Chapter 1: Capital Market and Capital Market …
Study Note 1: Introduction of Capital Market and Capital Market Instruments
Financial System : It is concerned about money, credit and finance. It is a composition of institutions, markets, rules, regulations and laws, agents, analysts etc. This system allows the flow of money from the savers where money is surplus to the spenders where the money is in deficit. The functions of a good financial system are many, some of them are :
i) Regulation and movement of currency;
ii) Banking functions;
iii) Credit control and foreign currency control
iv) Stability of economy
v) Custody of cash reserves.
Financial systems has three main components financial market, financial instruments and financial mediators or intermediaries.
Financial Market :Financial market is a place where savers of money and spenders of money meet. It is a place or system where financial assets are created and exchanged. Thus a financial market can be defined as the market in which financial assets are created and transferred.
The money savers invest their money in many ways. They can buy lands, buildings, gold and silver. They can also go to share market and buy shares and debentures. While land, buildings, gold etc are called physical assets, shares and debentures are called financial assets. Financial assets may also be called financial instruments, financial claims, financial securities or paper assets. Financial assets are issued by agencies who require money for their business or expansion purposes. Thus financial assets or financial instruments represent a claim to the payment of a sum of money with certain discipline.
Components of financial market :Since the money savers invest their savings, they are termed as investors. The spenders require money and issue securities for investment, therefore they are called issuers. The agencies who act as a medium or connection between investors and issuers are called intermediaries or mediators. To see that there is a fair game among the three, there has to be a monitor, such monitors are the regulatory bodies. Thus, there are four components of financial market viz. investors, issuers, mediators and regulators.
Classification of Financial market : There are different ways to classify the financial market. They can be classified on the basis of :
i) financial claims : Debt market and Equity market
ii) maturity of claims : Money market and Capital market
iii) new shares and existing shares : Primary market and secondary market
iv) Cash or spot market and futures market
v) Exchange traded market and OTC or Over the counter market.
Money Market : A money market is a mechanism which makes it possible for borrowers and lenders to come together. Essentially it refers to a market wherein short term funds are borrowed and lent. Contrary to its name, money market does not deal in cash but in trade bills, promissory notes etc. Government, banks and financial institutions are main components of money market. It is market for money transactions. In this market funds can be placed for a single day to say one year. It is a low risk, highly liquid and short-term investment market. It is simply a place where short-term money is given and taken. This mainly consists of fixed deposits, call money, commercial paper, mutual funds, treasury bills etc. The short term bills are also known as near money.
Importance of money market :
1. Excess short term funds of commercial banks can be suitably invested.
2. Dealings for short term duration of Treasury bills, commercial papers, bills of exchange, promissory notes and other short terms securities.
3. Reduction in unequal rates of interest of different banks.
Features of developed money market :
1. Existence of an effective and efficient central bank.
2. Existence of an effective and efficient network of other banks having free flow of funds;
3. Availability of adequate funds.
4. Availability of adequate facilities for transfer of funds.
5. Availability of adequate number of short terms instruments.
6. Uniformity of interest rates.
Weakness of Indian money market :
1. Non-existence of an effective and efficient central bank.
2. Non-existence of an effective and efficient network of other banks having free flow of funds;
3. Non-Availability of adequate funds.
4. Non-Availability of adequate facilities for transfer of funds.
5. Non-Availability of adequate number of short terms instruments.
6. Non-Uniformity of interest rates.
Money Market Instruments :
1. Call money or Notice money : Money at call is outright money. When money is given and taken for a very short period, it is called call money or notice money, sometimes also called as overnight money. The holidays or non-working days are excluded for period of lending. When money is borrowed on a day and repaid on the next working day, (holidays between them is not counted), it is called call money. When period is more than one day and less than or up to 14 days, such money is called notice money.
The market is over-the-telephone market. Only banks can borrow call money or notice money. Banks borrow for a variety of reasons for example to maintain their CRR, to meet heavy withdrawal during festivals or dates of payment of taxes, to adjust maturity payments not matching with receipts etc.
2. Inter bank term money : When period of deposit is more than 14 days, it is termed as term money. As the name indicates, the money is transacted between banks and public is not involved. The RBI has permitted some of the financial institutions (FIs) like ICICI, IDBI, IFCI, SIDBI, NABARD etc to borrow from the market for a period of 3 months and upto 6 months as per the limits set by RBI. The term money is accepted by the issuing banks or FIs at discounted value. On the maturity date, the payment will become equal to face value of the instrument.
3. Treasury Bills or T bills : These are instruments of GOI. Period is less than one year say for 14, 91, 182, 364 days. A treasury may be issued at a discount figure say Rs. 97 and will be paid as Rs. 100 on maturity. Rate of interest depends upon the period of bill.
4. Certificate of Deposits or CDs : The banks (or other financial institutions as approved by RBI) can obtain funds from the public by issuing CDs. How much a bank can raise by issue of CDs, is decided and directed by the RBI.
5. Commercial Paper : CP is used by reputed companies to obtain money from the general public. It is like Tbills with the difference that while Tbills are issued by GOI the CPs are issued by limited companies with the permission of RBI. Certain guide lines for the issue of CPs are :
i) the net worth of the company is not less than Rs. 4 crores as per last audited balance sheet ;
ii) the working capital limit is not less than Rs. 4 crores;
iii) Company has not defaulted in payments of its earlier loans.
The minimum period for CP is 7 days. CP is issued at discount and redeemed at par. CPs are sold directly to investors or indirectly through dealers or intermediaries.
6. Commercial Bills : Bank may purchase the commercial bills of a company at a discounted value. On maturity the bank recovers the full face value of the bill from the person who is obliged to pay such bills. It is negotiable instrument which means it can be given to any person as money.
Capital market : It is a market for long-term investments. It consists of primary and secondary market. It is a place where people buy and sell financial instruments. All national and international exchanges are examples of capital market.
Forex market : It is foreign exchange market which deals with currencies of different countries. Transfer of one currency into other currency takes place in this market. This is the most developed 24 x 7 market working across the globe.
Credit Market : It is a place where banks, financial institutions or non-banking financial institutions give money to companies and individuals on credit.
Primary market and secondary market : Primary market is that component of financial market where securities are issued for the first time. When they are traded subsequently, the place of subsequent trading is called secondary market. Mutual funds play very important role in both the markets.
Capital Market vis-à-vis Money Market :
|Particulars |Capital Market |Money Market |
|1. Time |For longer term. Goes beyond one accounting year. |Generally restricted to one accounting year. |
|2. Funds |Medium and long term funds. |Short term funds. |
|3. Market Place |Well defined. E.g. Stock exchange |Not defined clearly, can be done on any |
| | |location. |
|4. Divisions |Defined as primary market and secondary market. |No such division. |
|5. Volume |Less compared to money market. |More compared to capital market. |
|6. Instruments |Shares and Debentures |Many instruments like Inter-bank call money, |
| | |Notice money, short term deposits, 91-day |
| | |treasury bills, commercial papers etc. |
|7. Players |General investors, brokers, underwriters, Financial institutions |Banks, RBI and Government. |
| |etc. | |
Sweat Equity Shares (section 79A) mean equity shares issued to directors or employees for providing (i) technical knowledge (ii) intellectual property rights (iii) any value addition. These may be issued at a discount or for consideration other than cash. A company may issue sweat equity shares after fulfilling the following conditions :
i) the issue is authorised by special resolution ;
ii) resolution shall specify the number of shares, current market price and consideration if any and the directors and employees to whom such shares are to be issued ;
iii) the issue must be after one year from the date commencement of business ;
iv) SEBI guidelines to be followed for listed shares and prescribed guidelines to be followed for unlisted shares.
All the limitations, restrictions and provisions relating to equity shares are applicable to sweat equity shares.
Primary market or New issue market or IPO market :
The capital market can be classified in many ways. In one way it can be classified as Primary market and secondary market. Primary market is that part where new issues of shares are offered to public. This market is also called Initial public market or new issue market. New issues can also be made in many ways like rights issue, bonus issue, preferential issue and private issue. In the primary market shares and debentures are commonly used instruments.
Pure instruments and hybrid instruments : Pure instruments are pure in nature indicating that their characteristics remain same as at the time of their first issue. Equity shares, preference shares, debentures and bonds are pure instruments. Hybrid instruments are those instruments which are created by a combination of two pure instruments and their characteristics change with the passage of time. Examples are : Convertible preference shares, fully and partly convertible debentures etc
Functions of primary market: The main function of primary market is to transfer money from fund savers who have surplus money to invest, to fund users who need funds to convert their ideas into reality. This function can be performed in three steps namely origination, underwriting and distribution.
Origination : It is the beginning point of new issue. New project proposal is investigated, analyzed and assessed. The issuers or the sponsors of the issue have to ensure that the project is sound enough to produce the expected results. When new project is found okay, the next issue is to assess how much is to be raised from the public and how. To get answer to this, advisory services from experts of the game are sought and obtained. The advisory services include the following points :
1. Type of issue : What kind of securities to be issued whether equity shares, preference shares, convertible or non convertible debentures etc.
2. Magnitude of issue : What amount to be raised through the issue.
3. Time of floating of an issue
4. Pricing of issue : Whether at face value, at discount or at premium;
5. Other pertinent issue
Underwriting : Company's Act 1956 provides that the public issue should be treated as cancelled if the subscription for it is below 90% of issue size. To avoid this contingency the issuer company generally enters into an agreement with underwriters for the purchase of the required number of shares to reach the dead line of 90% subscription, in case the issue is under-subscribed. It is to be noted here that according to Company's Act 1956, if the subscription to any issue is less than 90% of the magnitude of the issue, the issue should be cancelled and the company should refund the amount collected on account of issue. To avoid this contingency, the company takes the services of underwriter who agrees to make the deficit if any by charging a commission.
As said earlier, the underwriting is an agreement between the underwriter and the issuer company in which the underwriter undertakes to buy shares so that the border line of 90% of the issue size is maintained. If the public does not subscribe to the extent of 90% of the issue size, the underwriter makes up the deficit and the issue remains alive. The underwriter provides this service at a commission. Thus underwriting is a guarantee for the marketability of the issue.
Methods of underwriting : There may be three kinds of underwriting
i) Standing behind the issue : In this method the underwriter guarantees to sell a specified number of shares in a particular time length. If he does not sell them fully, he himself buys the balance shares.
ii) Outright purchase : The underwriter purchases all the shares and resells them to the public.
iii) Consortium (group): When one underwriter is not capable of buying the shares, some underwriters may join hands and form a group (consortium). This method is adopted for large issues.
Advantages of underwriting :
i) If the issue is subscribed by less than 90% of its size, it is treated as cancelled. The underwriter avoids this danger and the company is sure that issue will be subscribed to the required extent.
ii) The public image of the issue is improved. The underwriters are supposed to make detailed investigation before entering into underwriting agreement with the company.
iii) The distribution of securities is a specialized function, the company is free from such function if it goes into agreement with underwriters.
Distribution : The securities are ultimately to be sold to investors. This is last function of the issue. This may be called distribution.
Book building is the process by which issue price of securities (shares) are fixed depending upon the market. Worded differently, it is process of marketing a public issue. In this process various investors are asked to offer their bids for purchasing the shares and the issue price is fixed after the closing of bidding. Thus book building is a process of fixing price for an issue of securities on a feedback from potential investors based upon their perception about a company. The prospectus used in the book building process is called Red Herring prospectus and it does not contain the issue size and issue price of the securities.
Previously the public issue contained the issue size as well as price of each share (security). In book building offer, the issue determines only the offer size (number of shares) and then invites bids from prospective investors for the offer. After the closure of bidding process, the inherent demand of issue is assessed and the price is computed. This price is offered to the investors via the public issue.
Advantages of Book building :
1. The book building process allows for price and demand discovery.
2. The costs of public issue is much reduced and the time taken for the completion of the entire process is much less than that in the normal issue.
3. The demand for share is known before the issue and if demand is not much, issue may be cancelled or postponed.
The process of book building goes as follows :
• The issuer company appoints a bank to conduct the book building process. The bank is called book runner.
• The company specifies the size (total number of shares) and minimum price of the share. The price range is also decided.
• The company may appoint other book runners as well.
• The investors start to bid for the price in the range. They are not allowed to bid either above highest price of range (call cap) or below the lowest price (called the floor price).
• The orders are recorded in electronic media. The media is called book. It is a book of orders from the investors in soft copy.
• After the end of the process, the price having maximum number of investors is selected to be the subscription price.
Book building is a process by which the fair price and the quantity of shares are determined for the forthcoming issue. Book Runner Lead Manager (BRLM) maintains a book in which bids (or offer price) by investors are recorded. SEBI has prescribed the following guide lines for raising capital by 100% book building process.
1. A company may make an issue with 100% book building process.
2. The issuer company is required to enter into agreement with one or more of the stock exchanges which have the requisite system of on-line offer of securities.
3. The Lead Banker will act as Lead Book Runner.
4. The draft prospectus containing all the required information shall be filed by the LM to the SEBI. The draft prospectus shall contain the total size of the issue.
5. The Red Herring prospectus shall disclose, either the floor price or range of prices. (Red-Herring prospectus : A prospectus is said to be Red-Herring prospectus which contains all information as per prospectus requirements but does not contain information on price of shares (securities) offered and number of securities offered. This is used in book building issues only.)
6. If there are more than one Book Runners are appointed, the duty, responsibility and obligation of each of them should be clearly defined.
7. The SEBI may suggest any modification within 21 days of receipt of the prospectus.
8. Retail individual investors may bid at cut off price.
9. When book building process is over, the Book Runner or the Lead manager will determine the issue price based on bids received. After determining the bid price the total number of shares to be offered shall be determined.
10. After determining the bid price, all the bidders will be entitled for allotment whose bids have been found to be successful. The successful bidders will be informed immediately about the entitlement.
11. No incentive either in cash or kind can be offered or given to successful bidders.
12. The final prospectus with the price and number of securities will be submitted to the ROC.
Point of difference between Normal issue and Book building issue :
|Normal Issue |Book Building Issue |
|The investor knows the price at which the shares are offered. |Investor does not know the exact price of offer of share but he knows |
| |the price range. |
|Demand of shares is known after the closure of the issue. |Demand can be known every day as the book is built on daily basis. |
|Application money is credited to investor a/c |It is credited to escrow account. |
|Payment is made at the time of subscription. |Payment is made only after allocation. |
|Refund is made after allotment, if necessary |No refund. Exact money is taken. |
Eligibility norms for public issue :
\SEBI has laid down various norms which should be followed for companies entering the primary market by making public issue. The entry norms for companies making IPO (initial public offer) or FPO (follow on public offer) are given in summary form:
Entry Norm I:
a) net tangible assets of at least Rs. 3.0 crores for 3 full years.
b) Distributable profits in at least three years.
c) Net worth of at least Rs. 1.0 crore in three years.
d) The issue size does not exceed 5 times the pre-issue net worth.
Entry Norm Ii:
a) Issue shall be through book building route, with at least 50% to be mandatorily allotted to the QIBs (Qualified Institutional Buyers);
b) The minimum post-issue face value of capital shall be Rs. 10 crores or there shall be a compulsory market-making for at least 2 years.
Entry Norm III :
a) The project is appraised and participated to the extent of 15% by financial institutions or scheduled commercial banks of which at least 10% comes from the appraisers.
b) The minimum post-issue face value of capital shall be Rs. 10 crores or there shall be a compulsory market-making for at least 2 years.
Raising of funds in primary market :Companies can raise funds through the primary market for setting up or expanding their business, by many methods, some of them are described in brier, below:
1. By issuing prospectus : Prospectus is an invitation by the company to the public for investing in the company in the form of buying shares of the company. Funds are mostly raised by this method. The prospectus contains various details of the company along with the details of risks associated with the investment.
2. By offer of sale : This is similar to fund raising through prospectus with a difference that all the shares are purchased by one institution or a syndicate of institutions in bulk. Later a statement similar to prospectus is issued for sale of shares to the public.
3. By private placement : The company can sell its shares directly to some individuals or institutions.
4. By offer of rights issue: The company may also raise capital from the existing shareholders by making a rights issue. Under the rights issue, the shares of company are first offered to existing shareholders at a price which is much lower than the prevailing market price of the share. The shares are offered in fixed proportion to the shares held by shareholders.
Green Shoe Option : The name Green Shoe Option comes from the name of a company. A company named Green Shoe Company first granted a right to its underwriters that they can be allotted 10% – 15% more shares if the issue is over subscribed. Green shoe option denotes an option of allocating shares in excess of the shares included in the public issue.
Company's Act 1956 provides that the public issue should be treated as cancelled if the subscription for it is below 90% of issue size. To avoid this contingency the issuer company generally enters into an agreement with underwriters for the purchase of the required number of shares to reach the dead line of 90% subscription, in case the issue is under-subscribed. However, in case the issue is oversubscribed, it is natural to think that underwriters should be suitably awarded.
When the public issue opens it remains open for certain period. During this period when the floatation is on, the issuer company can observe the demand of shares. If the demand is high for the shares and the issue is still open, SEBI guide lines allow the issuer company to accept oversubscription to a certain limit say 15%. This is green shoe option which denotes an option of allocating shares in excess of the shares included in public issue. It can be understood as an option that allows the underwriters to buy and resell additional shares up to a certain pre-determined quantity. Thus under this option the issuer company can issue additional shares on the public issue. This option is extensively used in international IPOs to stabilize the share price immediately after listing. This option is getting popularity in India recently.
Offer document:
It is a document for offering shares to the public. An offer document contains all relevant information regarding the issue of securities so as to held the investor in making prudent investment decisions. It is called 'prospectus' in case of public issue and called 'letter of offer' in case of rights issue.
Kinds of Offer Document:
Draft Prospectus (draft letter of offer, if it is right issue): It is the draft or rough copy of prospectus which will be approved by SEBI for submission to ROC. The company will manage the public issue through a merchant banker. The MB will submit the draft prospectus to SEBI at least 21 days before the submission to ROC. Any modification as suggested by SEBI will be incorporated in the draft prospectus by the MB and the company. The approved draft is then submitted to SEBI.
Prospectus : A prospectus is an invitation to offer to subscribe to public issue. It contains all the relevant information regarding the issue to help the investor to take a wise decision about the investment in the offered issue.
Abridged Prospectus : (abridge means to shorten, to cut, to reduce) It may be called a summary of prospectus. The entire prospectus is not attached with the application form because of its size. A bridged prospectus is a summary of the detailed prospectus in the prescribed form 2A of section 56 of Company's Act 1956. It contains all the salient features of prospectus.
Shelf Prospectus (Not self but shelf): When issue size is large and fund requirement is in different stages say for a big road project, filing of prospectus every time will be very expensive. In such cases section 60A of the Company's Act 1956 allows that a single prospectus (called shelf prospectus) for all the proposed issues can be filed with ROC with the first issue and with the subsequent issues only additional information for the subsequent issue may be filed in the form of 'information memorandum'. The validity of the Shelf prospectus is one year. Information memorandum will contain the details of changes between the date of filing of first offer and date of offer of the present issue.
Red Herring Prospectus : A RH prospectus contains all the information as required in the prospectus but does not contain the issue size and share price. This prospectus is used in book building process.
Disadvantages of making public issues (floatation) : Making of public issue is also called as floatation of public issue. There are several disadvantages of floatation, some of them are given below;
1. The cost of floatation is high. Small companies are sometimes not able to afford it.
2. It requires a lot of time and attention of management.
3. The company must comply with strict regulations of Company's Act 1956 and SEBI.
4. Legal formalities are complex for listing. It involves costs and load on the staff during and after listing.
Stock market in India :
Stock market means a market where stock is bought and sold. Stock means group or assembly or collection of shares. The P market and S market both constitute the stock market. Stock exchanges are shops of stock market. The stock exchange is a market for existing securities i.e. those which have been already issued and listed on a stock exchange.
Role and function of stock exchange :
1. The stock exchange provides a place for buying and selling of securities; securities is a wide term which include shares, debentures, bonds and other financial instruments which can be traded in a stock exchange. Shares are just part of securities.
2. It provides a meeting place between money savers and money users. Savings from household sector may be invested in corporate sector and stock exchange is the medium for such flow of money from house to company.
3. It provides a place from where the current prices of securities viz. shares, debentures, bonds and other financial instruments may be known. It is a barometer which measures the economic pressure of the country.
4. It provides not only free transferability of shares but also makes it possible for continuous evaluation of securities traded in the market.
Organization of Stock exchange :
1. Ahmedabad Stock exchange and Indore Stock exchange are in the form of 'An association of persons'. It is non profit making organization.
2. Stock exchanges at Delhi, Kolkata, Gohati, Bangalore etc. are in the form of public limited company.
3. Some other stock exchanges are in the form of company limited by guarantee.
Membership, Organization and Management of Stock exchange :
Prior to 2007, the stock exchanges were managed by its members. The trading members who were also brokers, used to own and manage the stock exchanges. The ownership rights and trading rights of a stock exchange were given in a card known to be membership card. The membership card was transferable and could be sold in the market.
To rationalize the functioning of the stock exchange, all the exchanges were demutualized from the year 2007. Demutualisation means the separation of ownership, trading and management of a stock exchange, which are managed by different sets of people. Now membership cards do not exist. Three separate sets of people are there, one set owns the exchange while the second set has the trading rights and the third set is responsible for management of the exchange. Earlier the stock exchanges were not-for-profit-organization but after demutualization all have become for-profit-organization. All the stock exchanges have been demutualised in India.
The interface (comparison) between New issue market and Stock exchange :
The distinction between new issue market and stock exchange are given below :
|New Issue Market |Stock exchange |
|It deals in new securities which are issue for the first time. |Deals in already issued securities. |
|No organizational set up required. |Organization set up is required. |
|Life is limited to point of issue. |Perpetual life. |
|Provides funds to the issuers for a particular purpose. |Funds from sell of shares can be utilised in any manner. |
|Individual issues are managed individually. |Manage and controlled by a central authority. |
|No fixed place for market. |Located at known fixed places. |
The stock exchanges have physical existence and are located in particular geographical areas. Stock exchange is well established organization with rules and regulations for conducting the activities and business. New issue market has no such special features.
Relationship between new issue market and stock exchange :
The securities (shares, debentures or bonds etc) are first allotted in new issues. The stock exchange provides opportunity to sell those securities and receive cash in the transaction. Thus the two markets are complimentary to each other. Each requires the other for its survival and growth.
Both the markets are connected to each other even at the time when new issue is presented. The company making the new issue has to apply for listing of new shares in the stock exchange. The stock exchange in turn requires certain compliances to be made by the company for listing. The stock exchange therefore enjoys considerable authority and control over the new issues. Both the market act and react upon each other in the same direction. When stock exchange goes up, the number of primary issues also goes up and vice versa.
Lock in period :
Lock in period is the period for which the shares will be locked in for sell or transfer, and will not be available for sell or transfer to other parties. The lock in provisions are :
Lock in for shares given to promoters in public issue : It is three years from the date of allotment or date of commencement of commercial production whichever is later. The date of commencement of commercial production means the last date of the month in which such production commenced or expected to commence as stated in offer document.
Lock in for shares given to promoters in excess of minimum specified contribution for promoters : In case of listed or unlisted, the excess contribution of promoters will be locked in for a period of one year.
Qualified Institutional buyers : These are the buyers (in the form of institutions) in capital market which are supposed to have technical and expert knowledge relating to selling and buying of securities. These are known as QIB. According to SEBI guidelines, the following are QIBs:
1. Public Financial Institutions as defined u/s 4A of Company's Act 1956;
2. Scheduled Commercial Banks;
3. Mutual Funds ; Venture Capital Funds;
4. Financial Institutions registered with SEBI
5. State Financial Institutions
6. All Insurance Companies registered under IRDA
7. Provident Funds with minimum corpus of Rs. 25 crores;
8. Pension Funds with minimum corpus of Rs. 25 crores.
These institutions do not require separate registration with SEBI as QIBs. They can participate in primary issuance process without any registration.
Placement : When the company does not want to bring public issue, it can raise the funds by placement to some private parties like issue houses or brokers. All the shares are sold to single or multiple parties without any invitation to common public. The private parties resell these shares to their own clients at some profit.
Features of placement :
1. Placement is better when public response to intended public issue is supposed to pessimistic.
2. Very suitable to small companies who can't manage public issue due to time and money constraints.
3. Very quick in raising funds.
4. Statutory compliance required in case of public issue is no longer necessary.
5. The disadvantage is obvious that the securities are not widely distributed and a small section of people gets the major portions of shares thus acquiring more degree of control in the company.
Bought out deal (BOD) : BOD is a process in which some people (sponsors) directly buy all the shares (to be offered to public in a public issue) from the company at one time and at one price. Thus in BOD, the company allots shares in full (or in parts) to sponsors at a price as agreed between them. After a particular period as agreed, such shares are reissued to public by the sponsors at a price more than what the sponsors paid to the company. After the public offering, the shares can be listed in any stock exchange.
Bought out deals are used to take over a running co. In a bought-out-deal the shares of a target co may be bought by a syndicate (group) of bank on behalf of others. In such a case the shares will be transferred to the relevant owners at an agreed premium after a lapse of time.
Advantages : BOD has many advantages to all the concerned parties viz. the company, the sponsors and the common investors. Some advantages may be :
1. BODs are very suitable in circumstances when money needs to be arranged pretty fast otherwise the project may suffer. In BOD, the company instantly gets funds and can invest it at the required project immediately.
2. The public issue from beginning to end generally takes around six months. This time can be saved if BOD is adopted.
3. In case of new product or project, it is easy to convince one investor than the general public.
Secondary Market :
The shares allotted in the primary market (P market) are traded in secondary market (S market). The S market gives liquidity to shares allotted in P market. The P and S market exist together and each needs the other for its survival.
There are mainly two reasons why people go to S market.
First is information motivated reasons : It is purely subjective in nature hence all persons may have all kinds of reasons. One person may believe that some share should be sold because it is overpriced and will fall in prices in future. On this information or knowledge or anticipation, the person sells his shares but there is another person who buys those shares and what does he think while buying? Just opposite of what the first person thought at the time of selling. Both the types always present in the S market making the market move.
The second reason may be liquidity motivated reasons, the investor may be having lack or excess of liquid cash and may find the S market very convenient place to park or to get cash.
The classification of securities : On the basis of issuer company, the securities may be classified as (i) Industrial securities (ii) Government securities and (iii) Financial Institutional securities .
Depository : Depository Act defines that a depository means ' a company registered under Company's Act 1956 and which has been given a certificate of registration under section 12(IA) of the SEBI act 1992'. The principal function of depository is to convert the shares in electronic form because the buying and selling of shares are now done only in electronic form. Thus it can be rightly said that a depository is bank of securities, where demat securities are kept and can be bought and sold through an account.
The conversion of shares from physical form to electronic form is called the dematerialization (in short demat) of shares. Thus Dematerialization is a process of converting physical form of securities into electronic form while rematerialisation is just reverse where the demat securities are converted back to their physical form.
Depository is an organization where the securities are deposited in electronic form. According to Depository Act 1996, the depository has four constituents namely (i) depository (ii) depository participants (iii) issuer company and (iv) investors. At present there are two depositories in India namely NSDL National Securities Depository Limited and Central Depository Services Limited (CDSL).
Depository participants are agents of depository. The depository offers its services through depository participants. DPs are link between investors and depository. According to SEBI, financial institutions, banks, brokers, custodians can become DP after compliance with prescribed formalities. All the transactions, transfers and transmissions of securities are carried out through DPs.
The main functions of DPs are :
1. To act as medium between depository and investors.
2. Opening and maintaining the Dmat account of the investor.
3. Demat and Remat processing on the instructions of investor.
4. Providing periodical information to investment regarding the dmat account.
5. Providing facilities for pledge and hypothecation of securities held in dmat form.
The issuer company is defined as holder of securities in electronic mode. It needs to be registered with the depository.
The investors are called beneficial owners, they are entitled to all benefits arising out of securities owned by them.
Various services offered by Central Depository Services (CDS):
CDS offers the following services to the investors through its Depository participants:
1. Dematerialization i.e. converting physical securities into electronic form in the investor's account.
2. Rematerialization i.e. to reconvert the electronic form of securities into physical form of securities
3. Maintaining holding (securities) in the electronic form
4. Settlement of transactions in respect of securities
5. Payment of application money from investors account to company in case of public issue, also receiving securities in electronic form as allotted in the public issue
6. Providing facilities regarding lending or borrowing of securities.
Advantages of Depository System : Advantages of depository system can be categorized in three categories :
For the Capital market :
1. It eliminates bad delivery and problem of odd lots.
2. It eliminates voluminous paper work.
3. It enables quick settlements and reduces settlement time.
4. It facilitates stock lending.
For the Investors :
1. It eliminates risks associated with loss, theft and forgery of physical shares.
2. It reduces the transaction costs and time.
3. It ensures more liquidity as the settlement time is less.
4. It makes investors free from holding the shares.
For the issuers :
1. It provides up-to-date of names and addresses of shareholders.
2. It reduces voluminous paper work and secretarial work.
3. It gives better image, better facilities to communicate with shareholders.
4. It increases the efficiency of registrar and transfer agents.
(d) Circuit Breakers: See above in this chapter.
Bank and Depository :
|Bank |Depository |
|1. Holds cash in an account. |1. Holds securities in an account. |
|2. Transfers cash as per instructions of the account holder. |2. Buys and sells securities as per the instructions of the account |
| |holder. |
|3. Money is not physically transferred. |3. Securities are not physically handled. |
|4. For safekeeping of cash; |4. For safekeeping of securities; |
Buy Back of Shares (BBS) : (Section 77A, 77AA and 77B)
|Section 77A : Power of company to purchase its own shares | | | |
|Section 77 AA : Transfer of certain sum to Capital Redemption Reserve a/c. This states that where a company purchases its own shares out of |
|free reserves, then a sum equal to the nominal value of the shares so purchased shall be transferred to the Capital Redemption Reserve a/c, and|
|details of such transfer shall be disclosed in the balance sheet. |
|Section 77 B : Prohibition of buy back under certain circumstances | | |
|Companies cannot purchase its own shares (i) through any subsidiary company (ii) through any investment company (iii) through any group of |
|investment company (iv) in case of default in repayment of its dues (v) if the company has not complied with sections 159, 207 and 211. |
Some notes :
Gilt edged securities : The securities issued by GOI or by State Govt. are called Gild edged securities. These securities may also be issued by semi-government organizations like state electricity boards, municipal corporations, housing boards etc. Being supported by government, these are supposed to well safe and secured with respect to income and refund of capital.
Repurchase Agreements (Repos) :
As the name indicates, repurchase agreement is an agreement to repurchase whatever is sold. More definitely, in repos the selling party promises to repurchase the sold articles at a predetermined price and at a predetermined date, These agreements are active between commercial banks. Permission of RBI is necessary for entering into repos. In repos a bank in need of cash, sells (or pledges) some financial instruments with the other bank and receives cash. Some collateral (additional) security is also placed with the financial instruments. The bank who receives cash also promises to repurchase those financial instruments after a fixed time and at a fixed price. Repos is a risk free short-term instrument for meeting short-term cash needs.
High Net Worth Individual (HNWI) : HNWI is an individual investor has high net worth. High net worth is generally quoted in terms of liquid assets over a certain figure. These are special investors who require special treatment and attention in respect of their investment. A general limit to decide HNWI is as follows :
Sub HNWI : having one lac US dollars but less than ten lac US dollars
HNWI : having equal to or more than ten lac US dollars but less than fifty lac US dollars.
Very HNWI :having equal to or more than fifty lac but less than 500 lac US dollars
Ultra HNWI : having more than 500 lac US dollars.
Forward Contracts and Futures Contracts:
Concept of Derivatives: A wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk in change of prices by that date. The price for such a contract would naturally depend upon the current spot price of the wheat. Such a transaction can take place in 'wheat forward market'. Here the wheat forward is the 'derivative' and wheat on the spot market is the 'underlying. The 'derivative contract' or 'derivative product' or simply 'derivative' are synonymously used and carry the same connotation.
A derivative is a financial instrument which derives its value from some other financial price. The other financial price is called the 'underlying'.
Derivatives can be viewed as being like insurance with the difference that while the insurance is specific right of the insurance companies while derivative is the right of any individual or firm. In this way, the derivatives can supply a method for people to reduce or eliminate risk.
Forward Contracts :
Consider a farmer who wants to sell his crop at a profit. The easiest and the traditional way for him is to harvest his crop and sell it in the present market. The present market may also be termed as spot market. But this method contains a risk that the price available to him in the spot market may not be at the same level as desired by him. Worded differently, in the traditional way the farmer is exposing himself to risk of downward movement in the price of crop which may occur by the time the crop is ready for sale.
Now consider a business person who deals in various products of the crop. The farmer enters into an agreement with the business person to sell his crop at an agreed rate or price with a promise to deliver the asset (crop) at a pre-determined date in future. This will at least ensure to the farmer the input cost and a reasonable profit while on the other hand this contract will ensure the business person to receive the crop for his products at a future date. The transaction that the farmer has entered into is called a forward transaction and the contract which covers this transaction between him and the business person is called the forward contract.
A forward contract is an agreement between a buyer (business person in the above case) and a seller (farmer) obligating the seller to deliver a specified asset of specified quality and quantity to the buyer on a specified date at a specified place and in turn the buyer is obligated to the seller to pay the seller a pre-negotiated price in exchange of the delivery. We can call this contract as tailor-made futures contract.
This connotes that in a forward contract, the contracting parties negotiate on, not only the price at which the commodity (or asset) is to be delivered on a future date but also on what quality and quantity to be delivered and at what place. As the contract of such type is specifically unique for both the concerned parties, both the parties are required to sit together and finalise each and every detail of contract before signing it. In other words, no part of the forward contract is standardised and every forward contract is specifically designed to serve the specific purpose for which it is meant. This is a time consuming process which requires considerable transaction cost to both the parties. Moreover, such forward contracts can't be used by the buyer (business person in the present case) as an instrument for trading further with other persons.
The concept of Futures Contracts :
To obviate the shortcomings of forward contract namely the time consumption, the transaction costs and its non-tradable character, Futures Contracts have been designed. In case all the features of a forward contract are standardized except the price of the contract, such a contract becomes standardized instrument which can be traded in the market or on a stock exchange. The only variable is the price of the contract which represents the expected future value of the underlying asset. Such a contract is called the Futures contract (note it is futures contract and not future contract). A futures contract is thus, a standardized forward contract. The standardization is the chief difference between a forward contract and a futures contract. The standardization provides not only the trading facility to the contract but also results in reduction of transaction costs.
As you have seen above, the instrument representing a futures contract is a standardized contract and incorporates the following essential ingredients :
• The date on which the contract is being executed,
• The name of the underlying asset;
• The quantity of the underlying asset;
• The contract price;
• The period of contract.
The distinction between the Futures and Forwards is on the following points :
|Futures |Forwards |
|Trade on organized exchange |OTC in nature |
|It is transparent. Price is disclosed openly. |The contract price is not publicly disclosed and hence not transparent |
|Standard contract terms. |As required, no standards |
|The contracts are standardized in terms of size, expiration date and all other |Each contract is unique in terms of size, expiration date, asset type and|
|features. |asset quality. |
|More liquid |Less liquid |
|Requires margin payments |No margin payment |
|Follows daily settlement |Settlement happens at end of period |
|There is no counter party risk. |The counter party risk exists all the time. |
|Price is transparent and is publicly disclosed. |Price is not publicly disclosed. |
|Clearing house is medium between buyer and seller. |No medium. |
|Price of contract changes everyday. |Price remains fixed till maturity. |
|Most of the contracts are settled in cash. |Most of the contracts result in physical delivery |
In actual practice, the futures contracts relate to transactions of shares (shares are also called stocks or securities). Let us try to comprehend the mechanism of Futures contracts in the share market (or security market).
Types of Futures Contracts :
Futures contracts may be classified into two categories :
Commodity Futures : Where the underlying asset is a commodity like wheat, gold, cotton, eggs, soyabean, black pepper etc.
Financial Futures : Where the underlying asset is a financial asset like shares, debentures, foreign currency, bills, stock index etc.
Standardized Items in Futures Contracts : Following are the standardized items in any futures contracts :
1. Quantity of underlying assets
2. Quality of the underlying assets (not required in financial futures)
3. Date of delivery and place of settlement
4. The units of price quotation.
5. Minimum change in price also called tick size.
Mechanism of Futures contracts : Future contract is operated as follows :
1. Buy a commodity future contract to agree to take delivery of a commodity. As the price is fixed in the contract (in commodity futures), it can ensure against any rise and fall in the price of commodity during the period of contract. Buying a future is also called going long.
2. Sell a commodity future contract to make delivery of the commodity at a special price. This will protect you from any rise and fall of the commodity during the period of contract.
A future contract is a contract for delivery of a standard package of a standard commodity or financial instrument at a specific date and place in the future but at a price which is agreed when the contract is drawn out. Certain futures contracts, such as on shares or currency, are settled on the differences in price of contract and of spot because the physical delivery of such assets may not be suitable and useful as described below.
Consider a buyer A and a seller S to enter into a futures contract such that Seller S is to sell 5,000 shares of a particular company to buyer A at Rs.10/share. Assuming that on the second day of trading the settle price is Rs. 11. (The settle price is generally the representative price at which the contracts trade during the closing minutes of the trading period and this price is declared as settle price by the stock exchange. The Stock exchange may declare some other price as settle price depending upon its discretion.) This price movement has caused a loss of Rs. 5,000 to seller S and a gain of equal amount to the buyer A. The movement of Rs. 5,000 from S to A is not direct but is routed through what is called The Clearing Mechanism.
A Clearing house is an indispensable component of a futures exchange. This exchange acts as a seller for the buyer and a buyer for the seller in the process of execution of a futures contract. For example, the moment the buyer and the seller agree to enter into a contract, the entry of clearing house takes place between them. The clearing house acts as a medium between the buyer and seller so that none of them can go back to his commitments. The clearing house ensures that the buyer buys from the clearing house and the seller sells to the clearing house. Thus because of the existence of clearing house between the buyer and seller, they do not get into contact directly; in other words there is no counter-party risk. To ensure that there is no counter-party risk, the clearing house requires the buyer and seller to deposit certain of money to cover the day-to-day fluctuations in the prices of securities being traded. This deposit is kept in an account called the initial margin account of the depositor (also called the equity account of the buyer or seller) and the clearing house debits or credits the account as the case may be. In the present example the account of S will be debited by Rs. 5,000 and same amount will be credited to A's account on the close of second day of trading.
On the third or next day of trading, the settle price for the previous day (i.e. Rs. 11) would become the starting price or reference price with respect to which the present day trading will be measured. In the present case the price of Rs. 11/share would be the new price at which next trading would start for this particular futures contract. Thus each futures contract is rolled over to the next day at a new price. Thus in other words a futures contract is, in a way, a roll-over forward contract of one day contract period. In the light of this feature, a futures contract can be defined as follows :
A futures contract can be defined as a standardized agreement between the buyer and the seller in terms of which the seller is forced or obliged to deliver a specified asset to the buyer on a specified date and the buyer is forced or obliged to pay to the seller the then prevailing futures price in exchange of the delivery of the asset.
As the price is a variable component of the futures contract, when the final settlement occurs, there is no difference between the contract price and the prevailing spot price and hence neither of the parties incurs a profit or loss on the last day. The profit or loss in the transaction is the net of all daily profits and losses during the life of the contract. The equity account keeps track of each profit and loss and its final balance less the deposits will represent the final profit or loss.
The relation between spot price and future price :
If Johny is certain that the demand-supply position of wheat is such that three months from now, the price of wheat is likely to go up, he should be tempted to buy wheat now and sell the stock after three months at a higher price. For this purpose, he will acquire a godown on rent, stock some quantity of wheat, pay interest on the money invested in the stock as well as pay the incidental charges in holding the stock, like handling charges, insurance charges etc, collectively called 'the carrying cost'. Let us assume that Johny buys a unit of wheat at Rs. 100 and the carrying costs aggregate Rs. 6 per unit. Logically, to earn profit, he would have to be sure that spot price of wheat; three months from now should be more than Rs. 106. Now if others have access to the same information that the wheat price is likely to go up beyond carrying costs, the number of buyers would increase. As the current demand for wheat increases because of this information, the current demand starts going up. Current spot price would keep on mounting till the anticipated future spot price becomes equal to the current price spot price plus the carrying costs.
From the above it is amply clear, that the future spot price tends to equal the current spot price plus the carrying costs. Suppose the current spot price is Rs. 100 and carrying costs are Rs. 6. The predicted future price, say, three months from now is Rs. 110. There would be inclination or tendency for the current spot price to rise from Rs. 100 to Rs. 104 as any raise beyond this point would mean a loss in the transaction. Worded differently, the relationship between the spot price and the futures price would be :
Futures price = Spot price + Carrying costs
If there are other factors which reduce or increase the carrying costs, these should also find place in the above equation. In financial futures, there are may carry-income or carry-returns like dividends, in addition to carrying costs, which may influence this relationship. Accommodating all these factors; we may write :
Futures Price = Spot price + Carrying Costs – Carrying Incomes.
Thus, the current spot price would tend towards a level where there is no profit or loss situation for both the buyers and the sellers alike. The conclusion, therefore, is that in a perfectly predictable and certain, neither the buyer nor the seller would be interested in future trading. If future spot price can be forecasted with hundred percent certainty, the very idea of future trading would just disappear. It is the element of uncertainty or suspense that gives rise to futures market.
The ' Marking to market' : Let us try to understand the way a futures contract is handled in practice. In a future contract, at the end of the trading session each day, both the parties to contract carry forward the transaction to the next day by closing out the previous day's transaction. The equity account of the party, whose account falls short of the specified amount, makes up the shortfall by paying what is called the variation margin. Technically, at the end of the day, the parties to the contract then enter into a new forward contract with the same maturity date as existed in the original contract but at a new forward price. Through this process known as ' Marking to market' the clearing house replaces each existing futures contract with a new one. In essence, the marking to market process implies that the value of the futures contract is set to zero at the end of each trading day.
Thus Marking to Market means, debiting or crediting the client's equity accounts with the losses and gains of the day, based on which, margins are demanded or released. It is important to note that through marking to market process, the clearing house substitutes each existing futures contract with a new contract that has the settle price or the base price (as referred to by NSE). Base price or the settle price shall be the previous day's closing Nifty value. Settle price is reported in the financial press as the purchase price for the new contract for the next trading day. In terms of NSE regulations, mark to market settlement on daily basis and final settlement procedures are as follows.
Daily mark to market settlement where T stands for the trading day :
For intermediate settlement : Mark to market debit : T + 1 at or after 08.30 a.m.
Mark to market credit : T + 1 at or after 03.30 p.m.
For final settlement where T stands for expiration day :
Final settlement debit : T + 1 at or after 08.30 a.m.
Final settlement credit : T + 1 at or after 03.30 p.m.
NSE has specified the final settlement price as 'the closing price of the underlying security on the last day of the futures contract or such other price, as may be decided by the relevant authority from time to time.'
Basis : The basis is the difference between current spot price of an asset and its futures price i.e.
Basis = Current spot price – Futures price.
Contango Market : In a normal market the prices are expected to go up with time; which implies that the futures price which includes the carryings cost (or cost of carry) would be more than the current spot price consequently, the basis is negative. The market which is solely or exclusively decided by the carrying costs or cost of carry is called ' contango market'.
Backward market or inverted market : The basis can become positive i.e. the spot price may be more than the futures price only if there are factors other than the cost of carry to influence the futures price. In case this happens, then basis becomes positive and the market under such circumstances is known as Backward market or Inverted Market.
Convergence : The spot price tends towards futures price. The basis will approach zero towards the expiry of the contract i.e. the spot and futures prices converge as the date of expiry of the contract approaches. The process of the basis approaching zero is called convergence.
Some Example of Relationship among Futures price, spot price, carrying costs and carrying incomes.
Clearing and Settlement Mechanism :
Settlement Mechanism :
Once an investor has purchased or sold the shares, he should receive the shares if he has purchased or he should deliver the shares if he has sold. This receiving or delivering the shares to complete the transaction is called settlement of the transaction or clearing the transaction in the stock market parlance (parlance means local language).
Settlement process : Please affix the diagram on page 60 of Module.
Settlement agents : These are the agents who complete the transaction between the buyer and seller. Funds or securities are transferred from buyer to seller by the agents. For transactions in BSE the settlement agent is called 'Clearing House or CH ' and for NSE it is 'National Securities Clearing Corporation Ltd. or NSCCL.
Trading Mechanism in Stock exchange : In the stock exchange, the buyer and seller do not come into contact with each other directly. All buying and selling are completed through a broker who is member of stock exchange. The steps are given below :
1. Agreement with a broker : the investor selects a broker and enters into an agreement with him by complying various rules, regulations and conditions.
2. Opening an account with broker : the investor has to open a DP account with the broker from where he can buy and sell the securities.
3. Once the account is open, it becomes the platform to give orders to broker for buying or selling any securities electronically. The investor places his various orders through his account.
4. Paying commission to the broker: For execution of every order of the investor, the broker charges a particular commission which is electronically debited to customer's account.
5. Giving margin money to broker : It the investor is dealing futures and options, he should deposit the specified margin money with the broker. The account becomes inoperative if the margin money goes below the specified limit.
6. Issue of contract note : The broker prepares a contract note regarding the orders of the client and issues this contract note to the client (investor).
7. Settlement of contract : Contract is settled by making the payments or delivering the securities as the case may be.
Types of orders :
1. Discretionary orders : The investor does not give specific quote for the price to buy or sell, rather leaves it to broker. For example, the broker may be instructed like, 'buy or sell Reliance around Rs.1,200.
2. Limit orders : Limit order is that order in which the trader or investor specifies a particular price or a range of prices (also called order limits or band of prices) within which the order should be executed.
3. Market Order : When a trader places a buy or sell order at the price which prevails at the time the order is given, it is called a market order. It is the best possible price.
4. Market-if-touched order (MIT) order : If the order is executed at the best available price after a trade occurs at a particular price or at a price more favourable than the specified price, it is called a MIT order or Market-if-touched order.
5. Stop Loss Order : When a trader holds a position either long or short (Long and Short : A buyer is called the Long and the seller is called the Short) and wants to control his loss against possible upward / downward movement of prices, he would place an order specifying a rate at which the deal would close out. Stop loss orders are normally placed by specifying a range (sometimes called band) of prices in which the order is required to be executed instead of giving a single price order.
Execution of Trade : The trade can be executed in many ways as given below:
Settlement cycle : In this system, the trade is settled at the end of each settlement cycle. The settlement cycle is trade day plus 2 days. Since April 2003, all stock exchanges follow a T+2 rolling settlement system.
Rolling Settlement : A rolling settlement is a term used in relation to buying and selling of shares. This simply means that all buying and selling of shares of a particular day should be settled by the end of a specified period of time. All transactions of a particular day should be settled by cash payment by the end of that day or at any particular point of time. In a rolling settlement of a T + 5 day, the dues will be settled 5 working days from the date of transaction. If an investor purchases 500 shares of RIL and sells 300 shares on Monday, he would be required to settle the net 200 shares on the following Monday. This means all open positions are squared up (all transactions are finalized) on the fifth or sixth day from the date of transaction. In the T+2 rolling settlement, trades are settled on the second working day.
Rolling settlement was introduced by SEBI for the first time in 1998 making it optional for demat scrips. Initially SEBI has selected some 10 scrips for rolling settlement on a T + 5 basis. The selection is done on the basis that one they should appear in dmat list and second each one should have daily turnover of Rs. one crore or more.
Circuit Breakers : Circuit breakers mean the rules which break the movement of prices of shares beyond a certain limit in either directions i.e. downward or upward. BSE imposes certain price limits for shares on daily and weekly basis. The daily price limit is fixed on the closing price of the previous day and weekly price limit is fixed on the closing price of last week. This system is so structured that it automatically rejects buy or sell order of a share (stock, security) beyond a certain price limit. Circuit breakers do not stop share trading within limits.
The index based circuit breakers were introduced by SEBI on July, 02, 2001. This applies at 3 stages of the index movement either way at 10%, 15% or 20%.
The % movement of the index and the time frame of the trading halt is given below:
10% movement :
− if the movement is before 1.00 pm one hour market halt.
− at or after 1.00 pm but before 2.30 pm : trading halt for half an hour
− at or other 2.30 pm, no trading halt.
15% movement :
− If the movement is before 1.00 pm, two hour trading halt.
− at or after 1.00 pm but before 2.00 pm, trading halt for one hour
− at or after 2.00 pm, trading halt for the remainder of the day
20% movement : trading shall be halted for the remainder of the day.
Long and Short : A buyer is called the Long and the seller is called the Short. We take a short position means we sell the stock.
Going Long a Stock : It means buying the stock. We take a long position means we buy the stock.
Selling Long : It means the seller is covered, that implies the seller has the stock he is supposed to deliver to the buyer.
Selling Short : It means the seller is not covered. It means that seller does not own the stock he has sold under the option and he will have to borrow the stock at the time of delivery to the buyer and buy the stock later to set-off the borrowing.
Margins : Margin in stock market has the same meaning as it has in any other financial trade. Margins are required to ensure performance of the promises made in the contract. The margin is the cash paid by the client to the clearing house. The party to the contract is required to introduce certain financial stake to cover day to day fluctuations in the prices of the securities bought.
The margin of futures contracts has two components : (i) initial margin (ii) maintenance margin
Initial Margin : In the futures contract, the buyer and the seller both are required to perform the contract. To obviate the counter party risk, both are required to deposit the Initial margin with the clearing house. Initial margin is also known as Performance margin and is usually 5 to 15% of the purchase price of contract. The margin is set by the stock exchange keeping in view the volume of business and size of transactions as well as operative risk of the market in general.
The Initial margin is the first line of defence for the clearing house. This protection is further reinforced by prescribing maintenance margin.
Maintenance Margin : When an investor wants to enter the futures market with a brokerage firm for buying and selling futures, the first requirement for the investor is to open an account with the firm. This account, called the equity account, has to be kept separate from any other account including the margin accounts. Maintenance margin is the margin required to be kept by the investor in equity account equal to or more than a specified percentage of the amount kept as initial margin. Maintenance margin should be sufficient to support the daily settlement process called 'mark to market'. Normally, the deposit in the equity account is equal to or greater than 75% to 80% of the initial margin.
In case this requirement is not met, the investor is advised to deposit cash to make up the shortfall. If the investor does not respond, then the broker will close out the investor's position by entering a reversing trade in the investor's account.
Daily Margin : It is the margin money paid on daily basis. The members are required to pay 10% of their daily trades as daily margin. The members are also required to pay mark to market margin based on their balances at the end of the day. Thus the members have to pay higher of the two margins viz. daily margin and mark to market margin. Earlier the daily margins were computed manually by the members and paid to the stock exchange next day. Now the system is completely automated and the risk of margin money evasion by the members is totally avoided.
Gross exposure margin : It is the margin given on exposure to market. The trader or investor is said to be exposed when there is some outstanding either in selling or buying. The cumulative total of shares outstanding to be bought and shares outstanding to be sold is total exposure and gross exposure margin is computed on this exposure. Suppose an investor has bought 100 shares of Reliance and later sold 200 shares of Reliance. His exposure would be 200 minus 100 i.e. 100 shares (in Rs.)
Mark to Market Margin (MTM) :
|Example on Marking to market margin: | | |
|Scrips |Buy qtyy |Buy price |Sell Qty |Sell Price |Closing | |
|A |1,000 |50,000 |2,000 |90,000 |56 | |
|B |1,600 |64,000 |1,800 |73,800 |36 | |
|C |600 |3,000 |300 |1,500 |5 | |
|D |0 |0 |2,000 |30,000 |14 | |
|E |1,000 |6,300 |0 |0 |5 | |
|F |800 |32,000 |500 |19,250 |35 | |
|The MTM profit or loss will be computed as follows : | |
|Scrips | |Computation of profit or loss | |
|A |[1000 x 56 − 50,000] +[90,000 − 2,000 x 56] |(16,000) |
|B |[1,600 x 36 − 64,000] + [73,800 − 1,800 x 36] |2,600 |
|C | |Similar | | | |0 |
|D | | | | | |2,000 |
|E | | | | | |(1,300) |
|F | | | | | |(2,250) |
Additional Volatility Margin : to control volatility (fast changes in prices either downwards or upwards is called volatility) volatility margin is also required to be paid to the stock exchange. The volatility is computed on a rolling basis over a period of six weeks. It is not computed for the shares which are quoted below Rs. 40.
Listing of Securities :
Listing of securities with stock exchange is a matter of great importance for companies and investors because listing provides the liquidity to the securities in the market.
The objectives, benefits and importance of listing of securities are as follows :
a) public image of the company is increased;
b) the liquidity of the securities is ensured, the buying and selling the securities become easy because of listing;
c) tax concessions are available to investors and companies;
d) listing compels the companies to comply to many disclosures of fact, figures and information to the investors enabling them to make sound decisions for investment;
e) listed companies have to follow the guidelines issued by SEBI which in turn improve the management and administration of the companies.
f) Listed company receives better support for financial assistance from banks and financial institutions.
Listing of securities have to be made in accordance with the provisions of various statutory laws viz. Company's Act 1956, SEBI Act 1992, Securities Contract Rules etc.
Chapter 2: Capital and Financial Market Regulations :
Functions of SEBI :
The chief function of SEBI is to protect the interests of investors in the securities market. To achieve this main aim SEBI has been given various powers and with the use of those powers it can take various measures to fulfill its objectives.
1. It is the central authority to enact SEBI Act 1992.
2. It controls and monitors all activities related to stock exchanges.
3. It regulates the business in stock exchanges.
4. It registers, controls and regulates all the persons relating to securities market. Without its registration certificate one cannot function in securities market. It registers and regulates stock brokers, sub-brokers, share transfer agents, fund managers, underwriters, portfolio managers, bankers to an issue, registrars to the issue.
5. It registers and regulates various funds and schemes for the securities market like venture capital funds, mutual funds, collective investment scheme.
6. It checks insider trading, fraudulent and unfair trade practices in the securities market.
7. It can call for any information, records or explanation from any bank, board, authority, company or corporation in respect of transactions in securities market.
8. Its chief function is to reduce the grievances of investors, it can take all actions and performs all functions in this regard.
Powers of SEBI : SEBI can
1. suspend the trading of any securities in a recognised stock exchange.
2. prohibit any person to buy, sell or deal in securities;
3. restrict or check any person to enter the securities market ;
4. ask investigation of any transaction and to retain the securities or proceeds related to that transaction
5. direct any intermediary in any manner relating to any transactions which are under investigation.
6. prohibit any company from issuing any prospectus or offer document for the issue of securities;
7. specify terms and conditions under which any prospectus, offer document or any advertisement may be issued.
Organization of SEBI :
The SEBI consists of (i) a chairperson (ii) two members from the Central government (iii) one member from RBI and (iv) two other members appointed by Central government.
For day to day functions, the activities of SEBI have been divided into five departments:
1. Investors grievances cell. This deals with investors' guidance and grievances
2. Primary market cell. This relates to administration and management of all activities related to primary issue of securities.
3. Secondary market cell. This relates to administration and management of all activities related to secondary market.
4. Institutional investment cell. Mutual funds are controlled from here.
5. Mergers and acquisitions cell.
Activities of SEBI : SEBI has issued a number of guidelines on various matters related to securities markets. Some contents of important guidelines are as below :
1. Rules and regulations for registration of intermediate bodies or intermediaries associated with securities market, such as share transfer agent, bankers for the issue, registrar to an issue, underwriters, portfolio managers and investment advisors etc.
2. Designing and defining the authorization and the activities of merchant bankers.
3. Designing and defining the code of conduct for merchant banker, portfolio managers, mutual funds, investment agencies and other asset management companies.. Setting the terms of punishment for professional misconduct;
4. Categorization of merchant bankers, portfolio managers, mutual funds and other investment agencies.
5. Formation of various committees on various matters related to primary and secondary market.
Regulatory Framework of Security Market:
The responsibility of controlling and monitoring of securities market is primarily on four departments of central government viz (i) Department of Economic Affairs (ii) Department of Company Affairs (iii) RBI and (iv) SEBI.
The four main legislations which govern the securities market are as follows :
1. Securities and Exchange Board of India 1992
2. Companies Act 1956
3. Securities Contract and Regulation Act 1956 and
4. Depositories Act 1996.
Securitization :
Debt Securitization : Asset based securitization or debt securitization or asset securitization denote the same concept. Debt securitization is the process of converting debt instruments into security (like shares, debentures or negotiable instruments). Worded differently it is the process by which non-tradable assets are converted into tradable assets. Debts are given by institutions and such debts are secured by some documents. A package of these documents is made and a guarantee is also given about the package. Such packages are then sold like any security or negotiable instruments to investors. The package will naturally be made in accordance with the legal framework. In this process, non-liquid assets like mortgage loans, auto loans etc are packaged and sold in the form of securities (like shares, debentures) to investors.
In securitization the loan installments receivables are converted to negotiable instruments and then sold to customers. These negotiable instruments are backed or secured by assets on which original loan was taken (underlying assets). Assets which could be securitized are auto loans, housing loans, consumer loans etc. Assets must be of good quality for the purpose of securitization.
Example 1: The price of Reliance stock on 31.12.2006 was Rs. 220 and the futures price on the same stock on the same date i.e. 31.12.2006 for March 2007 was forecasted as Rs. 230. Other information regarding the contract are as follows :
Time of Contract : Three months. Borrowing rate : 15% per annum.
Annual dividend on the stock : 25% payable before 31.12.2006
Find out the futures price for this stock as on 31.12.2006 as per 'carrying cost criteria'.
Solution : Using the relationship Futures price = Spot price + carrying cost – carrying income
Spot price : Rs. 220 as given
Carrying cost : Rs. 220 @ 15% for 3 months = 220 x 15% x (3/12).
Carrying income : Dividend is paid on the face value of the stock and question is silent about the face value of stock. When nothing is mentioned about the face value it is advisable to take this as Rs. 10. Thus the carrying income would be 25% on Rs. 10 i.e. Rs. 2.50.
The futures price will be given by : Futures price = Rs. 220 + Rs. 8.25 -- Rs. 2.50 = Rs. 225.75
The Futures price as per carrying cost criteria would be Rs. 225.75 while the forecasted futures price is Rs. 230. Thus the current stock price should start climbing to such a level to make Rs. 225.75 to Rs. 230. Thus the current stock price of Rs. 220 would escalate to a level of Rs. 224.25.
Arbitrager : In the situation of example given above, how the arbitrager will behave? She will buy the Reliance stock by borrowing the amount of Rs. 220 @ 15% p.a. for a period of 3 months and at the same time enter into futures contract to sell this stock in March 2007 at Rs. 230. By the end of March 2007, she will receive Rs. 2.50 as dividend on the share. On the expiry date of contract of March 31, 2007 she will deliver the Reliance stock against the March Futures contract sales and collect the sale proceeds.
The outflows and inflows of the arbitrager would be as follows :
| | | | | | | |
|Add : |Dividend | | | | | |
| |Cost of borrowing @ 15% for 3 months | |8.25 |228.25 | | |
| |
|Who will enter into contract with this arbitrager? The one who does not believe that the price of the stock would be Rs. 230.0 in March 2007. |
| |
Valuation of Forward / Futures Contracts :
The valuation of the forward / futures contract is done with the help of formula of compounding interest because in financial scene, the cost of carry of the stock is primarily the interest cost.
The forward price : A = P ( 1 + r) t
Where A is the terminal value of an amount P at a rate of interest r per compounding and t is the number of compoundings.
In case there becomes continuous, i.e. more than daily compounding, the above formula can be simplified mathematically and can be simply written as follows : A = P e r t where t stands for time in years and r is the rate of interest per annum and 'e' is called epsilon, is a mathematical constant having a value of 2.72. This function is available in all mathematical calculators and easy to operate and handle. In case there is cash income accruing to the security like dividend, the above formula will be modified as follows : A = (P – I) e r t Where I is the present value of the income flow during the tenure of the contract.
Example :
Consider a 3 month forward contract on a non-dividend paying stock. The stock is available for Rs. 200. With compounded continuously risk-free rate of interest (CCRRI) of 10% per annum, the price of the forward contract would be given by : t = time in years and r = rate of interest per annum
A = 200 x e 0.25 x 0.10 = Rs. 205.06 . The value of 'e' is obtainable from the scientific calculator.
Example :
Consider a 4 month forward contract on 500 shares with each share priced at Rs. 75. Dividend @ Rs. 2.50 per share is expected to accrue to the shares in a period of 3 months. The CCRRi is 10% per annum. The value of the forward contract is as follows :
Dividend proceeds will accrue for a period of 3 months while contract is for 4 months. Time frame for both the cash flows is different. Hence 't' in epsilon formula will differ for both the cases i.e. for dividend proceeds it will be 3 months while for valuation of contract it will be 4 months. Following formula will be used : : A = (P – I) e r t
Dividend proceed = 500 x Rs. 2.50 = Rs. 1,250. The present value on continuous compounding would be given by epsilon formula as PV = e r t where r is annual rate (10%) and t is time in years (3/12 = 0.25 year).
Present value of dividend proceeds I = e 0.10 x 0.25 = Rs. 1219 (from scientific calculator). This value will be used in place of I in the formula : A = (P – I) e r t
Value of forward contract = (500 x Rs. 75 – Rs. 1219) x e 0.10 x ( 4/12 )
= Rs. 37,498 (using scientific calculator)
If the dividend yield is given as percentage say as y% and individual stocks are given in the form of index the above formula will read as follows :
A = P e (r —y) t
Example : Consider the following : Current value of index : 1,400; Dividend yield : 6% and CCRRI : 10%
The value of a 3 month contract will be given by :
A = 1,400 x e (0.10 —0.06) 0.25 = Rs. 1,414
Stock Index Futures : A futures contract on a stock market index gives its owner the right and obligation to buy or sell the portfolio on stocks represented by that index. The Stock Index Futures (SIF) contracts involve the payment of cash on the delivery date of an amount as indicated below :
Cash Payment = (I – P) x M
Where I represents the value of index at the close of the last delivery day of the contract.
P represents the purchase price of the Futures contracts and M is the multiplier.
Value of M in NSE is 200 while in BSE its value is 50. Thus a Nifty futures contract at Rs. 1,700 is worth Rs. 3,40,000 i.e. 1700 x 200. If on the expiry of the contract, the Nifty index is at say at 1,750, an amount of (1750 – 1700) x 200 = Rs. 10,000 would be needed for cash settlement. In the instant case, as the index was above the futures price, those who have gone short (sellers), pay those who have long positions (buyers). Conversely, in the event of the index being below the futures price, the long (buyers) pay the short (sellers).
In actual practice, the transactions are settled through a clearing house and no actual or physical delivery of the stocks is made. At close of the trading session each day, every customer's position is marked to the market i.e. each account is debited or credited as may be needed on account of fluctuations in price of respective contracts of the customer.
The concept of an Option :
An option is a contract that gives the buyer the right, but not an obligation, to buy or sell a specified quantity of an asset (the shares in this case) at a pre-determined price on or before a specified time (expiry date). The one who buys an option is called option buyer and the one who sells the option is called the option seller. In option, as the name indicates, the buyer has an option (i) to exercise his acquired right of purchasing or selling the stock, or (ii) not at all exercise this right. When the buyer exercises his right, the seller has to honour it. In simpler words, the option buyers have rights and option sellers have obligations.
In a share market, an investor buys shares in anticipation of escalation of price of those shares. His expectation may or may not come true. Thus while the investor has unlimited potential for gains as the price of shares can go up to any extent, likewise he has unlimited potential for losses in the event that prices of shares can slide down to any level. As the investor has no control over the prices of the shares purchased by him, he naturally has no control over the gains or losses arising out of such fluctuations. How can an investor can protect or hedge himself against such possibilities of losses ?
He can limit his losses to the extent desired by him, by ordering a stop-loss transaction i.e. to order his broker to sell his shares as soon as these fall below a specified level. Let us consider an example :
Suppose an investor, Kareena, buys 100 shares of Saif Ltd. at Rs. 250 per share with the instruction of a stop-loss of Rs. 10, which means her shares would be sold as soon as these shares touch the value of Rs. 240 per share. Kareena expects the shares to go upto Rs. 300 in next three months. Suppose some time after the shares slide down to Rs. 240, the broker sells the shares as per standing instructions of Kareena, Kareena suffers a loss of Rs. 10 totalling Rs. 1,000 and goes out of the deal. Soon after, the shares of Saif Ltd. start climbing and touch the level of Rs. 300 as expected by Kareena. She now can do nothing because she has already sold those shares as she did not have the time to wait for shares to go up. She starts thinking if there is any way to protect or insure her from the anticipated losses but also to gain time to realise the upward potential in the share.
A Broker Shahid Kapoor comes to Kareena and suggests that if she pays a commission (or premium) of Rs. 20 per share, he can enter into an agreement with her to sell her the shares of Saif Ltd. at Rs. 250 at any time within next 180 days. Kareena says yes to it because she thinks or anticipates that the prices of the shares will go up in the times to come. Shahid also says yes to it because he thinks or anticipates that the shares of Saif Ltd. will not go up beyond an increase of Rs. 20 per share within next 180 days and he would certainly make some gains out of this transaction. Kareena and Shahid enter into an agreement with totally opposite perception of the prices of shares in the times to come, one thinking the prices will go up and the other thinking that the prices will not go up. Under the agreement, Shahid gives a legal document to Kareena which may read as follows :
I Shahid Kapoor, undertake to give Kareena an irrevocable right to buy from me, 100 shares of Saif Ltd. at a price of Rs. 250 per share at any time during the next 180 days (inclusive of the 180th day).
Shahid has sold an option when he made a commitment to deliver the specified number of shares of a specified company at the specified price during a specified period. He is the option seller and is bound to give Kareena the respective shares whenever she asks for them within the specified period.
Kareena has bought an option and paid premium for it. She is the option buyer. She has a right to buy described shares. It is important to note that she may or may not exercise her right but Shahid has to give her the shares whenever she asks for it. Shahid is obliged to perform the contract whenever required while Kareena has the option to invoke it or allow it to lapse. This requires that Shahid must have the shares specified in the option (if he doesn't want to expose himself to risk arising out of writing the option) at the time of writing the option. This is called Call Option when the option writer is called upon to deliver the asset to the option buyer.
It should be noted here that anyone who is eligible to enter into a contract as per the provisions of the Contract Act, can write an option irrespective of the fact whether one has the underlying asset or not. If the writer of the call (Shahid in the present case) owns the assets or stocks or shares that he is obliged to deliver upon the exercise of the call he has written, he is called a covered call writer otherwise he is called uncovered call writer.
Kareena can enjoy the scene as follows. She starts watching share price. If it goes below Rs. 250 level she would at the most, have to suffer a loss of Rs. 20 per share but she has an option to buy these shares at Rs. 250 if the prices go up within the specified time. If the prices slide down further she has nothing to do but if the prices climb up, she can call Shahid to deliver the shares or pay her the difference of current price and Rs. 250 whenever she feels like it. She has already paid a premium of Rs. 20 per share for the option, she can still be in profit if the share prices go up beyond Rs. 270 per share during the currency of the option. By this contract, Kareena has restricted her loss to the premium paid by her, she still has unlimited potential for gain in the event when share price climbs up.
Let us take another example:
Bipasha and John enter into a legal contract through which John writes a commitment to sell 100 shares of Priyanka Ltd. to Bipasha at a price of Rs. 250 per share (which is the current price) at any point of time during the next 90 days (90th day inclusive). John has charged a premium of Rs. 20 per share for writing the above option. Thus Bipasha has bought an option for buying 100 shares of Priyanka Ltd. at Rs. 250 per share (called the exercise price) at a premium of Rs. 20 with validity of 90 days.
What did John and Bipasha get out of this deal ?
Looking for Bipasha's angle, she has paid Rs. 20 per share as premium. Thus she can earn profit out of this deal only when the share prices go up beyond Rs. 270 (250 + 20). If the share price goes below Rs. 250 Bipasha will not invoke the contract as there is no point in buying the shares at Rs. 250 when they are already available at a lower price in the open market. If the price remains below Rs. 250 during the currency of the contract, she will have to suffer a loss of Rs. 20 per share paid by her as premium. She has suffered this loss because her anticipation that the share price would go up beyond Rs. 270 in the coming 90 days, has not turned out to be true. But by buying this option, she has limited her loss to Rs. 20 per share which is well within her capacity. If the price goes above Rs. 250 (exercise price) she has a reason to invoke the option, to recover the premium paid by her. If the price goes beyond Rs. 270 she would start making profit equal the increase beyond Rs. 270 (and John would start making losses to the equal extent if he is not covered). Thus by buying this option, Bipasha has unlimited potential to gain, her losses are limited to the amount paid by her as premium. Another important feature is that she gets time equal to time of currency of the option to take a decision without having to resort to panic sale.
Let us look from John's angle.
When he writes the option to sell Bipasha 100 shares of Priyanka Ltd. at a price of Rs. 250, the shares are already available in market at that price; he purchases 100 shares and keeps the delivery ready for Bipasha for the event if she decides to call him to make the delivery. If he is not covered meaning he does not own the stock for which he is writing the option, he is exposed to risk of unfavourable price rise.
John had written the option for a premium of Rs. 20, which he gets right in the beginning. In case the option is allowed to lapse by Bipasha (the option buyer) because the price keeps below the exercise price of Rs. 250 during the currency of the option, John is not in focus at all and is not required to do anything. He would simply enjoy the premium received by him. In case the prices go beyond Rs. 250 and Bipasha calls him to make the delivery, the financial implications still remain the same for him because he already has the shares ready for her and can deliver them any time as asked by her. Thus John, the option writer earns an amount equal to the premium received, irrespective of whether the share goes up or down (provided he is a covered call writer. The covered call writer is the one who has the stock with him at the time of writing the option. If he is not covered, he is exposed to risk of having to fulfil the obligations by buying the stock at the time of delivery at an unfavourable price).
This is the option when the option buyer has the write to purchase shares from the option writer. Such an option is called Call Option. In Call Option, the option writer is called to deliver the shares to the option buyer.
On the contrary to Call Option, there exists what is known as Put Option. A Put Option gives the option buyer a right (not an obligation meaning he may or may not exercise the right) to SELL a specified quantity of stock on or before the expiry date at the strike price.
Following terms are significant in context of the Option :
Options are generally operated on different types of strike price (also called exercise price) i.e. In-the-money, At-the-money and Out-of-the-money.
In the money : A call option is ' in the money' if the prevailing stock price of the underlying asset is more than the exercise price. The buyer of a call option is making a profit when he is 'In-the-money'. His overall profit will be determined by the amount he has paid as upfront premium. He may be overall at a loss and still ITM.
At-the-money : A call option is ' at the money' if the prevailing stock price of the underlying asset is at par with the exercise price.
Out-of-the-money : A call option is ' out of the money' if the prevailing stock price of the underlying asset is at lower than the exercise price.
Examples:
Identify which of the following options are In-the-money (ITM), At-the-money (ATM) and Out-of-the-money (OTM) for the buyer of the option. Which of these options would be exercised? Treat each of them individually.
a) RIL 840 Call when the price of expiry is Rs. 855.
b) GCC 510 PUT when the price on expiry is Rs. 510.
c) RIL 830 Call when the price of expiry is Rs. 840.
d) GCC 520 PUT when the price on expiry is Rs. 500.
e) RIL 800 CALL when the price on expiry is Rs. 765.
▀ Answers
a) Call Option gives the buyer the right to Buy the stock. RIL 840 CALL means the buyer of the option has the right to buy at Rs. 840 at the expiry. In the case the Shares are quoted at Rs. 855 in the market thus the buyer will exercise the Call Option and call upon the writer to sell him the stock at Rs. 840 so that the buyer can realise Rs. 15 per share from the market. In this case the buyer of the option is ITM.
From the view point of the writer (seller) of the option, if the writer is covered (he already has the stock with him), he can deliver the stock to buyer and enjoy the premium received by him at the time of writing the options. In case he is not covered, he will have to pay @ Rs. 15 (855 – 840) to the buyer of the option and suffer a loss of Rs. 15 less premium received per share. In this case the writer of the option is OTM.
b) In this case the exercise price is same as the spot price. No profit or loss to either buyer or writer of the option. Both will sit idly. Both are ATM.
c) Situation is similar to case (a).
d) GCC 520 PUT means the buyer of the option has acquired a right to SELL the stock at Rs. 520 to the writer of the option. The spot price on expiry is Rs. 500. The buyer will exercise the option and will realise Rs. 20 per share. The buyer of the option is ITM.
e) The buyer will not exercise the option as there is no point is buying stock from the writer of the option at Rs. 800 when he can buy the stock from the market at Rs. 765. He will allow the option to lapse and suffer a loss of premium paid by him for buying the option. Note that the buyer of the option will NOT pay the difference in price i.e. Rs. 35 per share to the writer of the option because it is buyer's right to activate the option or not. He is OTM in this case.
Long and Short : A buyer is called the Long and the seller is called the Short. We take a short position means we sell the stock.
Going Long a Stock : It means buying the stock. We take a long position means we buy the stock.
Selling Long : It means the seller is covered, that implies the seller has the stock he is supposed to deliver to the buyer.
Selling Short : It means the seller is not covered. It means that seller does not own the stock he has sold under the option and he will have to borrow the stock at the time of delivery to the buyer and buy the stock later to set-off the borrowing.
Upfront : The buyer (also called holder) of an option pays a premium to the writer (seller) of an option. This premium is sometimes called Upfront because it is collected upfront i.e. at the beginning. In simple terms the buyer pays the seller a price of the option i.e. he buys the right to buy / sell a stock by paying premium upfront.
Value of upfront premium : An option writer charges an upfront premium from the buyer for selling a right. The premium charged consists of two parts viz. (i) the intrinsic value and (ii) the extrinsic value or the time value. Intrinsic value is the value that any option would have, if it is exercised today. The intrinsic value of a put option (right to sell) is the difference between the strike price and the spot price, whereas the intrinsic value of a call option (right to buy) is the difference between the spot price and the strike price. Worded differently, the intrinsic value of an option is that part of option premium which represents the extent to which the option is In-the-money.
Time value of an option or the extrinsic value, is the price the buyer of the option has to pay to the writer of an option because of the risk the writer of the option undertakes. This is over and above the intrinsic value of that option. The time value component may be regarded as the '' insurance premium'' of the option. Time value decays over time and is directly related with the time the option has before expiration. Normally, the upfront premium charged by the writer of an option is equal to the sum of both the intrinsic value and the time value.
Example :
For each of the following options, find out the Intrinsic Value and the Time Value. The premium paid by the buyer is given in brackets. Details of options purchased are given. Treat each case individually.
1. HLL 180 PUT (Rs. 9)
2. LTL 1510 PUT (Rs. 7)
3. RIL 800 CALL (Rs. 37)
4. ACS 540 PUT (Rs. 39)
On the day of expiry the prices of the various stocks were as follows :
HLL Rs. 200; LTL Rs. 1510, RIL Rs. 825 and ACS Rs. 515
Answer :
If the option is ITM meaning it is in gain, the intrinsic value is the difference between strike price and market price, otherwise its intrinsic value is zero.
1. PUT option means the buyer has a right to SELL at the strike price. The buyer has a right to sell HLL share at Rs. 180 while it is being quoted at Rs. 200 in the market. Thus if the buyer exercises the option he would be required to sell at Rs. 180 to the writer of the option while he can very well sell the stock at Rs. 200 in the market. He will not exercise the option and will allow it to lapse. He is OTM and the intrinsic value is zero. The time value is Rs. 9 which is the premium paid towards acquiring the right to sell.
2. The strike price and market price (spot price) are same, it is a case of no profit no loss (ignoring premium). The buyer is ATM and he will allow the option to lapse. The intrinsic value is zero and the time value is equal to the premium paid (Rs. 7).
3. CALL option means the buyer has a right to BUY at the strike price. By exercising the option he can buy the RIL stock at Rs. 800 when it is being quoted at Rs. 825. He will exercise the call option and will realise Rs. 25 per share. He is ITM. The intrinsic value is Rs. 25 and the time value is Rs. 12.
4. The buyer can sell ACS at Rs. 540 while it is being quoted at Rs. 515 thus realising Rs. 25 each share. He is ITM to the tune of Rs. 25 per share. The intrinsic value is Rs. 25 and the time value is Rs. 14 (39 minus 25). He will exercise the option to cover Rs. 25 out of the premium of Rs. 39. He will be overall at the loss of Rs. 14 per share but he will be treated as ITM.
American option and European option : The option can be categorised in two types depending upon the exercise mode. In American option, the holder or buyer is allowed to exercise the option anytime during the life time of the option whereas in European option he can exercise the option only at the maturity date of the option.
Covered Call Options or Covered Calls : Call writers are considered to be covered if they have any of the following positions:
1. A long position in the underlying asset (he already has the asset to deliver if needed).
2. An escrow-receipt from a bank. Escrow-receipt from the bank certifies that the bank is holding the required shares in the account of seller).
3. A security that is convertible into required number of shares of the underlying asset.
4. A warrant exercisable for the required number of underlying asset.
5. A long position in a call on the same security or stock that has the same or lower strike price and that expires at the same time or later that the option being written.
Margins : Margin in stock market has the same connotations as it has in any other financial trade. Margins are required to ensure performance of the promises made in the form of contract. The party to the contract is required to introduce certain financial stake to cover day to day fluctuations in the prices of the securities bought. The margin is the cash paid by the client to the clearing house.
The margin of futures contracts has two components : (i) initial margin (ii) maintenance margin
Initial Margin : In the futures contract, the buyer and the seller both are required to perform the contract. To obviate the counter party risk, both are required to deposit the Initial margin with the clearing house. Initial margin is also known as Performance margin and is usually 5 to 15% of the purchase price of contract. The margin is set by the stock exchange keeping in view the volume of business and size of transactions as well as operative risk of the market in general.
The Initial margin is the first line of defence for the clearing house. This protection is further reinforced by prescribing maintenance margin.
Maintenance Margin : When an investor wants to enter the futures market with a brokerage firm for buying and selling futures, the first requirement for the investor is to open an account with the firm. This account, called the equity account, has to be kept separate from any other account including the margin accounts. Maintenance margin is the margin required to be kept by the investor in equity account equal to or more than a specified percentage of the amount kept as initial margin. Maintenance margin should be sufficient to support the daily settlement process called 'mark to market'. Normally, the deposit in the equity account is equal to or greater than 75% to 80% of the initial margin.
In case this requirement is not met, the investor is advised to deposit cash to make up the shortfall. If the investor does not respond, then the broker will close out the investor's position by entering a reversing trade in the investor's account.
Example :
A buyer buys a futures contract @ Rs. 50 per share for 500 shares from the seller. Both make a deposit of Rs. 2,500 being 10% of the total investment of Rs. 25,000 towards the initial margin.
The next day, to stock price rises to Rs. 52 per share. The equity of buyer gets increased by Rs. 1,000 and stands at Rs. 3,500 while the equity of seller goes down by the equal amount and stands at Rs. 1,500. As the maintenance margin is required to be maintained at 80% of initial margin, the buyer and seller both are required to maintain a margin of Rs. 2,000 in their equity accounts. Thus while the seller is called upon to deposit Rs. 500 in his equity account the buyer is given the option to withdraw the excess of Rs. 1,500 over the maintenance margin.
Variation Margin :
Variation margin is simply the running profit or loss on positions, the profit is paid out while the loss is received. If a margin call is made and the money is deposited by the account holder to bring the account to the level of initial margin, then the amount so deposited is called the variation margin.
Types of orders :
Market Order : When a trader places a buy or sell order at the price which prevails at the time the order is given, it is called a market order. It is the best possible price.
Limit orders : Limit order is that order in which the trader or investor specifies a particular price or a range of prices (also called order limits or band of prices) within which the order should be executed. Market-if-touched order (MIT) order : If the order is executed at the best available price after a trade occurs at a particular price or at a price more favourable than the specified price, it is called a MIT order or Market-if-touched order.
Stop Loss Order : When a trader holds a position either long or short (Long and Short : A buyer is called the Long and the seller is called the Short) and wants to control his loss against possible upward / downward movement of prices, he would place an order specifying a rate at which the deal would close out. Stop loss orders are normally placed by specifying a range (sometimes called band) of prices in which the order is required to be executed instead of giving a single price order.
The concept of Hybrid option :
The Hybrid option is a combination of call and put option simultaneously. The commonly adopted strategies using hybrid option combinations are as follows :
Straddle : It is a strategy which involves buying and selling (writing) both i.e. a call and a put on the same stock with both the options having same exercise price.
Example : Let us assume that Lara bought 100 shares of X Ltd. under call and put option at premiums of Rs. 10 and Rs. 8 respectively. The shares of X are presently quoted at Rs. 250.
Let us see what happens when share price goes up to say Rs. 280.
Premium paid for 100 X 250 call options : Rs. 10 x 100 shares = Rs. 1,000
Premium paid for 100 X 250 put options : Rs. 8 x 100 shares = Rs. 800
Total premium paid : Rs. 1,800
If the price goes up to Rs. 280, there is no chance that Lara will exercise put option ( right to sell) and sell the shares to writer at Rs. 250 when she can already sell them to market at Rs. 280. Thus she will allow the put option to lapse and loose the upfront premium of Rs. 800 (@ Rs. 8 on 100 shares).
Now she will activate the call option and will realise Rs. 30 per share total Rs. 3,000 and will make a net of Rs. 2,200 on this hybrid combination.
Let us see what happens if price goes to Rs. 210.
Note that movement of price of shares may be gradual and sudden both. If the shares are at Rs. 210, Lara will not exercise the call option ( means she will not ask the writer of the option to sell her shares of X at Rs. 250 when these are already available at Rs. 210 in open market) and let it (call option) lapse and loose the premium of Rs. 1,000. On the other hand, she will exercise the put option and ask the writer to buy the shares at Rs. 250 and will realise Rs. 4,000, thus in all she will realise Rs. 2,200 out of this hybrid combination.
Thus buying the opposite option, Lara has obviated a possible loss i.e. she hedged (protected) a possible loss by buying a call and put option simultaneously at the same stock for the same price and at the same exercise but with different premiums. This is called ' buying a straddle'.
If Lara is making Rs. 2,200 both ways, who is losing ?
If the writer is a covered call writer, she has the shares ready when the prices go up and thus she has protected against price going up. In case price going down, the writer of the option has to lose.
In all options contract, the seller of the option and the buyer of the option think in exactly opposite directions and their perception regarding the movement of market and the price of the stock in question, is totally contradictory to each other.
Strip Strategy : In previous example of straddle strategy, Lara anticipate 50:50 chances of prices going down as well as up and suitably bought one call option and one buy option. Suppose she anticipates that chances of moving downward are more drastic than chances of going up consequently she buys two put options (right to sell) and one call option of the same stock at the same exercise price for the same period. Such a strategy is called Srip. Needless to say that the writer of options (seller) does not think in the lines of Lara.
Strap Strategy : Strap strategy is followed when the buyer thinks that the chances of prices going up are more than the chances of prices going down, consequently he buys two calls and one put. Such an strategy is called Strap Strategy.
Spreads : A spread is strategy when purchase of one option is countered by sale of another (i.e. writing) on the same stock. It is important to note that Spreads consist of either all calls or all puts and not a combination of the two as in the case of straddle, strip or strap.
The spreads having different exercise prices but the same expiration date are called vertical spreads. On the contrary, the spreads having same exercise prices but different expiration dates are called horizontal spreads. Time spreads and calendar spreads are examples of horizontal spreads.
Mixtures of vertical spreads and horizontal spreads are called diagonal spreads. The diagonal spreads have different exercise prices and different expiration dates.
Some Examples :
Example 1: Mrs. Twinkle purchases the following European Call Options on Reliance. She also purchased the following Put Options on ACC. What decision she would take on expiry, if Reliance closes at Rs. 835 and ACC closes at Rs. 565. Ignore premium paid.
a) RIL 830 Call (b) ACC 510 Put (c) RIL 840 Call (d) ACC 520 Put.
Solution :
(a) and (c) : Remember the following :
• In European options, the buyer can exercise the option only at the expiry date.
• Call options are right to buy the asset.
RIL 830 Call, implies that Twinkle has bought a right to buy RIL at Rs. 830 on the expiry date. The RIL is quoting at Rs. 835 on expiry. Thus she should exercise the call option and realise Rs. 5 (835 – 830) per share. She also has option RIL 840 call, which implies that she has bought a right to buy RIL at Rs. 840 on expiry date. She would allow this option to lapse as there is no point in buying RIL at Rs. 840 from the writer of the option when it is already quoting at Rs. 835 in the market.
(b) and (d) : Remember : Put Option is the right to sell the asset at the mentioned (exercise price or strike price) price.
In this case, Twinkle bought the right to sell ACC at Rs. 510 (and Rs. 520) at the expiry of option. The stock is already quoting at Rs. 565 in the open market. Twinkle would not exercise any of the options because she would sell the stock in market at Rs. 565 rather than exercising the option and selling the stock to writer of the option at Rs. 510 and at Rs. 520. She would allow the Put options to lapse on expiry.
Example 2 (ca final nov. 2001)
Airlines Company entered into an agreement with Airbus for buying latest planes for a total value of FF (French Francs) 1,000 millions payable after 6 months. The current spot exchange rate is INR (Indian Rupees) is 6.60 / FF. The Airlines Company cannot predict the exchange rate in future. Can the Airlines Company hedge its Foreign Exchange Risk? Explain with examples.
Answer :
Airlines Company can hedge its foreign exchange risk by the following :
i) Hedging through forward contract : The Company can ascertain its liability in definite terms by entering into forward contract with any bank or financial institutions which deals in foreign exchange. Although the company cannot predict the exchange rate in future, but forward rate for 6 months from now is available in money market. Suppose the 6 month forward rate is INR 6.80 FF meaning the company can buy FF at Rs. 6.80 per FF to be delivered at 6 months from now. Thus whatever happens to exchange market or rate, the company can buy the FF at Rs. 6.80 per FF. The company can take full forward cover against foreign exchange exposure and entirely hedge its risk.
ii) Going for foreign currency option Say Put Option : The company can buy option to buy or sell a currency at an agreed exchange rate (exercise price or strike price) on or before an agreed maturity period. The right to buy is called Call Option and the right to sell is called Put Option. Suppose the company decides to go for Put Option. It will buy a Put Option and will acquire a right to sell FF at exercise rate of say INR 6.70. It will have to pay premium to buy the option, say it is 5% of the exercise rate. In all the company will have to pay Rs. 6700 millions on price and Rs. 335 million as premium. If the exchange rate on the date of payment (6 months from now), is say Rs. 6.80, it will activate the Put Option and ask the writer to pay the FF at Rs. 6.80 per FF to the Company. If the exchange rate on date of maturity is less than Rs. 6.70, it will not exercise the Put option and will allow it to lapse. It will purchase FF from the open market and will discharge its liability.
iii) Going for foreign currency option Say Call Option : Airline can hedge its FE risk with the assistance of Call Option as well. Call Option gives the buyer a right to buy the underlying asset at the contract price. Airline can buy a Call option of 6 month maturity at an agreed rate of say Rs. 6.8 FF plus a premium of say 3%. The total cost the Airline has to pay will be Rs. 6800 million + a premium of 3% of Rs. 6800 million (Rs. 204 million) totaling Rs. 7104 million. If the FF is quoting higher than Rs. 6.8, say Rs. 6.90, the Company will decide to exercise the Call option and will gain Rs. 100 million (0.1 x Rs. 1000 million). If the FF is quoted below the strike price of Rs. 6.8, the company will not activate the Call option and instead purchase the underlying asset from the open market and would be satisfied with the loss of premium paid towards acquisition of Call option.
iv) Going for Money market transactions : The company can borrow FF 1000 millions now from some financial institutions, convert them into rupee at the current exchange rate and invest the money market in India for 6 months. Interest Parity theorem (IPR) states that the difference in forward rate and the spot rate is the reflection of difference in the interest rates of two countries. Thus Airline will be able to hedge against the changes in exchange rate risk
Chapter 3 ; Capital Market Analysis
Risk : An investor invests his or her money into shares and expects the money to earn more than usual rate of earning than earning in safe investment like bank deposits or government bonds or certificates. It is also probable that the investment may not earn as expected and this is risk. Risk in share market or security market can be defined as the probability that the actual returns may be less than expected return. When probability is not assigned, the risk is called uncertainty.
Types of Risk : Risk can be classified in different ways. One way is to classify as systematic risk and unsystematic risk. The systematic risk (also called market risk) is that risk which is same to all types of securities or shares. Unsystematic risk is that risk which is special for a particular industry or company. Government policy may be a systematic risk if it affects all the industries uniformly like increase in tax rate or it can be unsystematic risk if it affects a particular industry only like increase in excise duty of cement. Unsystematic risk is also called non-systematic risk or non-market risk. Total risk is sum of systematic risk and unsystematic risk.
As the reasons leading to systematic risk are beyond the control of an individual investor or an individual company or industry, such risk are not avoidable at all. Virtually all securities have certain element of systematic risk.
As the risk is related with variations in returns from an investment, it must be measured by variations from some mean. In statistical terms the risk is measured as coefficient of variance or as standard deviation.
Beta : Beta of say 1.6 means that the returns from a security move 1.6 faster than the sensex. If sensex moves up by say 10%, the price of this share will go up by 1.6 x 10% = 16%. Beta is a measure of the systematic risk of share (security) and is expressed as a number.
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