CAPITAL MARKET EFFICIENCY AND CAPITAL MARKETS IN INDIA

CHAPTER 19

LEARNING OBJECTIVES

Explain the concept of the capital market efficiency Discuss the features of perfect capital market Highlight the developments in the stock markets

(secondary market) and the new issue market (primary market) in India

Understand role of merchant bankers and mutual funds

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CAPITAL MARKETS

Capital markets facilitate the buying and selling of securities, such as shares and bonds or debentures. They perform two valuable functions:

1. Liquidity

2. Pricing securities

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Weekly Share Price Index, 10 Feb. 1990 to 28 Feb. 2009

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Weekly market returns, 10 Feb. 1990 to 28 Feb. 2009

Capital Market Efficiency

Capital Market Efficiency may be defined as the ability of securities to reflect and incorporate all relevant information in their prices. Three forms of capital market efficiency may be distinguished –

1. Weak form of efficiency

2. Semi-strong form of efficiency

3. Strong form of efficiency

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Weak Form of Efficiency

The security prices reflect all past information about the price movements.

Semi-Strong Form of Efficiency The security prices reflect all public ally available

information about the price movements.

Strong Form of Efficiency

The security prices reflect all published and unpublished public and private information about the price movements.

Attributes of a Perfect Capital Market1. No entry Barriers.

2. Large Number of Buyers and Sellers.

3. Divisibility of financial assets.

4. Absence of transaction costs.

5. No tax differences.

6. Free Trading.

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Three significant imperfections of Capital markets Tax asymmetries Information asymmetries Transaction costs

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CAPITAL MARKETS IN INDIA Primary market Secondary market

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PRIMARY CAPITAL MARKET IN INDIA Primary capital market is a conduit for the sale of

new securities. Listed (existing or new) companies may make the

public issues of shares. The initial public offerings (IPOs) are the public

issues of securities by new companies for the first time.

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Financial Instruments

Equity and debt are the two basic instruments of raising capital from the primary markets. Ordinary shares Preference shares Debentures Convertible debentures Warrants Cumulative convertible preference shares (CCPS) Derivative securities Borrowings from financial institutions

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Resource Mobilization from IPOs and Rights Issues

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Private Placement

Instead of a public issue of securities, a company may offer them privately, only to a few investors; that is, less than 50 in number. This is referred to as private placement of securities.

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Reasons for the development of Private Placement Private placement of securities is subject to much

less compliance than the public issues Private placement is cost effective as compared to

public issues Private placement is time effective as deals can be

easily and directly negotiated with a few investors Private placement helps to tailoring the issues

according to the needs of the companies

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Euro Issues

Companies in India have started raising funds via euro issues in the foreign capital markets.

Euro issues include foreign currency convertible bonds (FCCBs), global depository receipts (GDRs) and American depository receipts (ADRs).

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Government Securities

Both the central and state governments borrow large sums of money from the primary market by issuing dated securities (long-term securities) and Treasury bills (T-Bills).

T-Bills in India are issued for short duration.

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Pricing of New Issues

Companies in India can freely price share issues, subject to the SEBI guidelines.

In the case of the listed companies, the current market price provides a basis for pricing the new issue of securities.

A company is required to issue a prospectus when it issues shares to the public.

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Book Building and Price Discovery

Book building is an alternative to the traditional fixed-price method of security issue.

In book building the issue price is not fixed. Book building is a process of offering securities at various

bid prices from investors. There is a price band with the floor price (lower price) and

the ceiling price (higher price). The demand for the security is assessed and the price is

discovered based on bids made by investors. Price discovery, therefore, depends on the demand for the

shares at different prices.

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Book building involves the following steps:1. The company plans an IPO via the book building

route.

2. It appoints an issue manager (usually a merchant banker) as book-runner.

3. It issues a draft prospectus containing all required disclosure.

4. The draft prospectus is filed with SEBI.

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Cont…

5. The issue manager (book-runner) appoints syndicate members and other registered intermediaries to garner subscription.

6. Price discovery begins through the bidding process.

7. At the close of bidding, book-runner and the company decide upon the allocation and allotments.

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SECONDARY MARKETS IN INDIA Secondary capital markets deal in the second-hand

issued securities.

Stock exchanges are secondary markets where buyers and sellers trade in already issued securities.

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A stock exchange provides the following useful economic functions:a) Help in determining fair prices based on demand and supply

forces and all-available information

b) Providing easy marketability and liquidity for investors

c) Facilitation in capital allocations in primary markets through price signalling

d) Enabling investors to adjusting portfolios of securities

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In terms of business activities, the two most prominent all-India stock exchanges are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).

Securities and Exchange Board of India(SEBI)

SEBI is required to regulate and promote the securities market by:

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Secondary Market: Selected Indicators

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Government Securities Market The government debt market constitutes about

three-fourths of the debt market in India. Commercial banks and financial institutions in

India own a large proportion of the government debt securities due to statutory liquidity and other investment requirements.

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Derivatives Market

Derivatives are securities derived from other securities (called underlying securities) like equity, debt, or any other type of security.

They also include contracts that derive their values from prices or index of prices.

In India, the OTC derivatives are not allowed; the legal derivatives must trade on recognised stock exchanges only.

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Trading and Settlement

Dematerialization of shares Trading Rolling settlement Circuit breaker

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MERCHANT BANKING: ROLE IN CAPITAL MARKETS

Merchant bankers play the role of intermediaries in the capital market in India.

They help companies in the total management of issues of securities.

Therefore, they are called issue managers. As members of stock exchange, underwriters of new issues

and book builders, they help to make market, and hence, are known as market makers also.

Merchant bankers cannot undertake the pure fund-based activities.

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MUTUAL FUNDS AND CAPITAL MARKETS Indian investors started investing through mutual

funds since 1964 when the government set up the Unit Trust of India (UTI).

UTI’s objective was to mobilize the savings of the public, and invest them in securities and other assets, enabling the investors to earn good returns.

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Broad categories of Mutual Funds Closed-ended mutual funds Open-ended fund

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Various kinds of funds possible: Income funds Growth funds Balanced funds Tax saving funds Sector-based funds

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Benefits of Mutual Funds

SimplicityDiversificationProfessional managementAffordabilityFlexibility

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Drawbacks of Mutual Funds High fees and expenses Brokerage fees Hidden costs Cost of diversification Risks of ownership

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Index Fund

In an index fund, the funds manager creates the fund by buying shares included in a stock market index such as the BSE Sensex or the NSE Nifty or a sector specific stock index.

Sector funds are index funds as they are based on stock market indices.

Stock market indices keep track of all types of companies.

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Advantages: Index FundsLess expensesLow research costRegular follow-up

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Limitations: Index Funds

Index funds can never outperform the market.The small investors may not be able to invest in

index funds as several funds require a large initial investment.

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Hedge Fund

A hedge fund does varieties of things than merely buying and selling securities.

It takes both long and short positions, uses arbitrage, buys and sells undervalued securities, trades options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk.

Most hedge funds aim at reducing volatility and risk, while offering high returns under different market conditions.

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Advantages: Hedge Fund

Positive returns Risk reduction Wide choices High returns Ideal investment Better diversification

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