Friday, February 22, 2013

Excellent Trading School - 2 - Financial Markets

Financial markets can mainly be classified into money markets and capital markets. Instruments in the money markets include mainly short-term, marketable, liquid, low-risk debt securities.

Capital markets, in contrast, include longer-term and riskier securities, which include bonds and equities. There is also a wide range of derivatives instruments that are traded in the capital markets.

Both bond market and money market instruments are fixed-income securities but bond market instruments are generally of longer maturity period as compared to money market instruments.

Money market instruments are of very short maturity period. 

Derivative market are mainly futures, forwards and options on the underlying instruments, usually equities and bonds.

The equities market can be further classified into the primary and the secondary market.

Primary and Secondary Markets
A primary market is that segment of the capital market, which deals with the raising of capital from investors via issuance of new securities. New stocks/bonds are sold by the issuer to the public in the primary market. When a particular security is offered to the public for the first time, it is called an Initial Public Offering (IPO). When an issuer wants to issue more securities of a category that is already in existence in the market it is referred to as Follow-up Offerings.

The principal distinction is between primary markets, where new securities are sold, and secondary markets, where outstanding securities are bought and sold.

Why IPO?
Until the IPO stage, there is no transparent price for the company’s shares. Once the IPO is concluded and the shares start trading in the stock exchange, the price of its shares can be watched in the market.
The price of its share multiplied by the total number of shares issued i.e. market capitalization is an indicator of the value of the company in the stock exchange.

Listing gives companies a certain visibility and brand positioning. Besides, companies, which are traded in the stock exchange, are perceived as large companies with transparent business operations adhering to corporate governance standards. They also tend to be better supervised by the regulators, and closely monitored by investors and the market, in general. 

The ultimate aspiration of most entrepreneurs is therefore to take their company public. But, the path from idea to IPO can be a long one with its own twists and turns. Besides business skills of the entrepreneurial team, grit and luck too have a role, in taking the company to the public.

Types of shares
In India, shares are mainly of two types: equity shares and preference shares. In addition to the most common type of shares, the equity share, each representing a unit of the overall ownership of the company, there is another category, called preference shares.

These preferred shares have precedence over common stock in terms of dividend payments and the residual claim to its assets in the event of liquidation. However, preference shareholders are generally not entitled to equivalent voting rights as the common stockholders.

In India, preference shares are redeemable (by issuing firm) and preference dividends are cumulative, means that in case the preference dividend remains unpaid in a particular year, it gets accumulated and the company has the obligation to pay the accrued dividend and current year’s dividend to preferred stockholders before it can distribute dividends to the equity shareholders.

An additional feature of preferred stock in India is that during such time as the preference dividend remains unpaid, preference shareholders enjoy all the rights (e.g. voting rights) enjoyed by the common equity shareholders. Some companies also issue convertible preference shares, which get converted to common equity shares in future at some specified conversion ratio.

Secondary markets
Secondary markets trades in outstanding issues; that is, stocks or bonds already sold to the public are traded between current and potential owners. The proceeds from a sale in the secondary market do not go to the issuing unit (the government, municipality, or company) but, to the current owner of the security.

The secondary market involves the trading of securities initially sold in the primary market, it provides liquidity to the individuals who acquired these securities. After acquiring securities in the primary market, investors want the ability to sell them again to acquire other securities, buy a house, or go on a vacation. The primary market benefits greatly from the liquidity provided by the secondary market because investors would hesitate to acquire securities in the primary market if they thought they could not subsequently sell them in the secondary market. That is, without an active secondary market, potential issuers of stocks or bonds in the primary market would have to provide a much higher rate of return to compensate investors for the substantial liquidity risk.

Secondary markets are also important to those selling seasoned securities because the prevailing market price of the securities is determined by transactions in the secondary market. New issues of outstanding stocks to be sold in the primary market are based on prices in the secondary market. Even forthcoming IPOs are priced based on the prices and values of comparable stocks in the public secondary market.

Why should one invest in equities in particular?
When you buy a share of a company you become a shareholder in that company. Shares are also known as Equities. Equities have the potential to increase in value over time. Research studies have proved that the equity returns have outperformed the returns of most other forms of investments in the long term.

However, this does not mean all equity investments would guarantee similar high returns. Equities are high-risk investments. Though higher the risk, higher the potential returns, high risk also indicates that the investor stands to lose some or all his investment amount if prices move unfavorably.

What has been the average return on Equities in India?
If we take the Nifty index returns for the past fifteen years, Indian stock market has returned about 16% to investors on an average in terms of increase in share prices or capital appreciation annually. Besides that on average stocks have paid 1.5% dividend annually. Dividend is a percentage of the face value of a share that a company returns to its shareholders from its annual profits. so the returns on capital invested is 18% tax free assuming the long term holding of the investments.

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