can be in terms of national boundaries due to the legal environment. The securities market can be subdivided into national and international markets. However, with technological innovations, international agreements and standards, the line distinguishing a national from an international market is fast disappearing.

National Market

National markets are markets within the boundary of a nation. Several local subdivisions can be made within the national market to benefit the players in the market. National markets cater to the financial requirements of the local players. Players from foreign countries are permitted to bring their financial instruments into the national market, subject to their following the rules and regulations imposed by the nation. There are vast differences in the rules and regulations of the securities market among nations. Each nation has a regulatory authority under whose scrutiny financial instruments are exchanged in that country. The regulatory authority imposes the overall procedures and guidelines to be followed by the players in the national market. National markets sometimes make a difference between pure domestic players and the participation of international players. Hence, there can be a further subdivision of the national market into a domestic segment and a foreign segment. An illustrative list of certain stock exchanges are given in Table 1.1

 

International Market

International markets are usually referred to as offshore markets. Certain national markets, due to their policy regulations, do not discriminate between the securities issued in its country vis-a-vis other countries. A precise example of an international market is the Euromarket, where the representation of several countries is viewed together. A firm in any one member nation in the European subcontinent could list its securities simultaneously in other countries of the European Union. For example, firm with its headquarters in France, could simultaneously trade its securities in France, Spain, and Germany. This concept of opening the national market to other group countries came to be known as international market.

Domestic Segment

The domestic market caters exclusively to firms registered in a country. The country’s regulatory authority controls the domestic market. In India, the Reserve Bank of India along with the Securities Exchange Board of India (SEBI) regulates the functioning of the money market and the capital market, the two types of markets within the umbrella of the domestic market. Based on the economic performance of the country, the domestic markets are also called advanced markets and emerging markets. Advanced markets are usually markets in nations that are economically sound and have also progressed technologically. The US and UK markets are termed as advanced markets. Emerging markets are those in developing nations whose economic progress is forward looking. The Indian market is termed as an emerging market. A comparison of the capitalisation and total listed companies in certain advanced and emerging markets is given in Table 1.2. The domestic markets can be further subdivided into money market and capital market.

Foreign Segment

Each nation, besides its exclusive domestic market, also allows firms registered outside the country to participate in its economic activities. This is termed as globalisation or opening up of the economy. To help the foreign firms gain access to local funds, the nation also allows foreign players such as foreign institutions and individuals to participate in the nation’s financial markets. This is known as foreign participation in a national market. The extent of foreign direct inflows into an economy motivates the government to allow foreign participation in the local markets. In many economies, depending on the foreign policy measures of the government, the regulations governing the foreign participation could be more rigorous than the domestic market. The foreign participation may be in the money market and/or capital market. Table 1.3 gives the flow of funds for certain economies.

 

Table 1.2 Domestic Capital Markets

Capital Market	Market Capitalisation ($ billion)	Total Listed Companies
Advanced Markets
USA	15,104	7,524
UK	2,577	1,904
Japan	3,157	2,561
Germany	1,207	1,022
Emerging Markets
Korea	172	704
China	581	1,086
India	166	9,922
Taiwan	248	270

 

Money Market

Money markets are short-term debt markets. Debt is a fixed income security and represents the borrowing of a market player. Money markets are mostly wholesale markets for financial instruments. Small values are not exchanged in the money market. The minimum value that is exchanged in the Indian money market, for instance, is Rs. 1 million. The large quantum of trade essentially limits the players in the money market to institutional investors such as banks, other financial institutions, government, and large business firms. Here, the players exchange surplus funds at the prevailing interest rates (call rates) for a short duration. The duration could be a day, a week, a month, six months, or a year. This duration indicates the maturity of the instrument. At the time of the issue of the money market instrument as well as at the time of maturity of the instrument, the account transfer of the initial amount along with the interest charges takes place between the players in the money market.

The call rates prevalent in certain countries are given in Table 1.4. Money market has accommodated within its fold several types of trades. Accordingly, the money market can be differentiated into the call market, T bill market, inter-bank market, certificate of deposit market, repo market, commercial paper market, inter-corporate deposit market, and commercial bill market.

 

Table 1.4 Money Market Rates

Country	Short-term Call Rate	Govt Bond Yield (10 Year)
USA	3.02	5.82
Japan	2.98	3.97
UK	5.94	7.87
Germany	7.29	6.50
Korea	12.12	12.08
Spain	10.53	10.16
India	8.64	–
South Africa	11.32	13.94

Call Market

Call/notice money is an amount borrowed or lent on demand for a very short period. If the period is more than one day and upto 14 days, it is called ‘notice money’, otherwise, the amount is known as ‘call money’. Intervening holidays and/or Sundays are excluded for computing the holding duration. No collateral security is required to cover these transactions.

The Indian call market enables the banks and institutions to even out their day-to-day deficits and surpluses of money. The adjustments for the cash reserve requirements are done through the mechanism of borrowing and lending in this market. Specified all-India financial institutions, mutual funds, and certain specified entities are allowed to access call/notice money only as lenders. Since it is entirely an inter-bank market, non-bank entities are not allowed access to the market. In view of the short tenure of such transactions, both the borrowers and the lenders are required to have current accounts with the Reserve Bank of India (RBI). Interest rates in the call and notice money market are market determined.

T-bill Market

The Treasury bill or T-bill market is also a constituent of the money market. T-bills are short-term (upto one year) borrowing instruments of the government of a nation. Treasury bills are the lowest risk category instruments, maturing in a short duration. A considerable part of the government’s borrowings happen through T-bills of various maturity periods.

In India, RBI issues T-bills on a predetermined day for a fixed amount. T-bills are auctioned by the Reserve Bank of India at regular intervals. They are issued at a discount to face value and, on maturity, the face value is paid to the holder. The rate of discount and the corresponding issue price is determined at each auction. Based on the bids received at the auctions, the Reserve Bank of India decides the cut-off yield and accepts all bids below this yield.

There are four types of Treasury bills that are auctioned in India—the 14-day T-bills and 91-day T-bills are auctioned every Friday of every week; the 182-day T-bills and 364-day T-bills are auctioned every alternate Wednesday (which is not a reporting week). The notified amount for all T-bills except the 364-day T-bill auction, is Rs 100 crores. The notified amount for the 364-day T-bill auction is Rs 500 crores.

The investors in these instruments are banks—who invest not only to part with their short-term surpluses but also since these instruments form part of their Statutory Liquidity Reserve (SLR) investments—insurance companies, and financial institutions. Foreign institutional investors, so far, have not been allowed to invest in these instruments.

These T-bills, which are issued at a discount, can be traded in the market. Most of the time, unless the investor requests specifically, they are issued not as securities but as entries in the Subsidiary General Ledger (SGL) maintained by RBI. There is no transaction cost on T-bills and trading is considerably high in each bill immediately after its issue and just before its redemption.

The yield on T-bills depends on the rates prevalent on liquidity in banks and the other investment avenues open for it. A low yield on T-bills is, generally, a result of high liquidity in the banking system as indicated by low call rates. Similarly, if banks already hold the minimum stipulated amount of SLR, in government paper they would look for other attractive investment opportunities.

Inter-bank Market

The inter-bank market is usually for deposits of maturity beyond 14 days and upto three months. It is also referred to as the term money market. The specified entities are not allowed to lend beyond 14 days. The development of a term money market is inevitable due to the declining spread in lending operations, volatility in the call money market, growing desire for fixed interest rates, borrowing by corporate entities, and as a measure for fuller integration between forex and money market. Inter-bank markets have stringent guidelines laid down by regulators and management of financial institutions.

Certificates of Deposit Market

After Treasury bills, the lowest risk category investment option is the certificate of deposit (CD) issued by banks and financial institutions. A CD is a negotiable promissory note, secure and short term (upto a year) in nature. It is issued at a discount to the face value, the discount rate being negotiated between the issuer and the investor. CDs are issued mainly to augment funds by attracting deposits from corporates, high net worth individuals, trusts, and others. The issue of CDs may be high when banks, faced with a reducing deposit base, secure funds by these means. Foreign and private banks, especially those, that do not have a large network of branches and hence have a lower deposit base, may use this instrument to raise funds.

In India RBI allows CDs upto one-year maturity. The maturity most often quoted in the market is for 90 days. CDs are one of RBI’s measures to deregulate the cost of funds for banks and financial institutions.

The rates on CDs are determined by various factors. Low call rates would mean higher liquidity in the market. Also, the interest rate on one-year bank deposits acts as a lower barrier for the CD rates in the market.

Ready Forward Contracts (Repo) Market

A repo is a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement, the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in the future at a predetermined price. Such a transaction is called a repo when viewed from the perspective of the seller of securities and reverse repo when described from the point of view of the supplier of funds. Thus, whether a given agreement is a repo or a reverse repo depends on which party initiated the transaction.

The lender or buyer in a repo is entitled to receive compensation for the use of funds provided to the counterparty. Effectively, the seller of the security borrows money for a period of time (repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the repo rate. The repo rate is negotiated by the counterparties independently of the coupon rate or rates of the underlying securities and is influenced by the overall money market conditions.

Repos help banks to invest surplus cash. It helps the investor to achieve money market returns with sovereign risk. It helps the borrower to raise funds at better rates.

The repo/reverse repo transaction in India can only be made between parties approved by RBI and in securities as approved by RBI, namely T-bills, and central/state government securities. A SLR-surplus and Credit Reserve Ratio- (CRR-) deficit bank can use repo deals as a convenient way of adjusting SLR/ CRR positions simultaneously.

Commercial Paper (CP) Market

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CP enables highly rated corporate entities to obtain sources of short-term borrowings and provides an additional instrument to investors.

In India, Commercial Papers can be issued by highly rated corporate borrowers, primary dealers (PDs) and satellite dealers (SDs), and all-India financial institutions which have been permitted to raise resources through money market instruments under the limit fixed by the Reserve Bank of India. Corporate borrowers may issue CPs only when their tangible net worth is not less than Rs 4 crores; the working capital (fund-based) limit from the banking system is not less than Rs 4 crores, and the borrower account is classified as a Standard Asset by the financing bank(s).

All issuers of CPs need to obtain credit rating for the Commercial Paper from recognised rating agencies. CPs can be issued for maturities between a minimum of 15 days and a maximum of upto one year from the date of issue. CPs can be issued in denominations of Rs 5 lakh or multiples thereof.

CPs may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India, Non-resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the 30 per cent limit set for their investments in debt instruments. CPs can be issued and held only in a dematerialised form, through any of the depositories approved by and registered with SEBI. CPs are issued at a discount to face value as may be determined by the issuer. On maturity of a CP, the holder of the CP can get it redeemed through the depository and receive the face value of the instrument.

Inter-Corporate Deposit Market

Apart from CPs, corporates also have access to another market called the inter-corporate deposit (ICD) market. An ICD is an unsecured loan, extended by one corporate to another. Existing mainly as a refuge for low-rated corporates, this market allows a fund-surplus corporate to lend to another corporate. A higher-rated corporate can borrow from the banking system and lend in this market as well. As the cost of funds for a corporate is much higher than for a bank, the rates in this market are higher than in other markets. ICDs are unsecured; hence, the inherent risk is high.

Commercial Bill Market

Bills of exchange are negotiable instruments drawn by the seller (drawer) of goods on the buyer (drawee) of the goods for the value of the goods delivered. These bills are called trade bills. Trade bills are called commercial bills when they are accepted by commercial banks. If the bill is payable at a future date and the seller needs money during the period of the bill, then the bill can be discounted with a bank. The bank will receive the maturity proceeds, or face value of discounted bill, from the drawee on the maturity date. If the bank also needs funds before the maturity date, then it can rediscount the bill, which it has already discounted, in the commercial bill rediscount market at the market related discount rate.

In India, commercial banks can rediscount the bills, originally discounted by them, with approved institutions such as commercial banks, financial institutions, mutual funds, and primary dealers.

With the intention of reducing paper movements and facilitating multiple rediscounting, RBI introduced an instrument called Derivative Usance Promissory Notes (DUPN). With this facility, the need for a physical transfer of bills does not arise and the bank that originally discounted the bills only draws DUPNs. These DUPNs are sold to investors in convenient lots of maturities (from 15 days upto 90 days) on the basis of trade bills, discounted by the bank.

Capital Market

Capital markets exchange both long-term fixed claim securities and residual/equity claim securities. The main economic role of a capital market is to match players who have excess funds to players who are in need of funds. The capital market turnover in certain countries is given in Table 1.5. Capital markets also provide liquidity to financial instruments. In this exchange process, there is a valuation of the instruments done by the market for the specific risk assumed by the investors.

Risk is prevalent in the capital market since the market valuation process is subject to change. For example, deviation in return is one type of risk prevalent in the instruments traded in the capital market. Besides, the instruments could also have economic risk, liquidity risk, default risk, trading risk, and so on. There are two forms of returns from instruments. One is the claim on the instrument; the other form of return is due to trade. The claim on the instrument could be fixed or residual. The return through claim is either nil or positive. While fixed claim instruments hardly show any variation in returns, residual claim instruments display fluctuating returns thus exposing the holders to greater risk.

The capital gain/loss in buying/selling the security is the trade return from the security. Given the risk-return characteristic of the capital market, the expectations of the market participants play a major role in the market price determination of the securities traded. This risk-return characteristic of the instruments necessitates a subdivision of the capital market into debt market and equity market.

 

Table 1.5 Capital Market Strength

Country	Capital Market Turnover ($ billion)	Turnover Ratio (%)
USA	31,862	200.8
UK	1,835	66.6
Japan	2,694	69.9
Germany	1,069	79.1
China	722	158.3
Singapore	91	52.1
Hongkong	378	61.3
India	621	374.7

Debt Market

Financial instruments that have a fixed income claim and have a maturity of more than one year are traded in the debt market. Debentures or bonds are examples of debt instruments in the capital market. Table 1.6 lists some characteristics of the international debt market.

 

 

Debt instruments may have several distinguishing features. They can be secured or unsecured debt. A secured debt has assets to fall back on while an unsecured debt is subject to more risk. Since an unsecured debt does not have an asset backing, the repayment risk is more. Mortgaged debt refers to a mortgage lien on a group of assets or on a specific asset category. Such a debt is also a secured debt.

Debt can also be categorised as redeemable debt or irredeemable debt. Based on the redemption (repayment) characteristic, it will be stated at the time of issue itself whether the debt will be repaid at maturity. Unless otherwise stated, all debt is usually redeemable debt. Irredeemable debt is a rollover debt, is renewed after maturity. Debt can also be classified as convertible debt or non-convertible debt. Convertible debt implies that the original debt instrument would be converted into another financial instrument at the time of maturity. A non-convertible debt is repaid at the end of the maturity period.

Based on the type of claim on the instrument, debt can be classified as regular interest debt, flexi debt, and zero coupon debt. A debt will bear a fixed claim, which is usually the interest payment made by the issuer to the debt holder. The nominal fixed percentage of interest is specified at the time of issue and the interest payments are made at fixed intervals. Hence these debt instruments are called regular income instruments. A flexi debt has the characteristic of changing its interest rate with the prevaling economic environment. The flexible debt is usually associated with inter-bank offer rates. For example, LIBOR (London Inter-bank Offer Rate) is a popular base rate for flexi debt instruments. A zero coupon debt, on the other hand, does not pay regular interest, but issues a document at an offer price and repays the document with value additions that compensates for the regular income through the duration of debt. The debt market distinguishes fresh issues from the subsequent trading of the securities and hence can be further subdivided into primary and secondary markets.

Equity Market

Equity instruments bestow ownership on the holder of the security. Equity hence implies ownership rights in the corporate entity that has issued the instruments to the public. The claim of the owners of these instruments is residual in nature, that is the owners will have a claim in the distribution of profits and not a fixed interest as in the case of debt instruments. The distribution of dividend out of the profits after payment to debt holders will be decided in the general body meeting of the corporate entity. Accordingly, the corporate will announce the dividend rates. Dividends can be annual or quarterly or extraordinary. Sometimes equity owners also claim additional returns from the firm in the form of bonus shares. Dividend can be distributed either in the form of cash or as new shares.

Equity instruments can also be of several types. The most distinguishable types of equity are preference equity and common/or ordinary equity. Preference equity has a preferential claim over dividend payment and/or payment of face value at the time of liquidation (closure) of a corporate. Sometimes a preferential equity may also have a claim for a minimum percentage of dividends when the corporate declares dividend. Common equity instruments do not have such preferential rights. The equity market is also subdivided into the primary market and secondary market.

Equity Instrument	Features
Ordinary	Residual claim Voting rights Ownership
Preference	Residual claim Preference over ordinary shares in claims With/without voting rights Ownership

Primary Market

The primary market is the doorway for corporate enterprises to enter the capital market. The issues of new/fresh/subsequent securities are offered to the public through the primary market. The issue is thus an open public offer to sell the securities. The sale is made at a value predetermined by the firm issuing the security. Sometimes a road show is conducted to feel the pulse of the public in fixing the value for a security. The securities have a face value, which is the denomination in which it is divided. For instance, an instrument could have a face value of Re 1, Rs 5, Rs 10, or Rs 100 in India. This denomination determines the number of units of the security that are offered to the public. The price at which the security is offered to the public is the offer price of the instrument. This price could be equal to or greater or lesser than the face value. When the offer price is greater than the face value, the offer is said to be at a premium. When the offer price is less than the face value, the offer is at a discount. When the two prices are equal, the offer is at par.

Several intermediaries have sprung up to help corporate entities to offer their debt and equity instruments to the public. Merchant bankers and underwriters are the major intermediaries who help to match the fund requirement of corporate entities with the surplus fund position of public. The public is represented by both individual investors and institutional investors. Sometimes, when the market is dominated by institutions, the market is said to be institutionalised. Once the offer process of the securities to the public is complete, the securities are listed in the markets. The corporate then has to comply with the specific regulations of each local market in which its securities are listed. The size of the primary market in certain countries is given in Table 1.7.

 

Secondary Market

The secondary market refers to the exchange of securities that have been listed through the primary market. The price at which it is traded in the capital market is the market price of the instrument. It is the secondary market that offers tradability to the financial instruments. The number of financial instruments participating in the secondary market hence, cannot exceed the number of financial instruments recorded through the primary market. The secondary market also comes under the regulatory authorities of the market and the main role of the regulator in the secondary market is to safeguard the interest of players in the market. Both individuals and institutions can take part in the secondary market. Brokers and depositories are the main intermediaries in this market, who transact business on behalf of the investors. The brokers can appoint a network of sub-brokers to mobilise investor participation in the market. Depositories help in scripless trading by holding investor accounts in electronic media.

Over a period of time, the secondary market has grown in size and in terms of efficiency. Table 1.8 highlights the efficiency of the secondary market globally. The secondary market may be further subdivided into the spot market and derivative market.

 

Forex Market

The foreign exchange or forex market is an international currency exchange market. It caters to the need of international mobility of funds. International trade requires exchange of one currency for another. The rate of exchange of one country’s currency for another is called the exchange rate. This rate can be stated in terms of a direct quote or an indirect quote. A direct quote is the number of units of local currency exchanged for one unit of foreign currency unit. For example, in India, Rs 47.30/$ is a direct quote, stating the amount required in terms of rupees to exchange one dollar. An indirect quote is the expression of the quantum of foreign currency units needed for one unit of local currency. Mathematically, an indirect quote is the inverse function of a direct quote [1 / direct quote]. For the illustration stated above, $0.02114/1Re is an indirect quote in India for the US currency.

If the number of units of a foreign currency that can be obtained for one local currency increases, the local currency is said to have appreciated relative to the specific foreign currency and the foreign currency is said to have depreciated relative to the local currency. Hence, an appreciation in the local currency implies a reduction in the direct quote or an increase in the indirect quote. Similarly, a depreciation in the local currency implies an increase in the direct quote and a decrease in the indirect quote. For example, if the direct quote at the end of two subsequent years is Rs 45.5/$ and Rs 47.3/$ respectively in the Indian market, the increase in the direct quote indicates the depreciation of the rupee in terms of the dollar and appreciation of the dollar in terms of the rupee.

The main players in the forex market are dealers, who are regulated by the specific regulatory authority of the country. The regulator may also participate in the market depending on the forex policies of that country. The forex market also is subdivided into the spot market, and derivative market. In India, the Reserve Bank of India regulates the forex market. The direct quote in India for the currencies of certain countries is given in Table 1.9.

 

Table 1.9 Direct Quote of Exchange Rates in India

Country	Currency	Exchange Rate (Rs.)
UK	Pound Sterling	78.52
USA	US Dollar	43.05
Europe	Euro	51.98
Japan	Yen	0.4095
Australia	Australian Dollar	32.49
Sweden	Swedish Kroner	5.63

Spot Market

Spot market denotes the current trading price of financial instruments. In the context of time, the spot market may range between one day, two days, or a week. The transactions in the spot market are settled immediately, that is, on the immediate settlement date. Each market specifies the type of settlement to be made—a rolling settlement or a fixed day settlement. The rolling settlement, according to the specific exchange, will be T+1, T+3, or T+5. A T+1 rolling settlement indicates that trading entered on day T will be settled for cash on day T+1. On the other hand, the fixed day settlement will be on a specific day of a week, say the working Thursday or Friday of a week.

Derivative Market

Unlike the spot market, the derivative market is a futures market. Trade takes place here with the intention to settle it at a later date. The derivative market has forward, futures, options, or other derivative instruments trading. Forward trade helps in the exchange of instruments in the future at prices or rates determined in the present. Forward contracts involve an obligation and are legally binding on the parties who have entered into a forward agreement. However, forward contracts have the disadvantage of inflexibility of timing. They are conducted on a one-to-one basis between parties who initially entered into the agreement. A forward contract cannot be surrendered or liquidated as easily as the other derivative instruments.

A futures contract is an agreement by one participant to either buy or sell a financial instrument at a predetermined date in the future at a predetermined price. The basic function of the futures trade is to enable the market participants to hedge against the risk of adverse price movements/volatility in the market. A contract to buy, say, 100 shares of Ranbaxy Laboratories three months later, at Rs 859.97 per share is a futures contract. The price at which the financial instrument is transferred at a later date (in this case, Rs 859.97) is called the futures price. The time stated in the contract in which the contract will be enforced (three months hence) is called the delivery date/expiry date. Futures contracts are derivatives since they are based on financial instruments that are traded in the capital market.

There are other forms of derivatives that give the holder of the contract the choice to buy or sell a financial asset. Such contracts are called option instruments. Options can take the form of equity options or index options. Equity options such as Infosys call options may have a strike price of Rs 3,900 at a premium of Rs 190 with the expiry date of one month. The premium is the amount that is given to the writer of the contract for giving the buyer the right to sell the Infosys share at the future date for the agreed price.

All these financial instruments derive their value from the price of the underlying asset. Hence they are called as derivative instruments. These instruments are traded in a physical stock exchange through brokers. Derivative instruments are used to a large extent to reduce the risk in the underlying asset price.

INVESTMENTS

Financial markets provide the basic function of mobilising the investments needed by corporate entities. They also act as market-places for investors who are attracted by the returns offered by the investment opportunities in the market. In this context there is a need to understand the meaning of investment and the motives of investment.

Investment may be defined as an activity that commits funds in any financial/physical form in the present with an expectation of receiving additional return in the future. The expectation brings with it a probability that the quantum of return may vary from a minimum to a maximum. This possibility of variation in the actual return is known as investment risk. Thus every investment involves a return and risk.

Investment is an activity that is undertaken by those who have savings. Savings can be defined as the excess of income over expenditure. However, all savers need not be investors. For example, an individual who sets aside some money in a box for a birthday present is a saver, but cannot be considered an investor. On the other hand, an individual who opens a savings bank account and deposits some money regularly for a birthday present would be called an investor. The motive of savings does not make a saver an investor. However, expectations distinguish the investor from a saver. The saver who puts aside money in a box does not expect excess returns from the savings. However, the saver who opens a savings bank account expects a return from the bank and hence is differentiated as an investor. The expectation of return is hence an essential characteristic of investment.

An investor earns/expects to earn additional monetary value from the mode of investment that could be in the form of physical/financial assets. A bank deposit is a financial asset. The purchase of gold would be a physical asset. Investment activity is recognised when an asset is purchased with an intention to earn an expected fund flow or an appreciation in value.

An individual may have purchased a house with an expectation of price appreciation and may consider it as an investment. However, investment need not necessarily represent purchase of a physical asset. If a bank has advanced some money to a customer, the loan can be considered as an investment for the bank. The loan instrument is expected to give back the money along with interest at a future date. The purchase of an insurance plan for its benefits such as protection against risk, tax benefits, and so on, indicates an expectation in the future and hence may be considered as an investment.

In all the above examples it can be seen that investment involves employment of funds with the aim of achieving additional income or growth in value. The essential quality of an investment is that it involves the expectation of a reward. Investment, hence, involves the commitment of resources at present that have been saved in the hope that some benefits will accrue from them in the future.

TYPES OF INVESTMENTS

Investments may be classified as financial investments or economic investments. In the financial sense, investment is the commitment of funds to derive future income in the form of interest, dividend, premium, pension benefits, or appreciation in the value of the initial investment. Hence, the purchase of shares, debentures, post office savings certificates, and insurance policies are all financial investments. Such investments generate financial assets. These activities are undertaken by anyone who desires a return and is willing to accept the risk from the financial instrument.

Economic investments are undertaken with an expectation of increasing the current economy’s capital stock that consists of goods and services. Capital stock is used in the production of other goods and services desired by the society. Investment in this sense implies the expectation of formation of new and productive capital in the form of new constructions, plant and machinery, inventories, and so on. Such investments generate physical assets and also industrial activity. These activities are undertaken by corporate entities that participate in the capital market.

Financial investments and economic investments are, however, related and dependent. The money invested in financial investments is ultimately converted into physical assets. Thus, all investments result in the acquisition of some asset, either financial or physical. In this sense, markets (real and financial) are also closely related to each other. Hence, the perfect financial market should reflect the progress pattern of the real market since, in reality, financial markets exist only as a support to the real market.

CHARACTERISTICS OF INVESTMENT

The characteristic features of economic and financial investments can be summarised as return, risk, safety, and liquidity.

Return: All investments are characterised by the expectation of a return. In fact, investments are made with the primary objective of deriving a return. The expectation of a return may be from income (yield) as well as through capital appreciation. Capital appreciation is the difference between the sale price and the purchase price of the investment. The dividend or interest from the investment is the yield. Different types of investments promise different rates of return. The expectation of return from an investment depends upon the nature of investment, maturity period, market demand, and so on.

The purpose for which the investment is put to use influences, to a large extent, the expectation of return of the investors. Investment in high growth potential sectors would certainly increase such expectations.

The longer the maturity period, the longer is the duration for which the investor parts with the value of the investment. Hence, the investor would expect a higher return from such investments.

The market demand for funds also raises the expectation of return by the investors. The scarcity of fund supply pushes the return expectation of investors who tend to be very choosy among investment alternatives.

Risk: Risk is inherent in any investment. Risk may relate to loss of capital, delay in repayment of capital, nonpayment of interest, or variability of returns. While some investments such as government securities and bank deposits are almost without risk, others are more risky. The risk of an investment is determined by the investment’s maturity period, repayment capacity, nature of return commitment, and so on.

The longer the maturity period, greater is the risk. When the expected time in which the investment has to be returned is a long duration, say 10 years, instead of five years, the uncertainty surrounding the return flow from the investment increases. This uncertainty leads to a higher risk level for the investment with longer maturity rather than on an investment with shorter maturity.

The lower the payment capacity, higher is the risk. This factor is termed as the credit worthiness/value generation capacity of the investment. If the value generation capacity is lower, then it increases the uncertainty surrounding the recovery/future cash flows from that investment. Hence, risk is higher for such investments.

Risk also varies with nature of the return commitment. Ownership commitment such as investment in equity shares carry a higher risk compared to lender commitments such as investments in debentures and bonds. Ownership commitment has a right to the profits that are available after making a payment to other types of bond commitments. The priority of cash flows is to bond payments rather than to ownership payments. Hence, the uncertainty of cash flows to owners is more than that of the bondholders and this increases the risk element of the investment instruments.

Risk and the expected return of an investment are related. Theoretically, the higher the risk, higher is the expected return. The higher return is a compensation expected by investors for their willingness to bear the higher risk.

Safety: The safety of investment is identified with the certainty of return of capital without loss of money or time. Safety is another feature that an investor desires from investments. Every investor expects to get back the initial capital on maturity without loss and without delay. Investment safety is gauged through the reputation established by the borrower of funds. A highly reputed and successful corporate entity assures the investors of their initial capital. For example, investment is considered safe especially when it is made in securities issued by the government of a developed nation.

Liquidity: An investment that is easily saleable or marketable without loss of money and without loss of time is said to possess the characteristic of liquidity. Some investments such as deposits in unknown corporate entities, bank deposits, post office deposits, national savings certificate, and so on are not marketable. There is no well-established trading mechanism that helps the investors of these instruments to subsequently buy/sell them frequently from a market. Investment instruments such as preference shares and debentures (listed on a stock exchange) are marketable. The extent of trading, however, depends on the demand and supply of such instruments in the market for the investors. Equity shares of companies listed on recognised stock exchanges are easily marketable. A well-developed secondary market for securities increases the liquidity of the instruments traded therein.

An investor tends to prefer maximisation of expected return, minimisation of risk, safety of funds, and liquidity of investments.

OBJECTIVES OF INVESTMENT

Income when not consumed immediately as expenditure promotes savings. A prudent and consistent saving habit lets income earners to set aside a certain amount of current income for future consumption. Savings kept as cash do not result in an incremental return. Hence, savings are invested in assets with the desired risk-return characteristics. The main objective of an investment process is to minimise risk while simultaneously maximising the expected returns from the investment and assuring safety and liquidity of the invested assets.

Investors look for growth/increase in current wealth through investment opportunities. Given an investment environment, an investor’s preference will be for investment opportunities that give the highest return. Investors desire to earn as large returns as possible but with the minimum of risk. Risk can also be stated as the probability that the actual return realised from an investment may be different from the expected return. Financial assets can be grouped into different classes of risk based on the return. Government securities constitute the low risk category as there is very little deviation from expectations and hence are riskless. Shares of corporate entities would form the high-risk category of financial assets as their returns depend on many uncontrollable factors. An investor would be prepared to assume a higher risk only if the expected return is proportionately higher. Hence, there is a trade-off between risk and return.

The objective of safety and liquidity helps an investor to design a retirement plan. This is done to substantiate an investor’s earnings beyond the employment tenure. With this in mind, the investor sets aside a part of the current income in growth/income-yielding assets that would give an assured return after a period of time.

Savings kept as idle cash do not become investments since it loses its value over time due to rise in prices. This rise in prices, or inflation, invariably erodes the value of money. Investments are, hence, made with the objective to provide a hedge or protection against inflation over the investment duration. This time value concept necessitates investors to choose asset types that will enable them to retain at least the cash value held at present over a future period. In effect, the real rate of return would be negative if the investment cannot earn a higher return than the inflation rate. For example, if inflation is at an average annual rate of 4 per cent, then the expected return from an investment should be above 4 per cent to help savings funds to flow into investment avenues. The objective of investment hence can be stated as giving an expected return from the asset that is higher than the prevalent inflation rate in the economy.

The third objective of investment is the utilisation of tax incentive schemes offered by the government. In order to foster investment habits, many economies offer incentives in the form of tax-saving schemes. Tax rates are applicable for a fiscal year; therefore, to cut down on immediate tax expenditures an investor would invest in tax-saving investment schemes offered by the government. This objective of the investor to reduce present tax payments and hence invest in tax-saving schemes can be considered as a short-term investment objective. Tax-saving schemes also offer a marginal return to the investors. Based on the tax policies of the country, investment criteria could solely depend on this factor also.

TYPES OF INVESTORS

Investors can be classified on the basis of their risk bearing capacity. Investors in the financial market have different attitudes towards risk and hence varying levels of risk-bearing capacity. Some investors are risk averse, while some may have an affinity for risk. The risk bearing capacity of an investor is a function of personal, economic, environmental, and situational factors such as income, family size, expenditure pattern, and age. A person with a higher income is assumed to have a higher risk-bearing capacity. Thus investors can be classified as risk seekers, risk avoiders, or risk bearers. A risk seeker is capable of assuming a higher risk while a risk avoider chooses instruments that do not show much variation in returns. Risk bearers fall in between these two categories. They assume moderate levels of risk.

Investors can also be classified on the basis of groups as individuals or institutions. Individual investors operate alongside institutional investors in the investment market. However, their characteristics are different. Individual investors in any financial market are large in number, but in terms of value of investment they are comparatively smaller. Institutional investors, on the other hand, are organisations with surplus funds beyond immediate business needs or organisations whose business objective is investment. Mutual funds, investment companies, banking and non-banking companies, insurance corporations, and so on are organisations with large surplus funds to be invested in various profitable avenues. While these institutional investors are fewer in number compared to individual investors, their resources are much larger. Institutional investors engage professional fund managers to carry out extensive analysis. Institutional investors and individual investors combine to make the investment market dynamic.

INVESTMENT vs SPECULATION

Investment and speculation both involve the purchase of assets such as shares and securities, with an expectation of return. However, investment can be distinguished from speculation by risk bearing capacity, return expectations, and duration of trade.

The capacity to bear risk distinguishes an investor from a speculator. An investor prefers low risk investments, whereas a speculator is prepared to take higher risks for higher returns. Speculation focuses more on returns than safety, thereby encouraging frequent trading without any intention of owning the investment.

The speculator’s motive is to achieve profits through price changes, that is, capital gains are more important than the direct income from an investment. Thus, speculation is associated with buying low and selling high with the hope of making large capital gains. Investors are careful while selecting securities for trading. Investments, in most instances, expect an income in addition to the capital gains that may accrue when the securities are traded in the market.

Investment is long term in nature. An investor commits funds for a longer period in the expectation of holding period gains. However, a speculator trades frequently; hence, the holding period of securities is very short.

The identification of these distinctions helps to define the role of the investor and the speculator in the market. The investor can be said to be interested in a good rate of return on a consistent basis over a relatively longer duration. For this purpose the investor computes the real worth of the security before investing in it. The speculator seeks very large returns from the market quickly. For a speculator, market expectations and price movements are the main factors influencing a buy or sell decision. Speculation, thus, is more risky than investment.

In any stock exchange, there are two main categories of speculators called the bulls and bears. A bull buys shares in the expectation of selling them at a higher price. When there is a bullish tendency in the market, share prices tend to go up since the demand for the shares is high. A bear sells shares in the expectation of a fall in price with the intention of buying the shares at a lower price at a future date. These bearish tendencies result in a fall in the price of shares.

A share market needs both investment and speculative activities. Speculative activity adds to the market liquidity. A wider distribution of shareholders makes it necessary for a market to exist.

INVESTMENT vs GAMBLING

Investment can also to be distinguished from gambling. Examples of gambling are horse race, card games, lotteries, and so on. Gambling involves high risk not only for high returns but also for the associated excitement. Gambling is unplanned and unscientific, without the knowledge of the nature of the risk involved. It is surrounded by uncertainty and a gambling decision is taken on unfounded market tips and rumors. In gambling, artificial and unnecessary risks are created for increasing the returns.

Investment is an attempt to carefully plan, evaluate, and allocate funds to various investment outlets that offer safety of principal and expected returns over a long period of time. Hence, gambling is quite the opposite of investment even though the stock market has been euphemistically referred to as a “gambling den”.

SPECULATION vs GAMBLING

Gambling and speculation may also be differentiated on the basis of their approach to trading and expectations. Speculation is a calculated move with an expectation to reap huge profits from the market. Gambling, on the other hand, is betting and reckless trading. A speculator is able to bear losses but would not tolerate continuous losses if not compensated by gains. A gambler could lose all capital in the trading process, based on his emotions.

HEDGING

Risk reduction is known as hedging. Any investment activity inherently has an element of risk. By using derivative instruments, investors try to reduce/minimise risk. Thus, the risk reduction practices of investors using derivative instruments are called as hedging activities.

SUMMARY

Financial assets represent current/future values of real assets. They are expressed in money terms, have the characteristics of divisibility, convertibility, and reversibility. They are traded in a market and provide cash flows to the holder.

A financial market is a place/system where the exchange of financial instruments takes place. Financial markets are broadly classified into money market and capital market. Capital market deals with both debt and equity instruments through the primary and secondary market segments. Money market, on the other hand, deals mostly in debt instruments of shorter duration. Another market existing in the financial structure of an economy is the forex market. This market enables the exchange of foreign currency.

CONCEPTS

• Physical assets	• Financial assets
• Financial markets	• Securities market
• Forex market	• Derivative market
• Primary market	• Secondary market
• Financial intermediaries	• Investment
• Investment risk	• Speculation
• Gambling	• Hedging

SHORT QUESTIONS

1. Distinguish between a physical asset and a financial asset.
2. Distinguish between primary market and secondary market.
3. Differentiate investment from speculation, and gambling.
4. What is an investment risk?
5. What is a derivative?
6. What is a reverse repo?
7. What are commercial papers?
8. What are commercial bills?
9. What are the types of T-bills in India?
10. What are certificate of deposits?
11. What is a call money market?
12. What is the special feature of a derivative usance promissory note?
13. What does “institutionalising the market”, mean?
14. What are the special features of preference shares?
15. Differentiate investment from savings.

ESSAY QUESTIONS

1. Explain the characteristics of financial assets.
2. Discuss the structure and function of financial markets.
3. Describe the characteristics of the security market.
4. Define investment. What are the characteristics of investment?
5. What are the motives for investment?