Notes

1. Financial markets & Securities markets

2. Primary markets
3. Secondary markets
4. Forex & Derivatives

1
 SECURITIES MARKET

1.1. Securities Markets and Securities: Definition and Features

Financial market consists of various types of markets (money market, debt market,
securities market); investors (buyers of securities), issuers of securities (users of funds),
intermediaries and regulatory bodies (SEBI, RBI etc.). The components of the Indian
financial market can be illustrated through Figure 1. In this book, the focus will be on the
securities markets.
Figure: 1 Component of Indian Financial Markets

The securities markets provide a regulated institutional framework for an efficient flow
of capital (equity and debt) from investors to businesses in the financial market
system. It
provides a channel for allocation of savings to investments. Thus, the savings of
households, business firms and government can be channelized through the medium of
securities market to fund the capital requirements of a business enterprise a nd
government.
Savings are linked to investments by a variety of intermediaries through a range of
complex financial products called “securities”. Securities are financial instruments issued
by companies, financial institutions or the government to raise funds. These securities

2
 are purchased by investors who in turn convert their savings into financial assets.
The term “securities” has been defined in Section 2 (h) of the Securities Contracts
(Regulation) Act 1956. The Act defines securities to include:
a) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable
securities of a like nature in or of any incorporated company or other body
corporate;
b) derivative 1;
c) units or any other instrument issued by any collective investment scheme to the
investors in such schemes;
d) security receipt as defined in clause (zg) of section 2 of the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest Act,
2002;
e) units or any other such instrument issued to the investors under any mutual fund
scheme (securities do not include any unit linked insurance policy or scrips or any
such instrument or unit, by whatever name called which provides a combined
benefit risk on the life of the persons and investment by such persons and issued
by an insurer refer to in clause (9) of section 2 of the Insurance Act, 1938 (4 of
1938));
f) any certificate or instrument (by whatever name called), issued to an investor by
any issuer being a special purpose distinct entity which possesses any debt or
receivable, including mortgage debt, assigned to such entity, and acknowledging
beneficial interest of such investor in such debt or receivable, including mortgage
debt, as the case may be;
g) government securities;
h) such other instruments as may be declared by the Central Government to be
securities (including onshore rupee bonds issued by multilateral institutions like
the Asian Development Bank and the International Finance Corporation);
i) rights or interest in securities.

Features of Securities:

• A security represents the terms of exchange of money between two parties.

Securities are issued by companies, financial institutions or the government and are
purchased by investors who have the money to invest. The broader universe of savers
with surplus to invest is available to the issuers of securities; a universe of wider
options is available to savers to invest their money in.
• Security issuance allows borrowers to raise money at a reasonable cost while security

3
 ownership allows investors to convert their savings into financial assets which
provide a return. Thus, the objectives of the issuer and the investor are
complementary, and the securities market provides a platform to mutually satisfy
their goals.
• The business enterprises issue securities to raise money from the entity with surplus
funds through a regulated contract. The enterprise list these securities on a stock
exchange to ensure that the security is liquid (can be sold when needed) and provides
information about its activities and financial performance to the investing entity.
• The issuer of the security provides the terms on which the capital is being raised.
• The investor in the security has a claim to the rights represented by the securities.
These rights may involve ownership, participation in management or claims on
assets.
• Securities can be broadly classified into equity and debt. The terms of issue, rights of
investors, risk and return for these two classes of securities varies widely. Return
refers to the benefits that the investor will receive from investing in the security. Risk
refers to the possibility that the expected returns may not materialise. For example,
a company may seek capital from an investor by issuing a bond. A bond is a debt
security, which means it represents a borrowing of the company. The security will be
issued for a specific period, at the end of which the amount borrowed will be repaid
to the investor. The return will be in the form of interest, paid periodically to the
investor, at a rate and frequency specified in the security. The risk is that the company
may fall into bad times and default on the payment of interest or return of principal.
• An investor has the right to seek information about the securities in which he invests.
For example, when investors buy the bond, they can seek information about the
company, ask for evaluation of its ability to repay the borrowed amount, seek the
rights to claim their dues if the company shuts down, and also have the benefit of a
liquid market in which they can sell off the security if they do not like to bear the
risks. Thus, the institutional structure of securities markets enables assuming risks in
exchange for returns, evaluating the risks and return based on information available
about the security, and transferring of risk when the investor sells th e security to
another investor who may be willing to bear the risk, for the expected return.
Those who need money can source it from those who have it primarily through two means:
a. A one-to-one transaction, whose terms are determined and agreed to mutually
b. A standard security, whose terms are accepted by both parties
What is the difference between these two choices? Assume that a bank accepts a 3-year
deposit from a customer. This is a transaction between the bank and its customer. The
bank has borrowed the money; the customer has lent the money. The bank will repay
the deposit only to the customer. The interest rate is fixed when the deposit is accepted.
The deposit has to be kept for a 3-year period. If the customer needs money earlier than
that, the deposit can be broken but may be subject to penalties. The bank may issue a

4
 fixed deposit receipt to the customer, but that receipt is not transferable.
Assume instead that the bank issues a certificate of deposit (CD), which is a security. The
CD is also for 3-years and carries the same interest rate as the deposit. But the similarities
end there. The customer can either hold the CD till its maturity or can transfer it to
another customer before the maturity date. The investor who holds the CD on the date
of its maturity submits it to the bank and collects the maturity val ue. When the CD
transfers from one investor to another, the price is determined based on what both agree
as the market rate at that time.
When a monetary transaction between two parties is structured using a security, the
flexibility to both parties is higher. Bank deposits, inter-corporate deposits, company
fixed deposits, deposits with housing finance and other finance companies, chit funds
and benefit funds are all not securities. Insurance policies are also contracts and are not
securities. Investment in provident funds or pension funds is also not investment in
securities. All these are financial arrangements between two parties that are not in the
form of transferable securities.

1.2. Securities Markets: Structure and Participants

Structure

The market in which securities are issued, purchased by investors, and subsequently
transferred among investors is called the securities market. The securities market has
two interdependent and inseparable segments, viz., the primary market and the
secondary market.
The primary market, also called the new issue market, is where issuers raise capital by
issuing securities to investors. The secondary market, also called the stock/securities
exchange, facilitates trade in already-issued securities, thereby enabling investors to exit
from an investment. The risk in a security investment is transferred from one investor
(seller) to another (buyer) in the secondary markets. Thus, the primary market creates
financial assets, and the secondary market makes them marketable.
Participants

Investors and issuers are the main building blocks of a securities market. Issuers supply
securities and create a demand for capital; and investors buy the securities and thereby
provide the supply of capital. Interaction between investors and borrowers is facilitated
through financial intermediaries who are the third component of the market. The entire
process of issuance, subscription and transaction in securities is subject to regulatory
control and supervision.
There are several major players in the primary market. These include the merchant
bankers, mutual funds, financial institutions, foreign portfolio investors (FPIs), individual

5
 investors; the issuers include companies, bodies corporate; lawyers, bankers to the issue,
brokers, and depository participants. The role of stock exchanges in the primary market
is limited to the extent of listing of the securities.
The constituents of secondary market are stock exchanges, stock brokers (who are
members of the stock exchanges), asset management companies (AMCs), financial
institutions, foreign portfolio investors (FPIs), investment companies, individual
investors, depository participants and banks.
The Registrars and Transfer Agents (RTAs), custodians and depositories are capital
market intermediaries, which provide important infrastructure services to both the
primary and secondary markets.
1.2.1 Investors

Investors are individuals or organisations with surplus funds which can be used to
purchase securities. The chief objective of investors is to convert their surplus and
savings into financial assets that earn a return. Based on the size of the investment and
sophistication of investment strategies, investors are divided into two categories--retail
investors and institutional investors.
Retail investors are individual investors who invest money on their personal account.
Institutional investors are organizations that invest large sum of money and employ
specialised knowledge and investment skills. For instance, if A saves Rs. 5000 from her
salary every month and uses it to buy mutual fund units, she is a retail investor, whereas
an institution like ICICI Mutual Fund which buys 50,000 shares of Reliance Industries Ltd.,
is an institutional investor.
Institutional investors are companies, banks, government organisations, mutual funds,
insurance companies, pension trusts and funds, associations, endowments, societies and
other such organisations that may have surplus funds to invest.
Some of the institutions such as mutual funds are institutional investors by objective i.e.
their primary business is to invest in securities. Other institutions may be into some other
primary business activities, but may have surplus funds to be invested in securities
markets. Some other institutions such as banks and financial institutions may operate in
the financial markets in various capacities, but also have an actively managed treasury
department that efficiently deploys money in the securities markets to earn a return.
Institutional investors manage their returns and risk through formal processes for (a)
evaluating and selecting the securities they buy; (b) reviewing and monitoring what they
hold, and (c) formally managing the risk, return and holding periods of the securities they
hold.
1.2.2 Issuers

Issuers are organizations that raise money by issuing securities. They may have short -

6
 term and long-term need for capital, and they issue securities based on their need, their
ability to meet the obligations to the investors, and the cost they are willing to pay for
the use of funds.
Issuers of securities have to be authorised by appropriate regulatory authorities to raise
money in the securities markets. The following are common issuers in the securities
markets:
a. Companies issue securities to raise short and long term capital for conducting their
business operations.
b. Central and State Governments issue debt securities to meet their requirements for
short term and long term to finance their deficits. (Deficit is the extent to which the
expenses of the government are not met by its income from taxes and other sources).
c. Local governments and municipalities may also issue debt securities to meet their
development needs. Government agencies do not issue equity securities.
d. Financial institutions and Banks may issue equity or debt securities for their capital
needs beyond their normal sources of funding from deposits and government grants.
e. Public Sector Companies which are owned by the government may issue securities
to public investors as a part of the disinvestment program of the government i.e.
when the government decides to offer its holding of these securities to public
investors.
f. Mutual Funds issue units of a scheme to investors to mobilise money and invest them
on behalf of investors in securities.
The securities are issued in the name and under the common seal of the issuer and the
primary responsibility of meeting the obligations are with the issuer. Earlier securities
were issued in the paper form as certificates. Since the mid-1990s securities are issued
in electronic form. Previously issued share certificates also were converted into
electronic form by the issuers. This process is called dematerialisation.
1.2.3 Intermediaries

Intermediaries in the securities markets are agents responsible for coordinating between
investors (lenders) and issuers (borrowers), and organising the transfer of funds and
securities between them. Without the services provided by intermediaries, it would be
quite difficult for investors and issuers to locate each other and carry out transactions.
According to the SEBI (Intermediaries) Regulations, 2008, following are the
intermediaries of securities markets:
• Asset Management Companies
• Portfolio managers
• Merchant bankers
• Underwriters
• Stock brokers

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 • Authorized Persons
• Clearing members of a clearing corporation or house
• Trading members of the derivative segment of a stock exchange
• Bankers to an issue
• Registrars of an issue
• Share transfer agents
• Depository participants
• Custodians of securities
• Trustees of trust deeds
• Credit rating agencies
• Investment advisers

Asset management companies and portfolio managers are investment specialists who
offer their services in selecting and managing a portfolio 2 of securities. Asset
management companies are permitted to offer securities (called units) that represent
participation in a pool of money, which is used to create the portfolio. Portfolio managers
do not offer any security and are not permitted to pool the money collected from
investors. They act on behalf of the investor in creating and managing a portfolio. Both
asset managers and portfolio managers charge the investor a fee for their services, and
may engage other security market intermediaries such as brokers, registrars, and
custodians in conducting their functions.
Merchant bankers, also called as issue managers, investment bankers, or lead managers,
engage in the business of issue management either by making arrangements regarding
the selling, buying or subscribing to securities or acting as manager, consultant, adviser
or corporate advisory service in relation to such issue management. They evaluate the
capital needs, structure an appropriate instrument, get involved in pricing the
instrument, and manage the entire issue process until the securities are issued and
listed on a stock exchange. They engage other intermediaries such as registrars,
brokers, bankers, underwriters and credit rating agencies in managing the issue process.
Underwriters are primary market specialists who promise to pick up that portion of an
offer of securities which may not be bought by investors. They serve an important
function in the primary market, providing the issuer the comfort that if the securities
being offered do not elicit the desired demand, the underwriters will step in and buy the
securities. The specialist underwriters in the government bond market are called primary
dealers.
Stock brokers are registered trading members of stock exchanges. They facilitate new
issuance of securities to investors. They put through the buy and sell transactions of
investors on stock exchanges. All secondary market transactions on stock exchanges
have to be conducted through registered brokers.

8
 Authorized persons (AP) are agents of the brokers (previously referred to as sub-brokers)
and are registered with the respective stock exchanges. 3 APs help in reaching the services
of brokers to a larger number of investors. Several brokers provide various services such
as research, analysis and recommendations about securities to buy and sell, to their
investors. Brokers may also enable screen-based electronic trading of securities for their
investors, or support investor orders over phone. Brokers earn a commission for their
services.
Clearing members and trading members are members of the stock exchange where
securities are listed and traded. Trading members put through the trades for buying and
selling, either on their own behalf, or on behalf of customers. Clearing members receive
funds and securities for completed transactions and settle the payment of money and
delivery of securities.
Bankers to an issue are selected bankers who are appointed during a new issue of
securities, to collect application forms and money from investors who are interested in
buying the securities being offered. They report the collections to the lead managers,
send the applications and investor details to the registrars and transfer the funds
mobilised to the bank accounts of the issuer.
Registrars & Share Transfer Agents maintain the record of investors for the issuer. Every
time the owner of a security sells it to another, the records maintained b y the issuer
needs to incorporate this change. Only then the benefits such as dividends and interest
will flow to the new owners. In the modern securities markets, the securities are held in
a dematerialised form in the depository. The changes to beneficiary names are made
automatically when a security is sold and delivered to the buyer. Investor records are
maintained for legal purposes such as determining the first holder and the joint holders
of the security, their address, bank account details and signatures, and any nominations
they may have made about who should be receiving the benefits from a security after
their death .
Depository participants enable investors to hold and transact in securities in the
dematerialised form. Demat securities are held by depositories, where they are admitted
for dematerialisation after the issuer applies to the depository and pays a fee. Depository
participants (DPs) open investor accounts, in which they hold the securities that they
have bought in dematerialised form. Brokers and banks offer DP services to investors.
DPs help investors receive and deliver securities when they trade in them. While the
investor-level accounts in securities are held and maintained by the DP, the company
level accounts of securities issued is held and maintained by the depository. In other
words, DPs act as agents of the Depositories.
Custodians typically work with institutional investors, holding securities and bank
accounts on their behalf. They manage the transactions pertaining to delivery of
securities and money after a trade is made through the broker, and also keeps the

9
 accounts of securities and money. They may also account for expenses and value the
portfolio of institutional investors. Custodians are usually large banks.
Trustees are appointed when the beneficiaries may not be able to directly supervise if
the money they have invested is being managed in their best interest. Mutual fund
trustees are appointed to supervise the asset managers; debenture trustees are
appointed to ensure that the lenders interests are protected.
Credit rating agencies evaluate a debt security to provide a professional opinion about
the ability of the issuer to meet the obligations for payment of interest and return of
principal as indicated in the security. They use rating symbols to rank debt issues, which
enable investors to assess the default risk in a security.
Investment advisers and distributors work with investors to help them make a choice of
securities that they can buy based on an assessment of their needs, time horizon, return
expectations and their ability to bear risk. They also create financial plans for investors,
where they define the goals for which investors need to save money and propose
appropriate investment strategies to meet the defined goals.
The role and responsibilities of intermediaries are laid down in Securities and Exchange
Board of India (Intermediaries) Regulations, 2008. In addition, specific guidelines have
been prescribed for each intermediary. All intermediaries operating in the securities
market are required to be registered with SEBI. Registration has to be renewed
periodically; this ensures continuous monitoring of intermediaries’ net worth, facilities
and operating history. In providing services to investors and issuers, intermediaries are
required to follow a SEBI- mandated code of conduct. The key points of this code are
protection of investor interests, providing fair, professional and skilled services, avoiding
collusion with other intermediaries to the detriment of investors, providing adequate
and timely information to clients, and maintaining appropriate financial and physical
infrastructure to ensure sound service.
1.2.4 Regulators of Securities Markets

The responsibility for regulating the securities market is shared by the Securities and
Exchange Board of India (SEBI), the Reserve Bank of India (RBI), the Department of
Economic Affairs (DEA) of the Ministry of Finance and Ministry of Corporate Affairs
(MCA).
Securities and Exchange Board of India (SEBI)

The Securities and Exchange Board of India (SEBI), a statutory body appointed by an Act
of Parliament (SEBI Act, 1992), is the chief regulator of securities markets in India. SEBI
functions under the Ministry of Finance. The main objective of SEBI is to facilitate growth
and development of the capital markets and to ensure that the interests of investors are
protected.

10
 Some of the functions of SEBI have been explained in detail:

• SEBI has been assigned the powers of recognising and regulating the functions of
stock exchanges. The Securities Contracts Regulation Act, 1956 is administered by
SEBI. This Act provides for the direct and indirect control of virtually all aspects of
securities trading and the running of stock exchanges. The requirements for granting
recognition to a stock exchange include representation of the Central Government
on each of the stock exchange by such number of persons not exceeding three as the
Central Government may nominate on this behalf. Stock exchanges have to furnish
periodic reports to the regulator and submit bye-laws for SEBI’s approval. Stock
exchanges are required to send daily monitoring reports.

• SEBI has codified and notified regulations that cover all activities and intermediaries
in the securities markets.
SEBI also oversees the functioning of primary markets. Eligibility norms and rules to
be followed for a public issue of securities are detailed in the SEBI (Issuance of Capital
and Disclosures Requirements) Regulation, 2018. The SEBI (ICDR) Regulation lays
down general conditions for capital market issuances like public and rights issuances,
Institutional Placement Programme (IPP), Qualified Institutions Placement (QIP) etc;
eligibility requirements; general obligations of the issuer and intermediaries in p ublic
and rights issuances; regulations governing preferential issues, qualified institutional
placements and bonus issues by listed companies; Issue of Indian Depository
Receipts (IDRs). SEBI (ICDR) also has detailed requirements pertaining to disclosures
and process requirements for capital market transactions by listed and unlisted
companies which are in the process of listing. The listing agreement that companies
enter into with the stock exchange has clauses for continuous and timely flow of relevant
information to the investors, corporate governance and investor protection.

• SEBI makes routine inspections of the intermediaries functioning in the securities

markets to ensure that they comply with prescribed standards. It can also order
investigations into the operations of any of the constituents of the securities market
for activities such as price manipulation, artificial volume creation, insider trading,
violation of the takeover code or any other regulation, public issue related
malpractice or other unfair practices. SEBI has set up surveillance mechanisms
internally as well as prescribed certain surveillance standards at stock exchanges, to
monitor the activities of stock exchanges, brokers, depository, R&T agents,
custodians and clearing agents and identify unfair trade practices.
• SEBI has the powers to call for information, summon persons for interrogation,
examine witnesses and conduct search and seizure. If the investigations so require,
SEBI is also empowered to penalize violators. The penalty could take the form of
suspension, monetary penalties and prosecution.
• SEBI has laid down regulations to prohibit insider trading, or trading by persons

11
 connected with a company having material information that is not publicly available.
SEBI regulations require companies to have comprehensive code of conduct to
prevent insider trading. This includes appointing a compliance officer to enforce
regulations, ensuring periodic disclosure of holding by all persons considered as
insiders and ensuring data confidentiality and adherence to the requirements of the
listing agreement on flow of price sensitive information. If an insider trading charge
is proved through SEBI’s investigations, the penalties include monetary penalties,
criminal prosecution, prohibiting persons from securities markets and declaring
transaction(s) as void.
The Reserve Bank of India (RBI)

The Reserve Bank of India regulates the money market segment. As the manager of the
government’s borrowing program, RBI is the issue manager for the government. It
controls and regulates the government securities market. RBI is also the regulator of the
Indian banking system and ensures that banks follow prudential norms in their
operations. RBI also conducts the monetary, forex and credit policies, and its actions in
these markets influences the supply of money and credit in the system, which in turn
impact the interest rates and borrowing costs of banks, government and other issuers of
debt securities.
Ministry of Corporate Affairs (MCA)

The Ministry of Corporate Affairs regulates the functioning of the corporate sector. The
Companies Act is the primary regulation which defines the setting up of companies, their
functioning and audit and control. The issuance of securities by companies is also subject
to provisions of the Companies Act.
Ministry of Finance (MoF)

The Ministry of Finance through its Department of Financial Services regulates and
overseas the activities of the banking system, insurance and pension sectors. The
Department of Economic Affairs regulates the capital markets and its participants. The
ministry initiates discussions on reforms and overseas the implementation of law.

1.3. Role of Securities Markets as Allocator of Capital

Securities markets enable efficient allocation of financial capital. Well developed
securities markets are usually associated with strong economic growth. The important
links between market segments and their role as allocator of capital are as follows:
Orderly channel for transfer of funds

The primary markets channelize savings from millions of investors to borrowers in an

organised and regulated manner. The system allows borrowers to raise capital at an
efficient price, and investors to minimize the risk of being defrauded. It is an orderly

12
 platform for transfer of capital to earn a return.
Generate productive investments

Through securities investment, individual savings of many households can be mobilised

into generating productive capacity for the country. This facilitates lo ng-term growth,
income and employment. For e.g. consider the setting up of a large steel plant that is
expected to generate jobs and growth for many years. An individual or a single household
would not be able to set up the plant, but a company that issues securities to raise funds
from many investors would be able to do so. By investing in the plant, investors would
benefit from the growth and revenue created by it.
Liquidity

Secondary markets provide liquidity to securities, by allowing them to be sold and

converted to cash. The ability to buy and sell securities is a big advantage because not
only does it permit investors to invest and disinvest as necessary, but also allows them
to profit from price movements. For e.g. suppose an investor has purchased 100 shares
of XYZ Ltd. at Rs.25 per share. After one year the price of the share is quoting at Rs.45 in
the market. The investor can opt to sell his shares and earn Rs.20 per share, or a total of
Rs.2000 from the sale.

Information signaling through prices

Information about the issuer of the security or its assets is reflected quickly in secondary
market prices. This is particularly useful for small investors who tend to have limited
access to company or industry information. For example, a poor monsoon has a negative
impact on agricultural inputs such as fertilizers and seeds, so prices of securities issued
by fertilizer manufacturing companies may go down if rains are expected to be
inadequate. The declining prices signal that sales and profits of the issuing company
are likely to decline.

==================================================================================
====
2. Primary Market:

Definition and Functions

Nature and Definition

The primary market refers to the market where equity or debt capital is raised by issuers
from public investors through an offer of securities. It is called the primary market
because investors purchase the security directly from the issuer. It is also called the “new

13
 issue market” where securities are issued for the first time. The process of expanding the
ability of an issuer to raise capital from public investors, who may not have been
associated with the initial stages of the business, is also known as “going public.” The
issuance of securities in the primary markets expands the reach of an issuer and makes
long-term capital available to the issuer from a larger number of investors.
Raising capital for a company may also be conducted through a syndicate of institutional
investors who buy equity or debt securities through a private placement. This is also a
primary market activity but the investors in these securities are a few pre-identified
institutional investors. These investors may also seek sale of their holdings, conversion
of debt to equity, or may offload their holdings in a public issue on a later date. Private
placement of debt is similar to private equity or venture capital deals, except that the
security issued is debt in the former and equity in the latter case.
An issuer who seeks capital through the primary market has to work with an investment
banker. The investment banker gauges the readiness of the business to raise fresh
capital, structures the instrument to be issued, enables pricing the issue, identifies the
investors to whom the securities will be offered and manages the entire capital
mobilization process. The investment banker earns fee for such services. Primary market
issues may also need arrangements such as a syndicate of investors to buy a portion of
the issue, or underwriters, who would subscribe to the securities being offered, for a fee,
if the issue fails to garner the required response. Securities offered in the primary market
are distributed through a network of brokers to prospective investors. The security
issuance process varies depending on the nature of the issue, the size and the target
investors.
The ability of a company to raise funds from such external sources will depend upon the
performance of the company in the past and the expected performance in the future.
Outside investors will also require protection against a possible default on getting their
dues or their rights getting diluted. This protection is available to them when they fund
the company through investing in securities rather than one-on-one agreement with the
promoters. This is because securities are issued under regulatory overview, which also
imposes obligations on the issuer of securities, to honor the commitments made at the
time of raising funds. Investors may also require the flexibility to review their investment
and exit the investment if need be. A security provides this facility as it is listed on the
exchanges, where key information about the company has to be periodically disclosed.
The expectation for its performance reflects in the prices at which its securities tend to
trade.
Functions of the Primary Market
The primary markets serve the following functions:
Tap larger markets for capital

By involving other investors in raising money for an issuer, the primary market enables

14
 tapping a larger market for its capital requirements. When an Indian company issues a
global depository receipt (GDR) in the Euro markets, it reaches out to institutional and
retail investors in those markets who may find investing in a growing Indian enterprise
an attractive proposition. For raising capital, the primary market enables a company to
shift from the known sources of funding (i.e. from its promoters, interested parties,
banks and such close-knit arrangements) to the new investors who can potentially
subscribe to the company’s capital.
Fosters Competitive Process

Securities are issued for public subscription at a price that is determined by the demand
and supply conditions in the market. The rate of interest a debt instrument will have to
offer and the price at which an equity share will be purchased are dependent on the
pricing mechanisms operating in the primary market. For example, government
securities, which are issued by RBI on behalf of the government, are priced through an
auction process. Banks and institutional investors are the main buyers of government
securities, and they bid the rates they are willing to accept and the final pricing of the
instrument depends on the outcome of the auction. This enables fair pricing of securities
in the primary market.
Diversify Ownership

As new subscribers of equity capital come in, the stakes of existing shareholders reduces
and the ownership of the business becomes more broad-based and diversified. As the
company expands and seeks capital from the public, ownership and management gets
separated. Since it is not feasible for thousands of shareholders holding a small
proportion of capital each, to be involved in managing the company, so professional
managers work in the broad interest of a large group of diverse shareholders. Publicly
held companies also have professional independent directors who represent the interest
of common small shareholders which enhances the governance standards of the
companies. Thus, the primary market facilitates diversification of ownership which in
turn strengthens governance norms.
Better Disclosures

A business that seeks to raise capital from new investors (who may not be familiar with
the history and working of the enterprise) has to meet higher standards of disclosure and
transparency. Investors need to have adequate, relevant, accurate and verifiable
financial and other information about the business before buying the securities being
offered. Thus, the primary market brings about transparency between the businesses
and the investors through means of disclosures by various firms raising capital.
Evaluation by Investors

The information provided by the issuer company is evaluated by a large number of

prospective investors. Thus, investor evaluation forms another layer of scrutiny of the
operations and performance of the company, apart from its auditors and regulators.

15
 Apart from these groups (investors, auditors and regulators), the publicly disclosed
financial statements, reports, prospectus and other information are scrutinized and
discussed by the analysts, researchers, activists, and media. Thus, evaluation by various
groups helps the investors to make informed decisions.
Exit for Early Investor

Promoters, private and inside investors who subscribed to the initial capital
requirements (early requirements for capital of a business) are able to seek an exit in the
primary markets by selling their stakes fully or partly as required. They invest in early-
stage business with the intent to nurture the business to a level at which public and other
investors would be interested. A primary market offer of securities provides them the
opportunity to exit their investments at a profit.
Liquidity for Securities

When capital is held by a few inside investors, the equity and debt securities held are not
liquid, unless sold in a chunk to another set of interested investors. A primary market
issue distributes the securities to a large number of investors and it is mandatory to list
a public issue of securities in the stock exchange. This opens up the secondary market
where the securities can be bought and sold between investors, without impacting the
capital raised and used by the business.
Regulatory Supervision

Inviting outside investors to subscribe to the capital or buy securities of an issuer comes
under a comprehensive regulatory supervision. The issue process, intermediaries
involved, the disclosure norms, and every step of the primary issue process is subject to
regulatory provisions and supervision. The objective is to protect the interest of investors
who contribute capital to a business which they may not directly control or manage.
While there is no assurance of return, risk, safety or security, regulatory processes are
designed to ensure that fair procedures are used to raise capital in the primary market,
adequate and accurate information is provided, and rights of all parties is well defined,
balanced and protected.

===============================================================

Primary Vs Secondary Markets

Securities are listed on the stock exchange after the public issue, so they can be traded
between investors who may like to buy or sell them. The stock market is also called the
secondary market, because investors purchase and sell securities among themselves,
without engaging with the issuer. While the primary market enables the issuer to raise
capital, the secondary market enables liquidity for securities bought by investors to
subscribe to such capital. Secondary markets also enable new investors to purchase
securities from the existing investors, who may like to sell the securities. Activities in the

16
 secondary market do not modify the capital available to the issuer. The prices of stocks
in the secondary market, for the issuer and the peer group as well as the overall trends
in the secondary market, are used as signals in pricing primary market issues. Primary
issues tend to depend on the cycles in the secondary market. In a bull market when
secondary market activity is high and prices are on a general upswing, the number of
primary issues is also higher, cashing in on the buying interest among investors. Pricing
of primary issues is also higher and favourable to issuers during such phase. A bear
market, when activity in secondary markets is lower and prices are also low due to lack
of buying interest, is a tough time for primary issues when adequate subscription to new
issues of securities is difficult to manage.
Types of Issues
All primary market issues need not be public issues. A primary issue of securities is made
to promoters when a company is set up and equity shares are issued to them; if bonds
are issued to institutions that lend to a company, that is also a primary issue, but issued
privately only to a select set of investors. It is not uncommon for companies in early
stages to issue equity capital to venture capitalists and private equity investors, who help
the business to grow in size and scale. When an issuer does not choose any specific group
of investors, but offers securities inviting anyone interested in buying the securities of
the business, we have a public issue.
Issuance of capital in the primary market can be classified under four broad heads:
a. Public issue: Securities are issued to the members of the public, and anyone eligible
to invest can participate in the issue. This is primarily a retail issue of securities.

b. Private placement: Securities are issued to a select set of institutional investors, who
can bid and purchase the securities on offer. This is primarily a wholesale issue of
securities to institutional investors.

c. Preferential issue: Securities are issued to an identified set of investors, on

preferential terms, along with or independent of a public issue or private placement.
This may include promoters, strategic investors, employees and such specified
preferential groups.

d. Rights and bonus issues: Securities are issued to existing investors as on a specific
cut-off date, enabling them to buy more securities at a specific price (rights) or get
an allotment of additional shares without any consideration (bonus).

When a public issue is made, it is not uncommon to have a portion issued preferentially,
or as rights, and for a portion to be privately placed to institutional investors, before the
issue is open for subscription by retail investors. The investment banker who is
responsible for the issue will work out how much has to be offered to whom and at what

17
 prices, within the framework of regulation and in consultation with the issuing company.

Issuers
An issuer in the primary market is the entity seeking capital through the issue of
securities. The securities are part of the equity or debt capital of the entity, on its balance
sheet. The primary responsibility to meet obligations associated with the security being
issued rests on the issuer. For example, an issuer of bonds is responsible for paying
interest and returning the principal on maturity; an issuer of equity shares is responsible
to pay dividends as and when declared and notify equity shareholders about resolutions
being brought for their approval through voting in the annual general meeting.
The following is a summary of issuers in the primary markets for securities:

Issuer Type of Securities Specific Needs and Structures

Central, State and Local Bonds (G-secs) • Do not issue equity capital
Governments Treasury bills • Only Central Government issues T-
bills
• Instruments carry government
guarantee
• Issued only in domestic markets in
India

Public Sector Units Equity shares • May offer equity held by the
Bonds Government to the public as
disinvestment

• Bonds may have special tax

concessions

Private Sector Equity shares • High dependence on securities

Companies markets for raising capital
Preference shares
Bonds • May issue equity and debt
instruments in international markets
Convertible bonds
Commercial Paper
Securitized paper

18
 Banks, Non-banking Equity shares • Banks have low dependence on
Finance Companies, securities market due to access to
Preference shares
and Financial public deposits
Institutions Bonds
• May offer long-term bonds and
Convertible bonds preference shares as Tier-2 capital
Securitized paper
• Issues may have special tax
Commercial paper concessions

Issuer Type of Securities Specific Needs and Structures

Certificates of deposit • May issue in international market

Mutual Funds Units • Capital is raised for specifically

defined schemes
• Schemes may be issued for a fixed
tenor (closed-end) or as open ended
schemes
• Issues are only made in domestic
markets

=====================================================================

SECONDARY MARKETS

Role and Function of the Secondary Market

The secondary market is where securities once issued are bought and sold between
investors. The instruments traded in secondary markets include securities issued in the
primary market as well as those that were not issued in the primary market, such as
privately placed debt or equity securities and derivatives of primary securities created
and traded by financial intermediaries.
Transactions in the secondary market do not result in additional capital to the issuer as

19
 funds are only exchanged between investors. The role of secondary market is to support
the capital raising function of the primary market by providing liquidity, price
identification, information- signalling, and acting as a barometer of economic activity.
Liquidity

Secondary markets provide liquidity and marketability to existing securities. If an investor

wants to sell off equity shares or debentures purchased earlier, it can be done in the
secondary market. Alternately, if new investors want to buy equity shares or debentures
that have been previously issued, sellers can be found in the secondary market. Investors
can exit or enter any listed security by transacting in the secondary markets.
A liquid market enables investors to buy perpetual securities such as equity that are not
redeemed by the issuer; risky securities whose future performance is unknown; and long-
term securities maturing far into the future. Investors can sell their securities at a low
cost and in a short span of time, if there is a liquid secondary market for the securities
that they hold. The sellers transfer ownership to buyers who are willing to buy the
security at the price prevailing in the secondary market.
Price Discovery

Secondary markets enable price discovery of traded securities. Each buy or sell
transaction reflects the individual assessment of investors about the fundamental worth
of the security. The collective opinions of various investors are reflected in the real time
trading information provided by the exchange. The continuous flows of price data allow
investors to identify the market price of equity shares. If an issuing company is
performing well or has good future prospects, many investors may try to buy its shares.
As demand rises, the market price of the share will tend to go up. The rising price is a
signal of expected good performance in the future. If an issuing company is performing
poorly or is likely to face some operating distress in the future, there are likely to be more
sellers than buyers of its shares. This will push down its market price. Market prices
change continuously and they reflect market judgement about the security.
Market valuation benefits issuers when they have to raise further capital from the
market, by giving an indication of the price at which new capital could be issued. For
example, consider a company with equity shares of face value of Rs. 10, which are being
traded for around Rs. 100 in the market. If the company wants to raise additional capital
by issuing fresh equity shares, it could issue them at a price close to Rs. 100, which is the
value determined by investors in the market.
Information Signaling

Market prices provide instant information about issuing companies to all market
participants. This information-signalling function of prices works like a continuous
monitor of issuing companies, and in turn forces issuers to improve profitability and
performance. Efficient markets are those in which market prices of securities reflect all
available information about the security. A large number of players trying to buy and sell

20
 based on information about the listed security tend to create a noisy and chaotic
movement in prices, but also efficiently incorporate all relevant information into the
price. As new information becomes available, prices change to reflect it.
Indicating Economic Activity

Secondary market trading data is used to generate benchmark indices that are widely
tracked in the country. A market index is generated from market prices of a
representative basket of equity shares. Movements in the index represent the overall
market direction. The S&P BSE- Sensex and the NSE-Nifty50 are the most popularly
watched indices in India. A stock market index is viewed as a barometer of economic
performance. A sustained rise in key market indices indicate healthy revenues,
profitability, capital investment and expansion in large listed companies, which in turn
implies that the economy is growing strongly. A continuous decline or poor returns on
indices is a signal of weakening economic activity.
Market for Corporate Control

Stock markets function as markets for efficient governance by facilitating changes in

corporate control. If management is inefficient, a company could end up performing
below its potential. Market forces will push down share prices of underperforming
companies, leading to their undervaluation. Such companies can become takeover
targets. Potential acquirers could acquire a significant portion of the target firm’s shares
in the market, take over its board of directors, and improve its market value by providing
better governance. An actual takeover need not happen; even the possibility of a
takeover can be an effective mechanism to ensure better governance.

Market Structure and Participants of Secondary Market.

The secondary market consists of the following participants:

• Stock exchanges – entities which provide infrastructure for trading in securities

• Investors – individuals and institutions that buy and sell securities
• Issuers - companies that issue securities
• Financial intermediaries – firms that facilitate secondary market activity
• Regulator – authority that oversees activities of all the participants in the market

Stock Exchange

The core component of any secondary market is the stock exchange. The stock exchange
provides a platform for investors to buy and sell securities from each other in an
organised and regulated manner. Stock exchanges stipulate rules for members who are
permitted to transact on the exchange, and for listing companies whose securities are
permitted to be traded. The three national level stock exchanges in India are the Bombay
Stock Exchange (BSE), the National Stock Exchange (NSE) and the Metropolitan Stock

21
 Exchange of India Ltd (MSEI). The trading terminals of these exchanges are present across
the country.
Members

Investors can trade in the secondary markets only through members of a stock exchange.
The trading members of stock exchanges are also called stock brokers; and their agents-
called Authorized Persons. They bring the buyers and sellers to the stock exchange
platform, thus enabling trading in securities. Members will be admitted to an exchange
only if they fulfill minimum requirements for capital, qualification, net worth and other
criteria for admission. Stock exchange members can be trading members, or clearing
members, or play both roles. Stock exchanges monitor members for their positions,
capital, and compliance. Members’ obligations towards their clients (investors) are also
clearly laid down.
Investors

If investors buy and sell shares among themselves, such trades are called “off-market”
and do not enjoy the benefits of regulatory and redressal provisions of the law. In order
to get a competitive price and a liquid market in which transactions can be completed
efficiently, investors come to the stock exchange through their brokers. Investors
complete a KYC (know your customer) process with a registered broker-member and
receive a unique client code (UCC). Institutional investors are supported by a distinct arm
of the broker-member since they transact in large volumes. Banks, insurance companies,
mutual funds, foreign portfolio investors are all large investors who may have their own
dealers interacting with member- brokers who put their transactions on the exchange.
Brokers also support investors with market information, updates, research reports,
analytical tools and other facilities that help in buying and selling securit ies.
Issuers

Issuers are companies and other entities that seek admission for their securities to be
listed on the stock exchange. Equity shares, corporate bonds and debentures as well as
securities issued by the government (G-secs and treasury bills) are admitted to trade on
stock exchanges. There are specific eligibility criteria to list securities on the stock market.
These can be in terms of size, extent of public share holding, credit rating, ownership
pattern, etc. Issuers have to pay a listing fee and also comply with requirement for
disclosure of information that may have a bearing on the trading prices of the listed
securities.
Trading, Clearing and Settlement

Secondary market transactions have three distinct phases: trading, clearing and
settlement. To trade in shares is to buy and sell them through the stock exchanges. Stock
exchanges in India feature an electronic order-matching system that facilitate efficient
and speedy execution of trades.

22
 After the trade is executed, the buyer has a payment obligation and the seller has a
delivery obligation. In order to facilitate efficient trading, the execution of trades and the
settlement of obligation are separated in modern stock exchanges.
Clearing is the process of identifying what is owed to the buyer and seller in a trading
transaction; and settlement is the mechanism of settling the obligations of counter
parties in a trade. All stock exchanges in India follow a common settlement system.
Trades take place on a particular day (say, T) and are settled after two business days after
the trading day (say, T+2).
Clearing Corporation

In the modern structure of secondary markets, clearing corporations (also known as

clearing houses) are set up as independent fully-owned subsidiaries of stock exchanges.
They function as counter-parties for all trades executed on the exchange they are
affiliated with. So all buyers pay funds to the clearing house / clearing corporation, and
all sellers deliver securities to the clearing house / clearing corporation. Specialised
intermediaries called clearing members complete these transactions. The clearing house
/ clearing corporation completes the other leg of the settlement by paying funds to
sellers and delivering securities to buyers.
Recently, SEBI introduced the framework for interoperability among Clearing
Corporations that allows the market participants to consolidate their clearing and
settlement functions at a single Clearing Corporation, irrespective of the stock exchange
on which the trade is executed. This will help in reduction of trading cost and better
execution of trades. The interoperability framework is applicable to all the recognized
clearing corporations (excluding those operating in the International Financial Services
Centre) and all the products available for trading on the stock exchanges (except
commodity derivatives) shall avail the facility.8
Some of the Clearing Corporations are: NSE Clearing Ltd., Indian Clearing Corporation
Ltd. (ICCL) and Metropolitan Clearing Corporation of India Ltd. (MCCIL).

Risk Management

Stock exchanges have risk management systems to insure against the event that
members of the exchange may default on payment or delivery obligations. Strategies
such as maintenance of adequate capital assets by members and regular imposition of
margin payments on trades ensure that damages through defaults are minimised.
Exchanges thus enable two distinct functions: high liquidity in execution of trades and
guaranteed settlement of executed trades.
Depositories and Depository Participants (DPs)

For a security to be eligible to trade in the secondary markets, it should be held in

electronic or dematerialised form. Issuers get their securities admitted to the

23
 depositories, where they are held as electronic entries against investor names, without
any paper certificate. National Securities Depository Ltd (NSDL) and Central Depository
Services (India) Ltd (CDSL) are the two depositories in India.
Investors have to open demat accounts with depository participants (DPs), who are
banks, brokers or other institutional providers of this service, to be able to trade in their
securities. Demat accounts are similar to bank accounts in securities. Since the entries
are electronic, transfer of securities from buyer to seller is easily completed by paper or
electronic instruction to the DP. Settlement of securities transactions is done through the
demat account held with
the DP, who in turn notifies the depositories of the change in ownership of the securities.
Payments are made and received through specifically identified clearing banks.
Custodians

Custodians are institutional intermediaries, who are authorised to hold funds and
securities on behalf of large institutional investors such as banks, insurance companies,
mutual funds, and foreign portfolio investors (FPIs). They settle the secondary market
trades for institutional investors. Several custodians are also clearing members and
clearing banks of the exchange and manage both funds and securities settlement.
Regulator

Secondary markets are regulated under the provisions of the Securities Contracts
(Regulation) Act, 1956 and Securities Contracts (Regulation) Rules, 1957. SEBI is
authorised by law to implement the provisions of this act and its rules. It has empowered
stock exchanges to administer portions of the regulation pertaining to trading,
membership and listing. All the intermediaries in the secondary markets are subject to
regulatory overview of SEBI and are required to register and comply with the rules as
may be stipulated.

4.DERIVATIVES
Definition of Derivatives
A derivative refers to a financial product whose value is derived from another. A
derivative is always created with reference to the other product, also called the
underlying.
A derivative is a risk management tool used commonly in transactions where there is risk
due to an unknown future value. For example, a buyer of gold faces the risk that gold
prices may not be stable. When one needs to buy gold on a day far into the future, the
price may be higher than today. The fluctuating price of gold represents risk. If it were
possible to fix today, the price for a transaction on a later date in future, such risks can
be managed better.

24
 A derivative market deals with the financial value of such risky outcomes. A derivative
product can be structured to enable a pay-off and make good some or all of the losses if
gold prices go up as feared. Similarly many other financial assets and physical
commodities can be hedged by the use of derivatives.
Managing Risk with Derivatives
A derivative market is formed when different players with different needs to manage
their risks come together and try to secure themselves from the respective risky events
that they fear in the future.
Coming back to the example of gold given above, let's think about the seller. If the buyer
is worried about buying gold at a higher price when the need arises, the seller is worried
about gold prices falling in the future. Both of them face the risk of the unknown future
price of gold. But one is negatively affected by a fall in price; the other is negatively
affected by a rise in price. If they both are able to get into a contract, in which they agree
on the price at which they will sell and buy gold on a future date, they have a “forward”
contract. The buyer and the seller are
then "counterparties" to the contract, meaning they represent opposing interests. Such
a contract gives comfort to both parties but one party's loss will be the other's gain.
Assume that the buyer and the seller agree to exchange 10 grams of gold at a price of Rs.
30,000 one year from now. This is a forward contract. The price at which gold will be sold
and bought has been agreed upon today, but the actual exchange will happen sometime
forward, a year from today hence the name, forward contract.
A forward is a derivative contract where two parties agree to exchange a specific good
at a specific price, on a specific date in the future. A forward contract reduces the risk of
an unknown price to both the seller and the buyer. If the prices fall, the buyer still pays
only the price agreed, but he gives up a possible gain if he had not bought the forward
contract; the seller on the other hand gains when prices falls, since he has sold his gold
using a forward, at a better price. If gold price were to rise, the seller would lose and the
buyer would gain in a forward contract arrangement.
Consider these possibilities one year from now:
A. Price of gold remains unchanged at Rs. 30,000.
Outcome: Neither party loses. They buy and sell at Rs. 30,000.

B. The price of gold moves up to

Rs. 35,000 Outcome: The buyer
gains.
He pays only Rs. 30,000 while the market price is Rs.
35,000. The seller loses.
He is able to get only Rs. 30,000 while the market price is Rs. 35,000.

25
 C. The price of gold falls to
Rs. 25,000. Outcome: The
seller gains.
He is able to get Rs. 30,000 while the market price
is lower. The buyer loses.
He pays Rs. 30,000 while he could have bought in the market at a lower price of Rs.
25,000.
It is clear that one of the two parties tends to lose, while the other gains. This is because
both of them did not accurately know what the price of gold would be in the future. Their
contract was structured to enable them to pay a pre-determined fixed price. Such a
contract is called a “forward.” A forward is one of the examples of a derivative contract.
If one carefully examined the forward contract above, the risk being managed here
pertains to the price of the gold, measurable in money terms. Derivative markets are
structured to deal with risk arising out of changes in value of something else in monetary
terms. In our example it is gold. This is known as the underlying. The underlying is subject
to risk that is being managed
using the derivative. Therefore the derivative, its price and value, is intricately linked with
the underlying.
Structuring a Derivative Product
A derivative product is defined by a set of payoffs, based on a specific set of criteria. For
example, a forward pays off the difference between the current price and the agreed
forward price, irrespective of whether the price is higher or lower. Some derivative
contracts can be set up to payoff only if there is rise in price, or a fall in price, but not
both. There are various innovative ways in which derivative payoffs are structured,
making derivatives some of the more complex financial products.
The primary objective in a derivative contract is to transfer the risk from one party to
another. The buyer of gold transfers the risk of a possible rise in prices to the seller; the
seller of gold transfers the risk of a possible fall in prices to the buyer. Depending on how
the risk is defined spliced and how many parties are there to the contract, the derivative
product can be structured differently.
Consider the following examples:
a. A farmer faces the risk of crop loss if the monsoons fail. He can enter into a derivative
contract whose payoff depends on the amount of rainfall. This is a weather
derivative.
b. A borrower faces the risk of paying a floating interest rate that varies with the
benchmark rate. His business situation needs a steady and fixed cash outflow. He can
enter into a derivative contract where he receives a floating rate and pays a fixed

26
 rate. This is an interest rate swap.
c. An Indian importer has to pay in US Dollars for the goods he has ordered in the
international markets. He is worried about the rupee depreciating in value, which will
increase the amount of rupees he needs, in order to pay the same amount of dollars
when his order is shipped. He can enter into a contract that fixes the exchange rate
of the rupee to the dollar on the future date when his payment is due. This is a
currency derivative.
d. A portfolio manager faces the risk that the value of his portfolio will fall if the equity
markets fall in the future. He has to make a few payouts to his investors, which will
come under risk if the value of his portfolio falls. He enters into a contract where he
will receive a payoff depending on the value of the equity index, if it were to fall. This
is an index derivative.
The underlying is different in each one of the above. The derivative is used to manage
risks arising out of the changes in the value of the underlying.
Underlying concepts in Derivatives
Zero Sum Game
In a derivative contract, the counterparties who enter into the contract have opposing
views and needs. The seller of gold futures thinks prices will fall, and benefits if the price
falls below the price at which he entered into the futures contract. The buyer of gold
futures thinks prices will rise, and benefits if the price rises beyond the price at which he
has agreed to buy gold in the future. The sum of the two positions is zero .
In a derivative market, there is a “long” position of a buyer, and there is a corresponding
“short” position of a seller. The willingness of both parties to agree to an exchange at a
specific term, on a specific date in the future, creates the derivative position. Therefore
by definition, the net economic value of all derivative positions should be zero. There is
no new asset or no new underlying created because of derivative contracts on the
underlying asset.
Settlement Mechanism
Earlier most derivative contracts were settled in cash. Cash settlement is a settlement
method where upon expiration or exercise of the derivatives contract, the counterparties
to the contract settle their position through exchange of the price differentials and do
not deliver the actual (physical) underlying asset.
However, SEBI has mandated physical settlement (settlement by delivery of underlying
stock) for all stock derivatives i.e. all the stock derivatives which are presently being cash
settled shall move compulsorily to physical settlement in a phased manner. The stock
exchanges have initiated the transition from cash settlement to physical settlement
based on the criteria notified by the relevant SEBI circulars. 18

27
 OTC and Exchange Traded Derivatives
Some derivative contracts are settled between counterparties on terms mutually agreed
upon between them. These are called over the counter (OTC) derivatives. They are non -
standard and they depend on the trust between counterparties to meet their
commitment as promised. These are prevalent only between institutions, which are
comfortable dealing with each other.

Exchange-traded derivatives are standard derivative contracts defined by an exchange,

and are usually settled through a clearing house. The buyers and sellers maintain margins
with the clearing-house, which enables players that do not know one another
(anonymous) to enter into contracts on the strength of the settlement process of the
clearing house.
Forwards are OTC derivatives; futures are exchange-traded derivatives.
Arbitrage
The law of one price states that two goods that are identical, cannot trade at different
prices in two different markets. It is easy to buy from the cheaper market and sell at the
costlier market, and make riskless profits. However, such buying and selling itself will
reduce the gap in prices. The demand in the cheaper market will increase prices there
and the supply into the costlier market will reduce prices, bringing the prices in both
markets to the same level. Arbitrageurs are specialists who identify such price differential
in two markets and indulge in trades that reduce such differences in price. Prices in two
markets for the same tradable good will be different only to the extent of transaction
costs. These costs can include transportation, storage, insurance, interest costs and any
other cost that impacts the activities of buying and selling.
In the derivative market, the underlying asset is the same as it is in the cash market. But
the price to buy the same asset in the derivative market can be different from that of the
cash market due to the presence of other costs such as physical warehousing or interest
costs. The pricing of derivatives takes into account these costs.

Types of Derivative Products

The four commonly used derivative products are:

• Forwards
• Futures
• Options
• Swaps
Forwards

28
 Forwards are over the counter (OTC) derivatives that enable buying or selling an
underlying on a future date, at an agreed upon price. The terms of a forward contract
are as agreed between counterparties.
Example:
A farmer agrees to sell his produce of wheat to a miller, 6 months later when his crop
is ready, at a price that both counterparties agree today.
This is a forward contract since it will be completed later (forward). It is also an OTC
contract. It can be settled in cash or result in actual delivery of wheat. The settlement
terms such as quantity and quality of wheat to be delivered, the price and payment terms
are as decided by the counterparties. A forward contract is a non -standard futures
contract. It carries counterparty risk if either one fails to honor their side of the contract.
It is therefore always entered into between known parties, and leans on informal
protection mechanisms to ensure that the contract is honored. The concentration of
commodity futures trading in certain geographical locations, or between a few
communities is to ensure such informal protection against counterparty risks. The
forward markets in commodities in several parts of India are based on mutual trust and
are functional despite the risks involved.
Futures
Futures are exchange-traded forwards. A future is a contract for buying or selling a
specific underlying, on a future date, at a price specified today, and entered into through
a formal mechanism on an exchange. The terms of the contract are specified by the
exchange.
Example:
Wheat futures traded on the Multi-commodity Exchange (MCX) of India has the following
specifications (among others):
Trading unit: 10 MT
Minimum order size:
500 MT
Maximum position per individual: 5000 MT
Quality: Standard Mill Quality as specified by the
exchange Contract begin date: 21st of the month
Delivery options: Physical
delivery only Delivery date:
20th of the month
Delivery centre: Exchange approved warehouses

29
 Futures are thus forward contracts defined and traded on an exchange. Another
important feature of an exchange-traded futures contract is the clearing-house. The
counterparty for each transaction is the clearing-house or a clearing corporation.
Buyers and sellers are required to maintain margins with the clearing-house/clearing
corporation, to ensure that they honor their side of the transaction. The counterparty
risks in a futures contract are eliminated using the clearing-house mechanism.
Options
An Option is a contract that gives its buyers the right, but not an obligation, to buy or sell
the underlying asset on or before a stated date/day, at a stated price, for a price. The
party taking a long position i.e. buying the option is called buyer/ holder of the option
and the party taking a short position i.e. selling the option is called the seller/ writer of
the option. The option buyer has the right but no obligation with regards to buying or
selling the underlying asset, while the option writer has the obligation in the contract.
Therefore, option buyer/ holder will exercise his option only when the situation is
favourable to him, but, when he decides to exercise, option writer would be legally
bound to honour the contract. Options may be categorized into two main types:-
• Call Options
• Put Options
Option, which gives buyer a right to buy the underlying asset, is called Call option and
the option which gives buyer a right to sell the underlying asset, is called Put option.
Option Terminology
Arvind buys a call option on the Nifty index from Salim, to buy the Nifty at a value of Rs.
10000, three months from today. Arvind pays a premium of Rs 100 to Salim. What does
this mean?
• Arvind is the buyer of the call option.
• Salim is the seller or writer of the call option.
• The contract is entered into today, but will be completed three months later on the
settlement date.
• Rs. 10000 is the price Arvind is willing to pay for Nifty, three months from today.
This is called the strike price or exercise price.
• Arvind may or may not exercise the option to buy Nifty at Rs. 10000 on the settlement
date.
• But if Arvind exercises the option, Salim is under the obligation to sell Nifty at Rs.
10000 to Arvind.
• Arvind pays Salim Rs.100 as the upfront payment. This is called the option
premium. This is also called as the price of the option.
• On the settlement date, Nifty is at Rs. 10200. This means Arvind’s option is “in -the-
money.” He can buy the Nifty at Rs.10000, by exercising his option.

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 • Salim earned Rs.100 as premium, but lost as he has to sell Nifty at Rs.10000 to meet
his obligation, while the market price was Rs. 10200.

On the other hand, if on the settlement date, the Nifty is at Rs. 9800, Arvind’s option
will be “out-of-the-money.”
• There is no point paying Rs.10000 to buy the Nifty, when the market price is Rs.
9800. Arvind will not exercise the option. Salim will pocket the Rs.100 he collected
as premium.
Swaps
A swap is a contract in which two parties agree to a specified exchange on a future
date. Swaps are common in interest rate and currency markets.
Example:
A borrower has to pay a quarterly interest rate defined as the Treasury bill rate on that
date, plus a spread. This floating rate interest payment means that the actual obligation
of the borrower will depend on what the Treasury bill rate would be on the date of
settlement. The borrower however prefers to pay a fixed rate of interest.
He can use the interest rate swap markets to get into the following swa p arrangement:
• Pay a fixed rate to the swap dealer every quarter
• Receive T-bill plus spread from the swap dealer every quarter

The swap in this contract is that one party pays a fixed rate to the other, and receives a
floating rate in return. The principal amount on which the interest will be computed is
agreed upon between counterparties. Only the interest rate on this amount is exchanged
on each settlement date (every quarter) between counterparties.
The borrower will use the floating rate that he has received from the swap market and
pay the floating rate dues on his borrowing. These two legs are thus cancelled, and his
net obligation is the payment of a fixed interest rate to the swap dealer. By using the
swap market, the borrower has converted his floating rate borrowing into a fixed rate
obligation.
Swaps are very common in currency and interest rate markets. Though swap transactions
are OTC, they are governed by rules and regulations accepted by swap dealer
associations.

Structure of Derivative Markets

In India the following derivative products are available on various stock exchanges:
• Equity index options

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 • Equity index futures
• Individual stock options
• Individual stock futures
• Currency options and futures on select currency pairs
• Interest rate futures
• Commodity futures for a select set of commodities
Apart from the above, forward markets for agricultural commodities and swap markets
for interest rates are available in the OTC markets. We will discuss the markets for equity
derivatives in this chapter. Currency and interest rate derivatives are more advanced
topics that can be pursued later as specialized areas of study.

Equity Derivatives Market

After necessary approvals from SEBI, derivative contracts in the Indian stock exchanges
began trading in June 2000, when index futures were introduced by the BSE and NSE. In
2001, index options, stock options and futures on individual stocks were introduced.
India is one of the few markets in the world where futures on individual stocks are traded.
Equity index futures and options are among the largest traded products in derivative
markets world over. In the Indian markets too, volume and trading activity in derivative
segments is far higher than volumes in the cash market for equities. Other highly traded
derivatives in global markets are for currencies, interest rates and commodities.
Market Structure
Equity derivative markets in India are structured as fully automated, nationwide screen-
based trading systems. Orders are placed anonymously and electronically and executed
using an automated order matching system. Clearing and settlement happens through
the clearing corporation. The derivative trades in Indian markets are guaranteed for
settlement through a rigorous risk management mechanism that includes capital
adequacy norms, intra-day monitoring of position limits and margins.
Derivative transactions have to be routed through the registered members of the stock
exchange where the derivative is listed and traded. Participants in the transactions can
be individuals or institutions, who have to trade through a trading member. Trading
members settle their transactions through clearing members. Some clearing members
are also trading members who settle their own trades and the trades of other
participants and trading members.
Exchanges collect transaction charges from members for enabling them to trade in
derivative contracts defined by them on their electronic platforms. Transaction costs are
levied based on value of contract for futures and amount of premium for options, and
may be collected from both parties to a transaction. Securities transaction tax (STT) at
the rate fixed by the government is also payable on derivative transactions conducted

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 on the exchange.
Derivative Products for Trading
Futures and options are available on specific indices such as on Nifty 50 index, Nifty Bank Index, S&P
BSE Sensitive Index etc, as may be notified by the exchange. Individual stock options and futures are
available for specific listed stocks that are chosen by the exchange. There are specific criteria for
selecting indices and stocks on which derivative contracts will be available for trading. These
specifications mostly pertain to size (market capitalization) and trading volume so that the derivatives
are liquid and can be traded at lower costs. SEBI issues guidelines and circulars for eligibility criteria.
Exchanges choose stocks and indices using these criteria. They may also impose more stringent criteria
than advised by the regulator.

Exchange-Traded Derivatives vs. OTC Derivatives

Based on the style in which a transaction is negotiated and settled, the market
can be classified into two segments: over-the-counter (OTC) and Exchange.
1. OTC derivatives (OTCD) are privately negotiated and settled contracts
between two parties whereas Exchange-traded derivatives (ETD) are
screen-based order matching platform and settled contracts with the aid
of Exchange (which provides platform for trade execution) and Clearing
Corporation (which conducts the settlement). This makes ETD more
transparent as compared to OTCD.
2. OTCDs can be customized to the specific requirements of the parties
where are ETDs are “standardized” in the sense that the trade amount
(called “market lot” or “Contract Amount”) and the settlement date
(called “expiry date”) are pre-determined by the Exchange.
3. OTCDs have counterparty credit risk (which is the risk of failure of the
counterparty before settlement date) and settlement risk (which is the
risk of default by the counterparty on settlement date), but both risks do
not arise in ETDs because of “trade guarantee” by Clearing Corporation.
The trade guarantee is provided by Clearing Corporation becoming a
common party, called central counterparty (CCP), to the buyer and seller
through the process of novation, as shown below. We say that both buyer
and seller novated the original trade to Clearing Corporation so that
Clearing Corporation becomes the buyer to the seller; and the seller to
the buyer.

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 4. Clearing Corporation protects itself from the counterparty credit risk and
settlement risk from both buyer and seller by implementing two processes
called margining and daily mark- to-mark. In OTCD, MTM is done only on
expiry of the contract.
5. The exchange traded market can offer hedging solution to even small size
requirements whereas in OTC market, hedging a very small size
requirement may not be possible, or the transaction cost may be
prohibitive.
6. Very transparent prices offered by ETD, whereas OTD prices varies from
person to person.
7. ETD can be accessed even by entities with very small exposure, say 1000
USD, whereas OTCD requires a minimum threshold volume.
8. ETD does not need any prior approvals. OTCD is done based on forex limits
9. ETD has very low bid ask spread, as low as ¼ th of a paisa, whereas OTCD
comes with a 1-2 paisa spread.
10. There is no need to provide proof of exposure for ETD whereas, OTCD asks
for proof of forex exposure to be hedged.

Though ETD has advantages in terms of transparency, elimination of counter

party risk, access to all types of market, low cost of trading, credit agnostic
etc. there are certain limitation like standardization improves liquidity, may
lead to imperfect hedge as amount and settlement dates cannot be
customized, cash settlement in ETD may not be helpful to actual hedgers,
daily MTM and margin may create operational issues to market participants.
Due to increased competition between OTC and Exchange markets, the
differences between them are slowly fading. For example, today many
derivatives Exchanges abroad offers customized contracts through the
facilities of request-for-quote (RFQ) and Exchange-for-Physical (EFP); and OTC
market offers both standardized (called “vanilla” products) and customized
(called “exotic” products).
There are electronic communication networks called “e-trading” platforms in
OTC market that does the functions of an Exchange for price discovery and
trade execution. Master Direction – Reserve Bank of India (Market-makers in
OTC Derivatives) Directions, 2021 define ‘Over-the-counter (OTC) derivative’
as a derivative (deliverable and non-deliverable) other than those which are
traded on exchanges and shall include those traded on electronic trading
platforms (ETPs).
Many OTC markets are going through central counterparty (CCP) clearing for
multilateral settlements, like in Exchange markets. In India, Clearing
Corporation of IndiaLtd (CCIL) is offering CCP services for settlement with trade
guarantee for USDINR forward contracts and USDINR swap contracts. The
margining and mark-to-market processes of Exchange markets have proved
so useful that OTC market implements them today.
In India, a person, whether resident in India or resident outside India, may
enter into an OTC foreign exchange derivative contract with an authorized

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 dealer. While offering a foreign exchange derivative contract involving INR,
other than NDDCs5 (Non-deliverable derivative contract) to a user, and during
the life of such contracts, Authorised Dealers shall ensure that the contract is
for the purpose of hedging. All OTC foreign exchange derivatives contracts
are settled through delivery except Non-deliverable derivative contract
(NDDC).
The clearing, settlement and risk management part of OTC contracts, if not
managed well could lead to unsustainable counter party credit risk exposure
leading to rapid unwindingof positions during periods of sharp volatility and
movement is asset prices. A default by one or two large counterparties may
leads to domino effect of default by other counterparties also and thereby
making financial market unstable. We had observed thisphenomenon during
financial crisis of 2008. World over regulators and governments are now
trying to move more and more derivative contracts to be exchange traded
with centralized clearing and settlement.

2.1 Key Economic Functions of Derivatives

Though the economic role of derivatives is Risk Management. Like other
segments of financial market, derivatives market serves following functions:

• Hedging risk exposure: Since the value of the derivatives is linked to the
value of the underlying asset, the contracts are primarily used for hedging
risks. For example, an investor may purchase a derivative contract whose
value moves in the opposite direction to the value of an asset the investor
owns. In this way, profits in the derivative contract may offset losses in
the underlying asset.
• Price discovery: Derivative market serves as an important source of
information aboutprices. Prices of derivative instruments such as futures
and forwards can be used to determine what the market expects future
spot prices to be. In most cases, the information is accurate and reliable.
Thus, the futures and forwards markets are especially helpful in price
discovery mechanism.
• Market efficiency: It is considered that derivatives increase the efficiency
of financial markets. By using derivative contracts, one can replicate the
payoff of the assets. Therefore, the prices of the underlying asset and the
associated derivative tend to be in equilibrium to avoid arbitrage
opportunities.
• Access to unavailable assets or markets: Derivatives can help
organizations get access to otherwise unavailable assets or markets. By
employing interest rate swaps, a company may obtain a more favorable
interest rate relative to interest rates available from direct borrowing.
• Price Stability: It has been seen that many countries central banks uses
derivatives for stabilising the currency prices. In India RBI also intervene in
forex market through derivatives for INR stability.
• Derivatives, due to their inherent nature, are linked to the underlying cash

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 markets. With the introduction of derivatives, the underlying market
witnesses higher trading volumes because of participation by more
players who would not otherwise participate for lack of an arrangement
to transfer risk.
• Speculation: This is not the only use, and probably not the most important
use, of financial derivatives. Financial derivatives are considered to be
risky. If not used properly, these can lead to financial destruction in an
organisation. However, these instruments function as a powerful
instrument for knowledgeable traders to expose themselves to calculated
and well understood risks in search of a reward, that is, profit.
• Derivatives market helps shift of speculative trades from unorganized
market to organized market. Risk management mechanism and
surveillance of activities of various participants in organized space provide
stability to the financial system.

Market Participants must understand that derivatives, being leveraged

instruments, haverisks like counterparty risk (default by counterparty), price
risk (loss on position because of price move), leverage risk (magnifying the
gain and losses), liquidity risk (inability to exit from a position), legal or
regulatory risk (enforceability of contracts), operational risk (fraud,
inadequate documentation, improper execution, etc.) and may not be an
appropriate avenue for someone of limited resources, trading experience and
low risk tolerance. A market participant should therefore carefully consider
whether such trading is suitable for him/her based on these parameters.
Market participants who trade in derivatives are advised to carefully read the
Risk Disclosure Document, given by the broker to his clients at the time of
signing agreement.

PRACTICAL ASPECTS OF DERIVATIVES

• EXPSOURE : The value of a contract or a flow that is likely to impacted by fx fluctuation is

called as exposure. Company decide to hedge the entire exposure or a part of it, as % of total
exposure.

• NATURAL HEDGE: The net value to hedge is derived by using natural hedging. Eg: Exports is 5
Million USD and imports is 3 Mn USD, then the net value to be hedged is an inflow of 3 Million
USD, provided the flows have the same maturity. If the payments happens in different times,
then Natural hedging is not possible.

• Currency rates are quoted as 2 way quotes. Bid Ask QUOTE . Eg: USDINR = 83.00 / 83.02.
The 1st rate is called bid price - which is applicable for a seller of USD (Exporter, Cos getting
inward remittances). 83.00 Rs/USD. i.e The exporter gets 83 Rs / USD on conversion of his
USD receivables

The 2nd rate is called Ask price – which is applicable for a buyer of USD (Importer, Cos

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 making outward remittances). 83.02 Rs / USD. i.e, the Importer has to pay 83.02 Rs to buy
1 USD for making his outward remittance or Import payments.

• Spot + Forward premium = Forward rate.

Eg: SPOT USDINR = 83.00 / 83.02, 1 Month FORWARD PREMIUM is quoted as 0.15 / 0.16,
The forward rate = 83.00+ 0.15 = Rs 83.15 for exporter
&
83.02+0.16 = Rs 83.18 for importer.

• USDINR moving from 83 to 84….is called as Depreciation of Rupee (or appreciation of INR).
This is the risk of an Importer.

• USDINR moving from 83 to 82…is called as Appreciation of Rupee (or depreciation of USD).
This is the risk of an exporter.

HEDGING CURRENY RISKS USING DERIVATIVES

Hedging fx risk using instruments can be done using OTC / ETD products.
• OTC PRODUCTS = FORWARDS, OPTIONS, SWAPS.
• EXCHANGE TRADED PRODUCTS = FUTURES & OTPIONS.

• HEDGING STRATEGY FOR EXPORTER or INWARD REMITTANCES

1. SELL FORWARD CONTRATCS IN BANK
2. SELL FUTURES CONTRACT IN STOCK EXCHANGE PLATFORM THROUGH A BROKING FIRM .
3. BUY PUT OPTION IN BANK
BUY PUT OPTION IN STOCK EXCHANGE PLATFORM THROUGH A BROKING FIRM
• HEDGING STRATEGY FOR IMPROTER or INWARD REMITTANCES
1. BUY FORWARD CONTRATCS IN BANK
2. BUY FUTURES CONTRACT IN STOCK EXCHANGE PLATFORM THROUGH A BROKING FIRM .
3. BUY CALLOPTION IN BANK
4. BUY CALL OPTION IN STOCK EXCHANGE PLATFORM THROUGH A BROKING FIRM .

MTM – MARK TO MARKET.

The difference between the entry price and the exit price of a derivative on the reset period is called
as MTM.
This is done on a daily basis for Exchange traded products. It is done on the contract expiry for OTC
products.
Eg 1: An exporter hedged using a forward contract at 83.00 Rs/USD. On the expiry date, if USDINR has
gone to 82 Rs, he gets a gain of Rs 1 / USD. ( In case if he is an exporter, for a similar situation, he
would incur an MTM loss of Rs 1/ USD). For a 1 lakh USD exposure, the exporter gets a MTM gain of
`1 lakh Rs in the above case and for the importer irs an MTM Loss of 1 lakh Rs)

Eg2 : An Importer hedged using a forward contract at 83.00 Rs/USD. On the expiry date, if USDINR
has gone to 84 Rs, he gets a gain of Rs 1 / USD. ( In case if he is an exporter, for a similar situation, he
would incur an MTM loss of Rs 1/ USD). For a 1 lakh USD exposure, the importer gets a MTM gain of
`1 lakh Rs in the above case and for the exporter irs an MTM Loss of 1 lakh Rs)

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ARBITRAGE: The difference between the prices of a product operating in different platforms or
different products. Leg 1: Simultaneously Buy where the product is cheaper and sell where the product
is costly (BUY&SELL)
Leg 2: On or before expiry, reverse the transaction by doing a SELL - BUY
Eg: Forward contract = 83.20 Rs / USD, Futures contract = 83.15 Rs / USD. Arbitrage = 5 paisa per
USD ( i.e 83.20 – 83.15). For a contract value of 1 lakh USD, the arbitrage benefit is around 5000 Rs.
(.05 x 1,00,000 USD)
SOLVED EXAMPLE

ABC Ent’ is into agro exports. They import cashew kernel from Africa and process them and export
them to rest of the world. The imports and exports are in USD. The exports receivables expected by
the month end is 3,00,000 USD. The imports payments to be made by the month end is 2,00,000
USD. Month start spot rate is 82.00 / 82.01. Forward premium is 0.15/0.16. Month start Futures is
trading at 82.1700/82.1725. On month end, the spot price is 81.50. Answer the following.

1. What is the exposure to be hedged?

2. Rates applicable for hedging using forwards
3. Rates applicable for hedging using Futures
4. Which instrument is preferred for hedging
5. What is the strategy to be adopted for forwards ?
6. What is the strategy to be adopted for futures?
7. What is the strategy to be adopted for options?
8. What is the MTM gain or loss ?
9. Is there any arbitrage benefit?
10. How many lots of futures has to enter?
Answers:
1. Scope of Natural hedging exists, as the exposures are of the same tenure (monthend). Hence
the netted value to be hedged is net value of export receivables & import payables.
+3,00,000 USD – 2,00,000 USD = + 1,00,000 USD. i.e 1,00,000 USD of inward flows (net
exports).
2. Since the hedge is for inward flows, the Bid price is taken. Applicable rate = 82.00 + 0.15 =
82.15
3. Since the hedge is for inward flows, the Bid price is taken. Applicable rate = 82.1725
4. Since hedging using Futures helps to peg the receivables price at a higher rate, Futures is
preferred. (Futures 82.1725 > Forward 82.15)
5. Since the hedge is for inward flows (net exports), SELL FORWARD.
6. Since the hedge is for inward flows (net exports), SELL FUTURES.
7. Since the hedge is for inward flows (net exports), BUY PUT OPTION
8. Futures is selected for hedging. MTM net benefit = entry price – exit price = 82.1725 – 81.50
= 0.6725 Rs / USD. MTM profit in the deal = 1,00,000 USD x 0.6725 Rs/USD = 67,250 Rs.
9. Yes. 82.1725 minus 82.15 = 2.25 paisa / USD. Gross Arbitrage benefit with out considering
the cost and bid-ask spread loss is 2.25 paise x 1 lakh USD = 2,250 Rs
10. Since lot size is 1000 USD / Lot, the No of lots to hedge = 1,00,000 USD / 1000 USD = 100 lots

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