Saturday, February 12, 2011
Monday, February 07, 2011
Indian Financial System and Capital Market
Overview of Indian Financial System
Indian Financial System and Capital Market
The Indian financial system comprises a set of financial institutions,
financial markets and financial infrastructure. The financial institutions mainly
consist of commercial and co-operative banks, regional rural banks (RRBs), all-
India financial institutions (AIFIs) and non-banking financial companies
(NBFCs). The banking sector which forms the bedrock of the Indian financial
system, falls under the regulatory ambit of the Reserve Bank of India under the
provisions of the Banking Regulation Act, 1949 and the Reserve Bank of India
Act, 1934. The Reserve Bank also regulates select AIFIs. Consequent upon
amendments to the Reserve Bank of India (Amendment) Act in 1997, a
comprehensive regulatory framework in respect of NBFCs was put in place in
January 1997.
The financial market in India comprises the money market, the
Government securities market, the foreign exchange market and the capital
market. A holistic approach has been adopted in India towards designing and
development of a modern, robust, efficient, secure and integrated payment and
settlement system. The Reserve Bank set up the Institute for Development and
Research in Banking Technology (IDRBT) in 1996, which is an autonomous
centre for technology capacity building for banks and providing core IT services.
(The structure of Indian financial system is presented in Slide 2).
Financial Institutions
Scheduled commercial banks (SCBs) occupy a predominant position in the
financial system accounting for around three fourths of the total assets in the
financial system. While the public sector banks (PSBs), consisting of eight banks
in the State Bank group and 19 nationalised banks, constitute almost threefourths
of the total assets of SCBs, the private sector banks, 30 in number,
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constitute less than one-fifth of the total assets. The 33 foreign banks operating in
India account for about 6-7 per cent of the assets of SCBs. The 196 RRBs play a
critical role in extending credit to the poorer sections of the rural society. The
ownership of RRBs jointly vests with the Central Government, the State
Governments and the sponsor banks. The co-operative banking system, with two
broad segments of urban and rural co-operatives, forms an integral part of the
Indian financial system. While the urban co-operative banking system has a
single tier comprising the Primary Co-operative Banks (commonly known as
ʹurban co-operative banks – UCBs), the rural co-operative credit system is
divided into long-term and short-term co-operative credit institutions which
have a multi-tier structure.
The term-lending institutions are mostly Government-owned and have
been the traditional providers of long-term project loans. Non-Banking Financial
Companies (NBFCs) encompass an extremely heterogeneous group of
intermediaries and provide a gamut of financial services. Primary Dealers (PDs)
in the Government securities market constitutes a systemically important
segment of the NBFCs. At present, there are a total of 17 PDs playing active role
in the Government securities market. A majority of them are promoted by banks.
Apart from this, India has a well-established and vibrant insurance sector within
the financial system. The Insurance Regulatory and Development Agency
(IRDA) has been established to regulate and supervise the insurance sector.
(The structure of Indian financial institutions is presented in Slide 3).
Pre-reforms Phase
Indian Financial System and Capital Market
Until the early 1990s, the role of the financial system in India was
primarily restricted to the function of channelling resources from the surplus to
deficit sectors. Whereas the financial system performed this role reasonably well,
its operations came to be marked by some serious deficiencies over the years.
The banking sector suffered from lack of competition, low capital base, low
productivity and high intermediation cost. After the nationalisation of large
banks in 1969 and 1980, the Government-owned banks dominated the banking
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sector. The role of technology was minimal and the quality of service was not
given adequate importance. Banks also did not follow proper risk management
systems and the prudential standards were weak. All these resulted in poor asset
quality and low profitability. Among non-banking financial intermediaries,
development finance institutions (DFIs) operated in an over-protected
environment with most of the funding coming from assured sources at
concessional terms. In the insurance sector, there was little competition. The
mutual fund industry also suffered from lack of competition and was dominated
for long by one institution, viz., the Unit Trust of India. Non-banking financial
companies (NBFCs) grew rapidly, but there was no regulation of their asset side.
Financial markets were characterised by control over pricing of financial assets,
barriers to entry, high transaction costs and restrictions on movement of
funds/participants between the market segments. This apart from inhibiting the
development of the markets also affected their efficiency.
Financial Sector Reforms in India
It was in this backdrop that wide-ranging financial sector reforms in India
were introduced as an integral part of the economic reforms initiated in the early
1990s with a view to improving the macroeconomic performance of the
economy. The reforms in the financial sector focussed on creating efficient and
stable financial institutions and markets. The approach to financial sector
reforms in India was one of gradual and non-disruptive progress through a
consultative process. The Reserve Bank has been consistently working towards
setting an enabling regulatory framework with prompt and effective supervision,
development of technological and institutional infrastructure, as well as
changing the interface with the market participants through a consultative
process. Persistent efforts have been made towards adoption of international
benchmarks as appropriate to Indian conditions. While certain changes in the
legal infrastructure are yet to be effected, the developments so far have brought
the Indian financial system closer to global standards.
(The major achievements of the financial sector reforms are presented in Slide 4).
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The reform of the interest regime constitutes an integral part of the
financial sector reform. With the onset of financial sector reforms, the interest
rate regime has been largely deregulated with a view towards better price
discovery and efficient resource allocation. Initially, steps were taken to develop
the domestic money market and freeing of the money market rates. The interest
rates offered on Government securities were progressively raised so that the
Government borrowing could be carried out at market-related rates. In respect of
banks, a major effort was undertaken to simplify the administered structure of
interest rates. Banks now have sufficient flexibility to decide their deposit and
lending rate structures and manage their assets and liabilities accordingly. At
present, apart from savings account and NRE deposit on the deposit side and
export credit and small loans on the lending side, all other interest rates are
deregulated.
Indian banking system operated for a long time with high reserve
requirements both in the form of Cash Reserve Ratio (CRR) and Statutory
Liquidity Ratio (SLR). This was a consequence of the high fiscal deficit and a
high degree of monetisation of fiscal deficit. The efforts in the recent period have
been to lower both the CRR and SLR. The statutory minimum of 25 per cent for
SLR has already been reached, and while the Reserve Bank continues to pursue
its medium-term objective of reducing the CRR to the statutory minimum level
of 3.0 per cent, the CRR of SCBs is currently placed at 5.0 per cent of NDTL.
(Interest rate deregulation is presented in Slide 5)
As part of the reforms programme, due attention has been given to diversification
of ownership leading to greater market accountability and improved efficiency. Initially,
there was infusion of capital by the Government in public sector banks, which was
followed by expanding the capital base with equity participation by the private investors.
This was followed by a reduction in the Government shareholding in public sector banks
to 51 per cent. Consequently, the share of the public sector banks in the aggregate assets
of the banking sector has come down from 90 per cent in 1991 to around 75 per cent in
2004. With a view to enhancing efficiency and productivity through competition,
guidelines were laid down for establishment of new banks in the private sector and the
Indian Financial System and Capital Market
foreign banks have been allowed more liberal entry. Since 1993, twelve new private
sector banks have been set up. As a major step towards enhancing competition in the
banking sector, foreign direct investment in the private sector banks is now allowed up to
74 per cent, subject to conformity with the guidelines issued from time to time.
(Banking Sector: Competition and Efficiency is presented in Slide 6).
As a part of the financial sector reforms, the regulatory framework and
supervisory practices have almost converged with the best practices elsewhere in the
world. The minimum capital to risk assets ratio (CRAR) has been kept at nine per cent
which is one percentage point above the international norm; and additionally, banks are
required to maintain a separate Investment Fluctuation Reserve (IFR) out of profits,
towards interest rate risk. Impressive institutional and legal reforms have been
undertaken in relation to the banking sector. There have been a number of measures for
enhancing the transparency and disclosures standards. The regulatory framework in
India, in addition to prescribing prudential guidelines and encouraging market discipline,
is increasingly focusing on ensuring good governance through "fit and proper" owners,
directors and senior managers of the banks. Transfer of shareholding of five per cent and
above requires acknowledgement from the Reserve Bank and such significant
shareholders are put through a 'fit and proper' test. Banks have also been asked to ensure
that the nominated and elected directors are screened by a nomination committee to
satisfy `fit and proper' criteria. Directors are also required to sign a covenant indicating
their roles and responsibilities. The Reserve Bank has recently issued detailed guidelines
on ownership and governance in private sector banks emphasizing diversified ownership.
In 1994, a Board for Financial Supervision (BFS) was constituted comprising
select members of the Reserve Bank Board with a variety of professional expertise to
exercise 'undivided attention to supervision' and ensure an integrated approach to
supervision of commercial banks, development finance institutions, non-banking finance
companies, urban cooperatives banks and primary dealers. Certain amendments are being
considered by the Parliament to enhance Reserve Bank’s regulatory and supervisory
powers.
(Issues in regulation and supervision are presented in Slide 6).
Indian Financial System and Capital Market
Over the last few years, the several policy initiatives undertaken in the
form of recapitalisation of the weak RRBs, deregulation of deposits and lending
rates and relaxation to lend to non-target groups, have improved their
operational efficiency, governance and regulation and brought them almost at
par with the rural branches of commercial banks.
The co-operative banks besides suffering from the problem of multiple
supervisory authorities, also face the challenge of reconciling the democratic
character with financial discipline and modernising systems and procedures. The
Task Force on Cooperatives constituted by the Government (December 2004) has
made several suggestions for the revival of the sector to be implemented in
consultation with the State Governments. The Reserve Bank has adopted a
cautious approach regarding granting licenses for new banks and branches of
urban cooperative banks (UCBs), while focussing on consolidation within the
sector through mergers and amalgamations. In addition, initiatives have been
undertaken to gradually tighten the prudential norms for regulation and
supervision of UCBs. As a prelude to revamping the sector, a vision document
for UCBs has been released by the Reserve Bank, highlighting the importance of
a differentiated regulatory regime for the sector.
The ongoing restructuring of AIFIs is evident in the recent conversion of
Industrial Credit and Investment Corporation of India (ICICI) and Industrial
Development Bank of India (IDBI) into banks. The Board of Directors of
Industrial Finance Corporation of India (IFCI) Ltd. have approved, in principle,
the merger with a bank. In view of the deteriorating financial position of
Industrial Investment Bank of India (IIBI) Ltd., the Government has undertaken a
programme of restructuring its liabilities. Apart from Infrastructure
Development Finance Company Ltd. (IDFC), there are three refinancing
institutions viz., National Bank of Agriculture and Rural Development
(NABARD), Small Industries Development Bank of India (SIDBI) and National
Indian Financial System and Capital Market
Housing Bank (NHB), and EXIM Bank. At the State level, the State Financial
Corporations registered under the State Financial Corporations Act, 1951 and the
State Industrial Development Corporations (SIDCs) - purvey credit to
industries/sectors in different States. On balance, the development financial
institution (DFI) model has become increasingly unsustainable and AIFIs are fast
adopting the business model of a bank for long-term commercial viability.
Non-Banking Financial Companies (NBFCs) encompass an extremely
heterogeneous group of intermediaries. The main area of concern has been the
substantial growth in deposits of the Residuary Non-Banking Companies
(RNBCs), with just two companies accounting for more than 80 per cent of the
total deposits held by NBFCs. The Indian banking sector is gradually heading
towards consolidation of core competencies of different financial intermediaries,
which would engender greater economic efficiency in the form of lower
transaction cost, and greater product sophistication.
Financial System: Current Status
There has been a notable reduction in the ratio of non-performing assets
(NPAs) to advances in response to various initiatives, such as, improved risk
management practices and greater recovery efforts driven, inter alia, by the
recently enacted Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI) Act, 2002. The financial
performance of most of the PSBs has improved in recent times as reflected in
their comfortable capital adequacy ratios and declining NPL ratios. The CRAR in
respect of all categories of banks has improved. New private sector banks have
displayed impressive performance particularly in terms of efficiency and
customer service (Table 1).
Indian Financial System and Capital Market
Table 1: Select Financial Sector Indicators: 2002-03 vis-a-vis 2003-04
Financial Indicator 2002-03 2003-04
Entity
1 2 3 4
1. a) Growth in Major Aggregates (Per cent)
Aggregate Deposits 13.4 * 17.5
Scheduled
Commercial
Banks Non-food Credit 18.6 * 18.4
Investment in Government Securities 27.3 25.1
b) Financial Indicators (as percentage of total assets)
Operating Profits 2.4 2.7
Net Profits 1.0 1.1
Spread 2.8 2.9
c) Non-Performing Assets (as percentage of advances)
Gross NPAs 8.8 7.2
Net NPAs 4.4 2.9
d) CRAR 12.7 12.9
2. a) Growth in Major Aggregates (Per cent)
Deposits 9.1 8.6
Credit 4.5 4.0
b) Financial Indicators (as percentage of total assets)@
Operating Profits 1.4 2.1
Net Profits -1.1 0.9
Spread 2.1 2.7
c) Non-Performing Assets (as percentage of advances)
Gross NPA 21.0 28.9
Scheduled
Urban
Co-operative
Banks
d) CRAR N.A. N.A.
3. All-India a) Growth in Major Aggregates (per cent)1
Financial Sanctions -31.3 65.2
Institutions Disbursements -30.5 25.9
b) Financial Indicators (as percentage of total assets) 2
Operating Profits 1.4 1.3
Net Profits 0.9 0.9
Spread 0.7 0.2
c) Non-Performing Assets (as percentage of advances) 2
Net NPA 10.6 N.A.
Indian Financial System and Capital Market
d) CRAR
i) IDBI 18.7 18.3
ii) IFCI 0.95 -17.0
iii) SIDBI 44.0 51.6
iv) NABARD 39.1 39.4
v) IDFC 51.3 36.9
4. a) Growth in Major Aggregates (per cent)
Public Deposits 6.8 —
Non-banking
Financial
Companies b) Financial Indicators (as percentage of total assets)
Net Profits 0.9 —
c) Non-Performing Assets (as percentage of advances)3
Net NPA 2.9 N.A.
CRAR 93.7#
*Adjusted for merger. @ Relates to scheduled urban co-operative banks.
# percentage of NBFCs above 30 per cent CRAR.
1. Comprise IDBI, IFCI, IIBI, IDFC, SIDBI, IVCF, ICICI Venture, TFCI, LIC, UTI, and GIC.
2. Comprise following nine FIs, viz., IDBI, IFCI, IIBI, IDFC, Exim Bank, TFCI, SIDBI, NABARD and NHB.
3. For reporting companies with variations in coverage.
Financial Markets
A major objective of reforms in the financial sector was to develop various
segments of the financial market as also eliminate segmentation across various markets
in order to smoothen the process of transmission of impulses across markets, easing the
liquidity management process and making resource allocation process more efficient
across the economy. The strategy adopted for meeting these objectives involved removal
of restrictions on pricing of assets, building the institutional structure and technological
infrastructure, introduction of new instruments, and fine-tuning of the market
microstructure. The 1990s saw the significant development of various segments of the
financial market. At the short end of the spectrum, the money market saw the emergence
of a number of new instruments such as CP and CDs and derivative products including
FRAs and IRS. Repo operations, which were introduced in the early 1990s and later
refined into a Liquidity Adjustment Facility, allow the Reserve Bank to modulate
liquidity and transmit interest rate signals to the market on a daily basis. The process of
financial market development was buttressed by the evolution of an active government
securities market after the Government borrowing programme was put through the
auction process in 1992-93. The development of a market for Government paper enabled
the Reserve Bank to modulate the monetisation of the fiscal deficit. The foreign
exchange market deepened with the opening up of the economy and the institution of a
market-based exchange rate regime in the early 1990s. Although there were occasional
Indian Financial System and Capital Market
episodes of volatility in the foreign exchange market, these were swiftly controlled by
appropriate policy measures. The capital market also underwent some metamorphic
changes during the 1990s. The development of the financial markets was well supported
by deregulation of balance sheet restrictions in respect of financial institutions, allowing
them to operate across markets. This resulted in increased integration among the various
segments of the financial markets.
Overview of Indian Capital Market
The Indian capital market is more than a century old. Its history goes back
to 1875, when 22 brokers formed the Bombay Stock Exchange (BSE). Over the
period, the Indian securities market has evolved continuously to become one of
the most dynamic, modern, and efficient securities markets in Asia. Today,
Indian market confirms to best international practices and standards both in
terms of structure and in terms of operating efficiency.
Indian securities markets are mainly governed by a) The Company’s Act
1956, b) the Securities Contracts (Regulation) Act 1956 (SCRA Act), and c) the
Securities and Exchange Board of India (SEBI) Act, 1992. A brief background of
these above regulations are given below
a) The Companies Act 1956 deals with issue, allotment and transfer of
securities and various aspects relating to company management. It
provides norms for disclosures in the public issues, regulations for
underwriting, and the issues pertaining to use of premium and discount
on various issues.
b) SCRA provides regulations for direct and indirect control of stock
exchanges with an aim to prevent undesirable transactions in securities. It
provides regulatory jurisdiction to Central Government over stock
exchanges, contracts in securities and listing of securities on stock
exchanges.
Indian Financial System and Capital Market
c) The SEBI Act empowers SEBI to protect the interest of investors in the
securities market, to promote the development of securities market and to
regulate the security market.
The Indian securities market consists of primary (new issues) as well as
secondary (stock) market in both equity and debt. The primary market provides
the channel for sale of new securities, while the secondary market deals in
trading of securities previously issued. The issuers of securities issue (create and
sell) new securities in the primary market to raise funds for investment. They do
so either through public issues or private placement. There are two major types
of issuers who issue securities. The corporate entities issue mainly debt and
equity instruments (shares, debentures, etc.), while the governments (central and
state governments) issue debt securities (dated securities, treasury bills). The
secondary market enables participants who hold securities to adjust their
holdings in response to changes in their assessment of risk and return. A variant
of secondary market is the forward market, where securities are traded for future
delivery and payment in the form of futures and options. The futures and
options can be on individual stocks or basket of stocks like index. Two
exchanges, namely National Stock Exchange (NSE) and the Stock Exchange,
Mumbai (BSE) provide trading of derivatives in single stock futures, index
futures, single stock options and index options. Derivatives trading commenced
in India in June 2000 (Slide 7).
Major Reforms in the Indian Capital Market
The major reforms in the Indian capital market since the 1990s are
presented below:
As a first step to reform the capital market, the Securities and Exchange
Board of India (SEBI), which was earlier set up in April 1988 as a nonstatutory
body under an administrative arrangement, was given statutory
powers in January 1992 through an enactment of the SEBI Act, 1992 for
regulating the securities markets. Twin objectives mandated in the SEBI
Indian Financial System and Capital Market
Act are investor protection and orderly development of the capital
market.
The most significant development in the primary capital market has been
the introduction of free pricing. The issuers of securities are now allowed
to raise the capital from the market without requiring any consent from
any authority either for making the issue or for pricing it. However, the
issue of capital has been brought under SEBI’s purview in that issuers are
required to meet the SEBI guidelines for Disclosure and Investor
Protection, which, in general, cover the eligibility norms for making issues
of capital (both public and rights) at par and at a premium by various
types of companies, reservation in issues, etc.
The abolition of capital issues control and the freeing of the pricing of
issues led to unprecedented upsurge of activity in the primary capital
market as the corporates mobilised huge resources. It, inter alia, exposed
certain inadequacies of the regulations. Therefore, without seeking to
control the freedom of the issuers to enter the market and freely price
their issues, the SEBI further strengthened the norms for public issues in
April 1996. Alongside, SEBI raised the standards of disclosure in public
issues to enhance their transparency for improving the levels of investor
protection. Issuers of capital are now required to disclose information on
various aspects, such as, track record of profitability, risk factors, etc.
Issuers now also have the option of raising resources through fixed price
floatations or the book building process.
Trading infrastructure in the stock exchanges has been modernised by
replacing the open outcry system with on-line screen based electronic
trading, unlike several of the developed countries where the two systems
still continue to exist on the same exchange. In all, 23 stock exchanges in
India have approximately 8,000 trading terminals spread all over the
country. This improved the liquidity of the Indian capital market and a
better price discovery.
Indian Financial System and Capital Market
The trading and settlement cycles were initially shortened from 14 days to
7 days. Subsequently, to further enhance the efficiency of the secondary
market, rolling settlement was introduced on a T+5 basis. With effect from
April 1, 2002, the settlement cycle was further shortened to T+3 for all
listed securities. The settlement cycle is now T+2.
All stock exchanges in the country have established clearing houses.
Consequently, all transactions are settled through the clearing house only
and not directly between members, as was practiced earlier.
Several measures have been undertaken/strengthened to ensure the safety
and integrity of the market. These are: margining system, intra-day
trading limit, exposure limit and setting up of trade/settlement guarantee
fund.
Securities, which were earlier held in physical form, have been
demateralised and their transfer is done through electronic book entry,
which has eliminated some of the disadvantages of securities held in
physical form. There are two depositories operating in the country.
In India, all listed companies are now required to furnish to the stock
exchanges and also publish unaudited financial results on a quarterly
basis. To enhance the level of continuous disclosure by the listed
companies, the SEBI decided to amend the Listing Agreement to
incorporate the Segment Reporting, Accounting for Taxes on Income,
Consolidated Financial Results, Consolidated Financial Statements,
Related Party Disclosures and Compliance with Accounting Standards.
The Indian capital market is also increasingly integrating with the
international capital markets. One of the significant steps towards
integrating Indian capital market with the international capital markets
was the permission given to Foreign Institutional Investors (FIIs) such as,
mutual funds, pension funds and country funds to operate in the Indian
markets. Indian firms have also been allowed to operate in the Indian
markets. Indian firms have also been allowed to raise capital from
Indian Financial System and Capital Market
international capital markets through issues of Global Depository Receipts
(GDRs), American Depository Receipts (ADRs), Euro Convertible Bonds
(ECBs), etc.
Boards of various stock exchanges, which in the past included mainly
brokers, have been broad-based in order to make them more widely
representative so that they represent different interests and not just the
interests of their members. Reconstituted Governing Boards have now
broker and non-broker representation in the ratio of 50-50 apart from the
Executive Director who has a seat on the Board and is required to be a
non-broker professional. To remove the influence of brokers in the
functioning of stock exchanges, the SEBI decided that no broker member
of the stock exchange shall be an office bearer of an exchange or hold the
position of President, Vice President, Treasurer, etc. Efforts are afoot to
demutualise and corporatise the stock exchanges.
Apart from stock exchanges, various intermediaries, such as mutual
funds, stock brokers and sub-brokers merchant bankers, portfolio
managers, registrars to an issue and share transfer agents, underwriters,
debenture trustees, bankers to an issue, custodian of securities, venture
capital funds and issuers have been brought under the SEBI’s regulatory
purview.
There are now regulations in place governing substantial acquisition of
shares and takeovers of companies. The Regulations are aimed at making
the takeover process more transparent and to protect the interests of
minority shareholders.
Trading in derivative products, such as stock index future, stock index
options and futures and options in individual stocks have also been
introduced.
(The major reforms in Indian capital market are presented in Slide 8-11)
Indian Financial System and Capital Market
Foreign Institutional Investment in India
The liberalisation and consequent reform measures have drawn the
attention of foreign investors leading to a rise in portfolio investment in the
Indian capital market. Over the recent years, India has emerged as a major
recipient of portfolio investment among the emerging market economies. Apart
from such large inflows, reflecting the confidence of cross-border investors on
the prospects of Indian securities market, except for one year, India received
positive portfolio inflows in each year. The stability of portfolio flows towards
India is in contrast with large volatility of portfolio flows in most emerging
market economies.
The Indian capital market was opened up for foreign institutional
investors (FIIs) in 1992. The FIIs started investing in Indian markets in January
1993. The Indian corporate sector has been allowed to tap international capital
markets through American Depository Receipts (ADRs), Global Depository
Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and External
Commercial Borrowings (ECBs). Similarly, non-resident Indians (NRIs) have
been allowed to invest in Indian companies. FIIs have been permitted in all types
of securities including Government securities and they enjoy full capital
convertibility. Mutual funds have been allowed to open offshore funds to invest
in equities abroad.
FII investment in India started in 1993, as FIIs were allowed to invest in
the Indian debt and equity market in line with the recommendations of the High
Level Committee on Balance of Payments. These investment inflows have since
then been positive, with the exception of 1998-99, when capital flows to emerging
market economies were affected by contagion from the East Asian crisis. These
investments account for over 10 per cent of the total market capitalisation of the
Indian stock market.
Limits on Foreign Institutional Investors
Each FII (investing on its own) or sub-account cannot hold more than 10
per cent of the paid-up capital of a company. A sub-account under the
Indian Financial System and Capital Market
foreign corporate/individual category cannot hold more than 5 per cent of
the paid up capital of the company.
The maximum permissible investment in the shares of a company, jointly
by all FIIs together is 24 per cent of the paid-up capital of that company.
The limit is 20 per cent of the paid-up capital in the case of public sector
banks. The ceiling of 24 per cent for FII investment can be raised up to
sectoral cap/statutory ceiling, subject to the approval of the board and the
general body of the company passing a special resolution to that effect.
A cap of US $1.75 billion is applicable to FII investment in dated
Government securities and treasury bills under 100 per cent and the 70:30
route. Within this ceiling of US $1.75 billion, a sub-ceiling of US $200
million is applicable for the 70:30 route. (FIIs are required to allocate their
investment between equity and debt instruments in the ratio of 70:30.
However, it is also possible for an FII to declare itself a 100 per cent debt
FII in which case it can make its entire investment in debt instruments.)
A cumulative sub-ceiling of US $500 million outstanding has been fixed
on FII investments in corporate debt and this is over and above the subceiling
of US $1.75 billion for Government debt.
(The limits on FII investments and trends in FII investments in India are presented in
Slide 12-13)
Growth of Indian Capital Market
The Indian equity market has developed tremendously since the 1990s.
The market has grown exponentially in terms of resource mobilisation, number
of listed stocks, market capitalisation, trading volumes, turnover and investors’
base. Along with this growth, the profiles of the investors, issuers and
intermediaries have changed significantly. The market has witnessed a
fundamental institutional change resulting in drastic reduction in transaction
costs and significant improvement in efficiency, transparency and safety. In the
1990s, reform measures initiated by the SEBI such as, market determined
allocation of resources, rolling settlement, sophisticated risk management and
Indian Financial System and Capital Market
derivatives trading have greatly improved the framework and efficiency of
trading and settlement. Almost all equity settlements take place at two
depositories. As a result, the Indian capital market has become qualitatively
comparable to many developed markets.
There are 23 stock exchanges in the country with 9413 listed companies as
at end-December 2004. The market capitalization of BSE has grown over the
period and is estimated at Rs.16,860 billion as at end-December 2004. (Slide 14).
(The comparative picture of Indian capital market with select country groups is
presented in Slide 15)
Latest Trends in Indian Stock Markets
Indian stock markets are currently trading at all-time high levels. The BSE
Sensex (a BSE index comprising 30 large-cap companies with Base: 1978-79=100)
closed at all-time high level of 7859.53 on August 17, 2005. On a point-to-point
basis, the BSE Sensex has gained 21.05 per cent during the current financial year
so far (up to August 17, 2005). The rally has been supported by strong investment
by the FIIs, satisfactory progress of monsoon, firm trends in the international
markets and satisfactory financial results by the corporates for Q1 2005-06.
The market capitalization of BSE increased by 24.3 per cent to Rs.21,112
billion (60.7 per cent of GDP) as on August 17, 2005 over the level of March 31,
2005. The market capitalization as a percentage of GDP has increased from 43.5
per cent as at end-March 2004 to 54.6 per cent as at end-March 2005 due mainly
to increase in the stock prices as well as listing of new securities.
Despite unprecedented price levels, the price-earning ratio for Indian
equities has remained attractive due to strong growth in corporate earnings. The
P/E ratio of BSE Sensex, however, is marginally higher than that in the other
emerging market economies, even though the ratio is much lower than that
witnessed in earlier stock market rallies in India.
The gains in the stock markets in the financial year so far have been
widespread among blue-chips as well as small and mid-cap stocks.
Indian Financial System and Capital Market
The Indian stock markets have outperformed the other markets. On pointto-
point basis, the BSE Sensex witnessed an increase of 21.05 per cent during
current financial year so far (up to August 17, 2005) over end-March 2005, as
compared with Hong Kong (14.3 per cent), Japan (5.2 per cent), UK (8.1 per cent),
US (Dow Jones – 0.4 per cent), South Korea (15.3 per cent), Taiwan (3.9 per cent),
Indonesia (3.1 per cent), and Malaysia (6.3 per cent).
(The latest trends in Indian stock markets are presented in Slide 16)
Payment and Settlement System
In recent years, the endeavour of the Reserve Bank has been to improve
the efficiency of the financial system by ensuring safe, secure and effective
payment and settlement system. In the process, the Reserve Bank apart from
performing the regulatory and oversight functions has also played an important
role in promoting its functionality and modernisation on an on-going basis. The
consolidation of the existing payment systems revolves around strengthening
computerised cheque clearing, expanding the reach of Electronic Clearing
Services (ECS) and Electronic Funds Transfer (EFT). The critical elements of the
developmental strategy are opening of new clearing houses, interconnection of
clearing houses through the Indian Financial Network (INFINET); development
of Real Time Gross Settlement (RTGS) System, Centralised Funds Management
System (CFMS), Negotiated Dealing System (NDS) and the Structured Financial
Messaging System (SFMS). Similarly, integration of the various payment
products with the systems of individual banks has been another thrust area. A
Board for Regulation and Supervision of Payment and Settlement Systems
(BPSS) has also been recently constituted to prescribe policies relating to the
regulation and supervision of all types of payment and settlement systems, set
standards for existing and future systems, authorise the payment and settlement
systems and determine criteria for membership to these systems.
(Issues in payment and settlement system are presented in Slide 17)
Indian Financial System and Capital Market
The Indian Financial Sector: Some Issues
The Indian financial system has undergone structural transformation over
the past decade. The financial sector has acquired strength, efficiency and
stability by the combined effect of competition, regulatory measures, and policy
environment. While competition, consolidation and convergence have been
recognised as the key drivers of the banking sector in the coming years,
consolidation of the domestic banking system in both public and private sectors
is being combined with gradual enhancement of the presence of foreign banks in
a calibrated manner. There has been improvement in banks’ capital position and
asset quality as reflected in the overall increase in their capital adequacy ratio
and declining NPLs, respectively. Significant improvement in various
parameters of efficiency, especially intermediation costs, suggest that
competition in the banking industry has intensified. The efficiency of various
segments of the financial system also increased.
The major challenges facing the banking sector are the judicious
deployment of funds and the management of revenues and costs. Concurrently,
the issues of corporate governance and appropriate disclosures for enhancing
market discipline have received increased attention for ensuring transparency
and greater accountability. Financial sector supervision is increasingly becoming
risk based with the emphasis on quality of risk management and adequacy of
risk containment. Consolidation, competition and risk management are no doubt
critical to the future of Indian banking, but governance and financial inclusion
have also emerged as the key issues for the Indian financial system.
(Issues facing the banking sector are presented in Slide 18).
The capital market in India has become efficient and modern over the
years. It has also become much safer. However, some of the issues would need
to be addressed. Corporate governance needs to be strengthened. Retail
investors continue to remain away from the market. The private corporate debt
market continues to lag behind the equity segment.
Indian Financial System and Capital Market
The Indian financial system comprises a set of financial institutions,
financial markets and financial infrastructure. The financial institutions mainly
consist of commercial and co-operative banks, regional rural banks (RRBs), all-
India financial institutions (AIFIs) and non-banking financial companies
(NBFCs). The banking sector which forms the bedrock of the Indian financial
system, falls under the regulatory ambit of the Reserve Bank of India under the
provisions of the Banking Regulation Act, 1949 and the Reserve Bank of India
Act, 1934. The Reserve Bank also regulates select AIFIs. Consequent upon
amendments to the Reserve Bank of India (Amendment) Act in 1997, a
comprehensive regulatory framework in respect of NBFCs was put in place in
January 1997.
The financial market in India comprises the money market, the
Government securities market, the foreign exchange market and the capital
market. A holistic approach has been adopted in India towards designing and
development of a modern, robust, efficient, secure and integrated payment and
settlement system. The Reserve Bank set up the Institute for Development and
Research in Banking Technology (IDRBT) in 1996, which is an autonomous
centre for technology capacity building for banks and providing core IT services.
(The structure of Indian financial system is presented in Slide 2).
Financial Institutions
Scheduled commercial banks (SCBs) occupy a predominant position in the
financial system accounting for around three fourths of the total assets in the
financial system. While the public sector banks (PSBs), consisting of eight banks
in the State Bank group and 19 nationalised banks, constitute almost threefourths
of the total assets of SCBs, the private sector banks, 30 in number,
2
constitute less than one-fifth of the total assets. The 33 foreign banks operating in
India account for about 6-7 per cent of the assets of SCBs. The 196 RRBs play a
critical role in extending credit to the poorer sections of the rural society. The
ownership of RRBs jointly vests with the Central Government, the State
Governments and the sponsor banks. The co-operative banking system, with two
broad segments of urban and rural co-operatives, forms an integral part of the
Indian financial system. While the urban co-operative banking system has a
single tier comprising the Primary Co-operative Banks (commonly known as
ʹurban co-operative banks – UCBs), the rural co-operative credit system is
divided into long-term and short-term co-operative credit institutions which
have a multi-tier structure.
The term-lending institutions are mostly Government-owned and have
been the traditional providers of long-term project loans. Non-Banking Financial
Companies (NBFCs) encompass an extremely heterogeneous group of
intermediaries and provide a gamut of financial services. Primary Dealers (PDs)
in the Government securities market constitutes a systemically important
segment of the NBFCs. At present, there are a total of 17 PDs playing active role
in the Government securities market. A majority of them are promoted by banks.
Apart from this, India has a well-established and vibrant insurance sector within
the financial system. The Insurance Regulatory and Development Agency
(IRDA) has been established to regulate and supervise the insurance sector.
(The structure of Indian financial institutions is presented in Slide 3).
Pre-reforms Phase
Indian Financial System and Capital Market
Until the early 1990s, the role of the financial system in India was
primarily restricted to the function of channelling resources from the surplus to
deficit sectors. Whereas the financial system performed this role reasonably well,
its operations came to be marked by some serious deficiencies over the years.
The banking sector suffered from lack of competition, low capital base, low
productivity and high intermediation cost. After the nationalisation of large
banks in 1969 and 1980, the Government-owned banks dominated the banking
3
sector. The role of technology was minimal and the quality of service was not
given adequate importance. Banks also did not follow proper risk management
systems and the prudential standards were weak. All these resulted in poor asset
quality and low profitability. Among non-banking financial intermediaries,
development finance institutions (DFIs) operated in an over-protected
environment with most of the funding coming from assured sources at
concessional terms. In the insurance sector, there was little competition. The
mutual fund industry also suffered from lack of competition and was dominated
for long by one institution, viz., the Unit Trust of India. Non-banking financial
companies (NBFCs) grew rapidly, but there was no regulation of their asset side.
Financial markets were characterised by control over pricing of financial assets,
barriers to entry, high transaction costs and restrictions on movement of
funds/participants between the market segments. This apart from inhibiting the
development of the markets also affected their efficiency.
Financial Sector Reforms in India
It was in this backdrop that wide-ranging financial sector reforms in India
were introduced as an integral part of the economic reforms initiated in the early
1990s with a view to improving the macroeconomic performance of the
economy. The reforms in the financial sector focussed on creating efficient and
stable financial institutions and markets. The approach to financial sector
reforms in India was one of gradual and non-disruptive progress through a
consultative process. The Reserve Bank has been consistently working towards
setting an enabling regulatory framework with prompt and effective supervision,
development of technological and institutional infrastructure, as well as
changing the interface with the market participants through a consultative
process. Persistent efforts have been made towards adoption of international
benchmarks as appropriate to Indian conditions. While certain changes in the
legal infrastructure are yet to be effected, the developments so far have brought
the Indian financial system closer to global standards.
(The major achievements of the financial sector reforms are presented in Slide 4).
4
The reform of the interest regime constitutes an integral part of the
financial sector reform. With the onset of financial sector reforms, the interest
rate regime has been largely deregulated with a view towards better price
discovery and efficient resource allocation. Initially, steps were taken to develop
the domestic money market and freeing of the money market rates. The interest
rates offered on Government securities were progressively raised so that the
Government borrowing could be carried out at market-related rates. In respect of
banks, a major effort was undertaken to simplify the administered structure of
interest rates. Banks now have sufficient flexibility to decide their deposit and
lending rate structures and manage their assets and liabilities accordingly. At
present, apart from savings account and NRE deposit on the deposit side and
export credit and small loans on the lending side, all other interest rates are
deregulated.
Indian banking system operated for a long time with high reserve
requirements both in the form of Cash Reserve Ratio (CRR) and Statutory
Liquidity Ratio (SLR). This was a consequence of the high fiscal deficit and a
high degree of monetisation of fiscal deficit. The efforts in the recent period have
been to lower both the CRR and SLR. The statutory minimum of 25 per cent for
SLR has already been reached, and while the Reserve Bank continues to pursue
its medium-term objective of reducing the CRR to the statutory minimum level
of 3.0 per cent, the CRR of SCBs is currently placed at 5.0 per cent of NDTL.
(Interest rate deregulation is presented in Slide 5)
As part of the reforms programme, due attention has been given to diversification
of ownership leading to greater market accountability and improved efficiency. Initially,
there was infusion of capital by the Government in public sector banks, which was
followed by expanding the capital base with equity participation by the private investors.
This was followed by a reduction in the Government shareholding in public sector banks
to 51 per cent. Consequently, the share of the public sector banks in the aggregate assets
of the banking sector has come down from 90 per cent in 1991 to around 75 per cent in
2004. With a view to enhancing efficiency and productivity through competition,
guidelines were laid down for establishment of new banks in the private sector and the
Indian Financial System and Capital Market
foreign banks have been allowed more liberal entry. Since 1993, twelve new private
sector banks have been set up. As a major step towards enhancing competition in the
banking sector, foreign direct investment in the private sector banks is now allowed up to
74 per cent, subject to conformity with the guidelines issued from time to time.
(Banking Sector: Competition and Efficiency is presented in Slide 6).
As a part of the financial sector reforms, the regulatory framework and
supervisory practices have almost converged with the best practices elsewhere in the
world. The minimum capital to risk assets ratio (CRAR) has been kept at nine per cent
which is one percentage point above the international norm; and additionally, banks are
required to maintain a separate Investment Fluctuation Reserve (IFR) out of profits,
towards interest rate risk. Impressive institutional and legal reforms have been
undertaken in relation to the banking sector. There have been a number of measures for
enhancing the transparency and disclosures standards. The regulatory framework in
India, in addition to prescribing prudential guidelines and encouraging market discipline,
is increasingly focusing on ensuring good governance through "fit and proper" owners,
directors and senior managers of the banks. Transfer of shareholding of five per cent and
above requires acknowledgement from the Reserve Bank and such significant
shareholders are put through a 'fit and proper' test. Banks have also been asked to ensure
that the nominated and elected directors are screened by a nomination committee to
satisfy `fit and proper' criteria. Directors are also required to sign a covenant indicating
their roles and responsibilities. The Reserve Bank has recently issued detailed guidelines
on ownership and governance in private sector banks emphasizing diversified ownership.
In 1994, a Board for Financial Supervision (BFS) was constituted comprising
select members of the Reserve Bank Board with a variety of professional expertise to
exercise 'undivided attention to supervision' and ensure an integrated approach to
supervision of commercial banks, development finance institutions, non-banking finance
companies, urban cooperatives banks and primary dealers. Certain amendments are being
considered by the Parliament to enhance Reserve Bank’s regulatory and supervisory
powers.
(Issues in regulation and supervision are presented in Slide 6).
Indian Financial System and Capital Market
Over the last few years, the several policy initiatives undertaken in the
form of recapitalisation of the weak RRBs, deregulation of deposits and lending
rates and relaxation to lend to non-target groups, have improved their
operational efficiency, governance and regulation and brought them almost at
par with the rural branches of commercial banks.
The co-operative banks besides suffering from the problem of multiple
supervisory authorities, also face the challenge of reconciling the democratic
character with financial discipline and modernising systems and procedures. The
Task Force on Cooperatives constituted by the Government (December 2004) has
made several suggestions for the revival of the sector to be implemented in
consultation with the State Governments. The Reserve Bank has adopted a
cautious approach regarding granting licenses for new banks and branches of
urban cooperative banks (UCBs), while focussing on consolidation within the
sector through mergers and amalgamations. In addition, initiatives have been
undertaken to gradually tighten the prudential norms for regulation and
supervision of UCBs. As a prelude to revamping the sector, a vision document
for UCBs has been released by the Reserve Bank, highlighting the importance of
a differentiated regulatory regime for the sector.
The ongoing restructuring of AIFIs is evident in the recent conversion of
Industrial Credit and Investment Corporation of India (ICICI) and Industrial
Development Bank of India (IDBI) into banks. The Board of Directors of
Industrial Finance Corporation of India (IFCI) Ltd. have approved, in principle,
the merger with a bank. In view of the deteriorating financial position of
Industrial Investment Bank of India (IIBI) Ltd., the Government has undertaken a
programme of restructuring its liabilities. Apart from Infrastructure
Development Finance Company Ltd. (IDFC), there are three refinancing
institutions viz., National Bank of Agriculture and Rural Development
(NABARD), Small Industries Development Bank of India (SIDBI) and National
Indian Financial System and Capital Market
Housing Bank (NHB), and EXIM Bank. At the State level, the State Financial
Corporations registered under the State Financial Corporations Act, 1951 and the
State Industrial Development Corporations (SIDCs) - purvey credit to
industries/sectors in different States. On balance, the development financial
institution (DFI) model has become increasingly unsustainable and AIFIs are fast
adopting the business model of a bank for long-term commercial viability.
Non-Banking Financial Companies (NBFCs) encompass an extremely
heterogeneous group of intermediaries. The main area of concern has been the
substantial growth in deposits of the Residuary Non-Banking Companies
(RNBCs), with just two companies accounting for more than 80 per cent of the
total deposits held by NBFCs. The Indian banking sector is gradually heading
towards consolidation of core competencies of different financial intermediaries,
which would engender greater economic efficiency in the form of lower
transaction cost, and greater product sophistication.
Financial System: Current Status
There has been a notable reduction in the ratio of non-performing assets
(NPAs) to advances in response to various initiatives, such as, improved risk
management practices and greater recovery efforts driven, inter alia, by the
recently enacted Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI) Act, 2002. The financial
performance of most of the PSBs has improved in recent times as reflected in
their comfortable capital adequacy ratios and declining NPL ratios. The CRAR in
respect of all categories of banks has improved. New private sector banks have
displayed impressive performance particularly in terms of efficiency and
customer service (Table 1).
Indian Financial System and Capital Market
Table 1: Select Financial Sector Indicators: 2002-03 vis-a-vis 2003-04
Financial Indicator 2002-03 2003-04
Entity
1 2 3 4
1. a) Growth in Major Aggregates (Per cent)
Aggregate Deposits 13.4 * 17.5
Scheduled
Commercial
Banks Non-food Credit 18.6 * 18.4
Investment in Government Securities 27.3 25.1
b) Financial Indicators (as percentage of total assets)
Operating Profits 2.4 2.7
Net Profits 1.0 1.1
Spread 2.8 2.9
c) Non-Performing Assets (as percentage of advances)
Gross NPAs 8.8 7.2
Net NPAs 4.4 2.9
d) CRAR 12.7 12.9
2. a) Growth in Major Aggregates (Per cent)
Deposits 9.1 8.6
Credit 4.5 4.0
b) Financial Indicators (as percentage of total assets)@
Operating Profits 1.4 2.1
Net Profits -1.1 0.9
Spread 2.1 2.7
c) Non-Performing Assets (as percentage of advances)
Gross NPA 21.0 28.9
Scheduled
Urban
Co-operative
Banks
d) CRAR N.A. N.A.
3. All-India a) Growth in Major Aggregates (per cent)1
Financial Sanctions -31.3 65.2
Institutions Disbursements -30.5 25.9
b) Financial Indicators (as percentage of total assets) 2
Operating Profits 1.4 1.3
Net Profits 0.9 0.9
Spread 0.7 0.2
c) Non-Performing Assets (as percentage of advances) 2
Net NPA 10.6 N.A.
Indian Financial System and Capital Market
d) CRAR
i) IDBI 18.7 18.3
ii) IFCI 0.95 -17.0
iii) SIDBI 44.0 51.6
iv) NABARD 39.1 39.4
v) IDFC 51.3 36.9
4. a) Growth in Major Aggregates (per cent)
Public Deposits 6.8 —
Non-banking
Financial
Companies b) Financial Indicators (as percentage of total assets)
Net Profits 0.9 —
c) Non-Performing Assets (as percentage of advances)3
Net NPA 2.9 N.A.
CRAR 93.7#
*Adjusted for merger. @ Relates to scheduled urban co-operative banks.
# percentage of NBFCs above 30 per cent CRAR.
1. Comprise IDBI, IFCI, IIBI, IDFC, SIDBI, IVCF, ICICI Venture, TFCI, LIC, UTI, and GIC.
2. Comprise following nine FIs, viz., IDBI, IFCI, IIBI, IDFC, Exim Bank, TFCI, SIDBI, NABARD and NHB.
3. For reporting companies with variations in coverage.
Financial Markets
A major objective of reforms in the financial sector was to develop various
segments of the financial market as also eliminate segmentation across various markets
in order to smoothen the process of transmission of impulses across markets, easing the
liquidity management process and making resource allocation process more efficient
across the economy. The strategy adopted for meeting these objectives involved removal
of restrictions on pricing of assets, building the institutional structure and technological
infrastructure, introduction of new instruments, and fine-tuning of the market
microstructure. The 1990s saw the significant development of various segments of the
financial market. At the short end of the spectrum, the money market saw the emergence
of a number of new instruments such as CP and CDs and derivative products including
FRAs and IRS. Repo operations, which were introduced in the early 1990s and later
refined into a Liquidity Adjustment Facility, allow the Reserve Bank to modulate
liquidity and transmit interest rate signals to the market on a daily basis. The process of
financial market development was buttressed by the evolution of an active government
securities market after the Government borrowing programme was put through the
auction process in 1992-93. The development of a market for Government paper enabled
the Reserve Bank to modulate the monetisation of the fiscal deficit. The foreign
exchange market deepened with the opening up of the economy and the institution of a
market-based exchange rate regime in the early 1990s. Although there were occasional
Indian Financial System and Capital Market
episodes of volatility in the foreign exchange market, these were swiftly controlled by
appropriate policy measures. The capital market also underwent some metamorphic
changes during the 1990s. The development of the financial markets was well supported
by deregulation of balance sheet restrictions in respect of financial institutions, allowing
them to operate across markets. This resulted in increased integration among the various
segments of the financial markets.
Overview of Indian Capital Market
The Indian capital market is more than a century old. Its history goes back
to 1875, when 22 brokers formed the Bombay Stock Exchange (BSE). Over the
period, the Indian securities market has evolved continuously to become one of
the most dynamic, modern, and efficient securities markets in Asia. Today,
Indian market confirms to best international practices and standards both in
terms of structure and in terms of operating efficiency.
Indian securities markets are mainly governed by a) The Company’s Act
1956, b) the Securities Contracts (Regulation) Act 1956 (SCRA Act), and c) the
Securities and Exchange Board of India (SEBI) Act, 1992. A brief background of
these above regulations are given below
a) The Companies Act 1956 deals with issue, allotment and transfer of
securities and various aspects relating to company management. It
provides norms for disclosures in the public issues, regulations for
underwriting, and the issues pertaining to use of premium and discount
on various issues.
b) SCRA provides regulations for direct and indirect control of stock
exchanges with an aim to prevent undesirable transactions in securities. It
provides regulatory jurisdiction to Central Government over stock
exchanges, contracts in securities and listing of securities on stock
exchanges.
Indian Financial System and Capital Market
c) The SEBI Act empowers SEBI to protect the interest of investors in the
securities market, to promote the development of securities market and to
regulate the security market.
The Indian securities market consists of primary (new issues) as well as
secondary (stock) market in both equity and debt. The primary market provides
the channel for sale of new securities, while the secondary market deals in
trading of securities previously issued. The issuers of securities issue (create and
sell) new securities in the primary market to raise funds for investment. They do
so either through public issues or private placement. There are two major types
of issuers who issue securities. The corporate entities issue mainly debt and
equity instruments (shares, debentures, etc.), while the governments (central and
state governments) issue debt securities (dated securities, treasury bills). The
secondary market enables participants who hold securities to adjust their
holdings in response to changes in their assessment of risk and return. A variant
of secondary market is the forward market, where securities are traded for future
delivery and payment in the form of futures and options. The futures and
options can be on individual stocks or basket of stocks like index. Two
exchanges, namely National Stock Exchange (NSE) and the Stock Exchange,
Mumbai (BSE) provide trading of derivatives in single stock futures, index
futures, single stock options and index options. Derivatives trading commenced
in India in June 2000 (Slide 7).
Major Reforms in the Indian Capital Market
The major reforms in the Indian capital market since the 1990s are
presented below:
As a first step to reform the capital market, the Securities and Exchange
Board of India (SEBI), which was earlier set up in April 1988 as a nonstatutory
body under an administrative arrangement, was given statutory
powers in January 1992 through an enactment of the SEBI Act, 1992 for
regulating the securities markets. Twin objectives mandated in the SEBI
Indian Financial System and Capital Market
Act are investor protection and orderly development of the capital
market.
The most significant development in the primary capital market has been
the introduction of free pricing. The issuers of securities are now allowed
to raise the capital from the market without requiring any consent from
any authority either for making the issue or for pricing it. However, the
issue of capital has been brought under SEBI’s purview in that issuers are
required to meet the SEBI guidelines for Disclosure and Investor
Protection, which, in general, cover the eligibility norms for making issues
of capital (both public and rights) at par and at a premium by various
types of companies, reservation in issues, etc.
The abolition of capital issues control and the freeing of the pricing of
issues led to unprecedented upsurge of activity in the primary capital
market as the corporates mobilised huge resources. It, inter alia, exposed
certain inadequacies of the regulations. Therefore, without seeking to
control the freedom of the issuers to enter the market and freely price
their issues, the SEBI further strengthened the norms for public issues in
April 1996. Alongside, SEBI raised the standards of disclosure in public
issues to enhance their transparency for improving the levels of investor
protection. Issuers of capital are now required to disclose information on
various aspects, such as, track record of profitability, risk factors, etc.
Issuers now also have the option of raising resources through fixed price
floatations or the book building process.
Trading infrastructure in the stock exchanges has been modernised by
replacing the open outcry system with on-line screen based electronic
trading, unlike several of the developed countries where the two systems
still continue to exist on the same exchange. In all, 23 stock exchanges in
India have approximately 8,000 trading terminals spread all over the
country. This improved the liquidity of the Indian capital market and a
better price discovery.
Indian Financial System and Capital Market
The trading and settlement cycles were initially shortened from 14 days to
7 days. Subsequently, to further enhance the efficiency of the secondary
market, rolling settlement was introduced on a T+5 basis. With effect from
April 1, 2002, the settlement cycle was further shortened to T+3 for all
listed securities. The settlement cycle is now T+2.
All stock exchanges in the country have established clearing houses.
Consequently, all transactions are settled through the clearing house only
and not directly between members, as was practiced earlier.
Several measures have been undertaken/strengthened to ensure the safety
and integrity of the market. These are: margining system, intra-day
trading limit, exposure limit and setting up of trade/settlement guarantee
fund.
Securities, which were earlier held in physical form, have been
demateralised and their transfer is done through electronic book entry,
which has eliminated some of the disadvantages of securities held in
physical form. There are two depositories operating in the country.
In India, all listed companies are now required to furnish to the stock
exchanges and also publish unaudited financial results on a quarterly
basis. To enhance the level of continuous disclosure by the listed
companies, the SEBI decided to amend the Listing Agreement to
incorporate the Segment Reporting, Accounting for Taxes on Income,
Consolidated Financial Results, Consolidated Financial Statements,
Related Party Disclosures and Compliance with Accounting Standards.
The Indian capital market is also increasingly integrating with the
international capital markets. One of the significant steps towards
integrating Indian capital market with the international capital markets
was the permission given to Foreign Institutional Investors (FIIs) such as,
mutual funds, pension funds and country funds to operate in the Indian
markets. Indian firms have also been allowed to operate in the Indian
markets. Indian firms have also been allowed to raise capital from
Indian Financial System and Capital Market
international capital markets through issues of Global Depository Receipts
(GDRs), American Depository Receipts (ADRs), Euro Convertible Bonds
(ECBs), etc.
Boards of various stock exchanges, which in the past included mainly
brokers, have been broad-based in order to make them more widely
representative so that they represent different interests and not just the
interests of their members. Reconstituted Governing Boards have now
broker and non-broker representation in the ratio of 50-50 apart from the
Executive Director who has a seat on the Board and is required to be a
non-broker professional. To remove the influence of brokers in the
functioning of stock exchanges, the SEBI decided that no broker member
of the stock exchange shall be an office bearer of an exchange or hold the
position of President, Vice President, Treasurer, etc. Efforts are afoot to
demutualise and corporatise the stock exchanges.
Apart from stock exchanges, various intermediaries, such as mutual
funds, stock brokers and sub-brokers merchant bankers, portfolio
managers, registrars to an issue and share transfer agents, underwriters,
debenture trustees, bankers to an issue, custodian of securities, venture
capital funds and issuers have been brought under the SEBI’s regulatory
purview.
There are now regulations in place governing substantial acquisition of
shares and takeovers of companies. The Regulations are aimed at making
the takeover process more transparent and to protect the interests of
minority shareholders.
Trading in derivative products, such as stock index future, stock index
options and futures and options in individual stocks have also been
introduced.
(The major reforms in Indian capital market are presented in Slide 8-11)
Indian Financial System and Capital Market
Foreign Institutional Investment in India
The liberalisation and consequent reform measures have drawn the
attention of foreign investors leading to a rise in portfolio investment in the
Indian capital market. Over the recent years, India has emerged as a major
recipient of portfolio investment among the emerging market economies. Apart
from such large inflows, reflecting the confidence of cross-border investors on
the prospects of Indian securities market, except for one year, India received
positive portfolio inflows in each year. The stability of portfolio flows towards
India is in contrast with large volatility of portfolio flows in most emerging
market economies.
The Indian capital market was opened up for foreign institutional
investors (FIIs) in 1992. The FIIs started investing in Indian markets in January
1993. The Indian corporate sector has been allowed to tap international capital
markets through American Depository Receipts (ADRs), Global Depository
Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and External
Commercial Borrowings (ECBs). Similarly, non-resident Indians (NRIs) have
been allowed to invest in Indian companies. FIIs have been permitted in all types
of securities including Government securities and they enjoy full capital
convertibility. Mutual funds have been allowed to open offshore funds to invest
in equities abroad.
FII investment in India started in 1993, as FIIs were allowed to invest in
the Indian debt and equity market in line with the recommendations of the High
Level Committee on Balance of Payments. These investment inflows have since
then been positive, with the exception of 1998-99, when capital flows to emerging
market economies were affected by contagion from the East Asian crisis. These
investments account for over 10 per cent of the total market capitalisation of the
Indian stock market.
Limits on Foreign Institutional Investors
Each FII (investing on its own) or sub-account cannot hold more than 10
per cent of the paid-up capital of a company. A sub-account under the
Indian Financial System and Capital Market
foreign corporate/individual category cannot hold more than 5 per cent of
the paid up capital of the company.
The maximum permissible investment in the shares of a company, jointly
by all FIIs together is 24 per cent of the paid-up capital of that company.
The limit is 20 per cent of the paid-up capital in the case of public sector
banks. The ceiling of 24 per cent for FII investment can be raised up to
sectoral cap/statutory ceiling, subject to the approval of the board and the
general body of the company passing a special resolution to that effect.
A cap of US $1.75 billion is applicable to FII investment in dated
Government securities and treasury bills under 100 per cent and the 70:30
route. Within this ceiling of US $1.75 billion, a sub-ceiling of US $200
million is applicable for the 70:30 route. (FIIs are required to allocate their
investment between equity and debt instruments in the ratio of 70:30.
However, it is also possible for an FII to declare itself a 100 per cent debt
FII in which case it can make its entire investment in debt instruments.)
A cumulative sub-ceiling of US $500 million outstanding has been fixed
on FII investments in corporate debt and this is over and above the subceiling
of US $1.75 billion for Government debt.
(The limits on FII investments and trends in FII investments in India are presented in
Slide 12-13)
Growth of Indian Capital Market
The Indian equity market has developed tremendously since the 1990s.
The market has grown exponentially in terms of resource mobilisation, number
of listed stocks, market capitalisation, trading volumes, turnover and investors’
base. Along with this growth, the profiles of the investors, issuers and
intermediaries have changed significantly. The market has witnessed a
fundamental institutional change resulting in drastic reduction in transaction
costs and significant improvement in efficiency, transparency and safety. In the
1990s, reform measures initiated by the SEBI such as, market determined
allocation of resources, rolling settlement, sophisticated risk management and
Indian Financial System and Capital Market
derivatives trading have greatly improved the framework and efficiency of
trading and settlement. Almost all equity settlements take place at two
depositories. As a result, the Indian capital market has become qualitatively
comparable to many developed markets.
There are 23 stock exchanges in the country with 9413 listed companies as
at end-December 2004. The market capitalization of BSE has grown over the
period and is estimated at Rs.16,860 billion as at end-December 2004. (Slide 14).
(The comparative picture of Indian capital market with select country groups is
presented in Slide 15)
Latest Trends in Indian Stock Markets
Indian stock markets are currently trading at all-time high levels. The BSE
Sensex (a BSE index comprising 30 large-cap companies with Base: 1978-79=100)
closed at all-time high level of 7859.53 on August 17, 2005. On a point-to-point
basis, the BSE Sensex has gained 21.05 per cent during the current financial year
so far (up to August 17, 2005). The rally has been supported by strong investment
by the FIIs, satisfactory progress of monsoon, firm trends in the international
markets and satisfactory financial results by the corporates for Q1 2005-06.
The market capitalization of BSE increased by 24.3 per cent to Rs.21,112
billion (60.7 per cent of GDP) as on August 17, 2005 over the level of March 31,
2005. The market capitalization as a percentage of GDP has increased from 43.5
per cent as at end-March 2004 to 54.6 per cent as at end-March 2005 due mainly
to increase in the stock prices as well as listing of new securities.
Despite unprecedented price levels, the price-earning ratio for Indian
equities has remained attractive due to strong growth in corporate earnings. The
P/E ratio of BSE Sensex, however, is marginally higher than that in the other
emerging market economies, even though the ratio is much lower than that
witnessed in earlier stock market rallies in India.
The gains in the stock markets in the financial year so far have been
widespread among blue-chips as well as small and mid-cap stocks.
Indian Financial System and Capital Market
The Indian stock markets have outperformed the other markets. On pointto-
point basis, the BSE Sensex witnessed an increase of 21.05 per cent during
current financial year so far (up to August 17, 2005) over end-March 2005, as
compared with Hong Kong (14.3 per cent), Japan (5.2 per cent), UK (8.1 per cent),
US (Dow Jones – 0.4 per cent), South Korea (15.3 per cent), Taiwan (3.9 per cent),
Indonesia (3.1 per cent), and Malaysia (6.3 per cent).
(The latest trends in Indian stock markets are presented in Slide 16)
Payment and Settlement System
In recent years, the endeavour of the Reserve Bank has been to improve
the efficiency of the financial system by ensuring safe, secure and effective
payment and settlement system. In the process, the Reserve Bank apart from
performing the regulatory and oversight functions has also played an important
role in promoting its functionality and modernisation on an on-going basis. The
consolidation of the existing payment systems revolves around strengthening
computerised cheque clearing, expanding the reach of Electronic Clearing
Services (ECS) and Electronic Funds Transfer (EFT). The critical elements of the
developmental strategy are opening of new clearing houses, interconnection of
clearing houses through the Indian Financial Network (INFINET); development
of Real Time Gross Settlement (RTGS) System, Centralised Funds Management
System (CFMS), Negotiated Dealing System (NDS) and the Structured Financial
Messaging System (SFMS). Similarly, integration of the various payment
products with the systems of individual banks has been another thrust area. A
Board for Regulation and Supervision of Payment and Settlement Systems
(BPSS) has also been recently constituted to prescribe policies relating to the
regulation and supervision of all types of payment and settlement systems, set
standards for existing and future systems, authorise the payment and settlement
systems and determine criteria for membership to these systems.
(Issues in payment and settlement system are presented in Slide 17)
Indian Financial System and Capital Market
The Indian Financial Sector: Some Issues
The Indian financial system has undergone structural transformation over
the past decade. The financial sector has acquired strength, efficiency and
stability by the combined effect of competition, regulatory measures, and policy
environment. While competition, consolidation and convergence have been
recognised as the key drivers of the banking sector in the coming years,
consolidation of the domestic banking system in both public and private sectors
is being combined with gradual enhancement of the presence of foreign banks in
a calibrated manner. There has been improvement in banks’ capital position and
asset quality as reflected in the overall increase in their capital adequacy ratio
and declining NPLs, respectively. Significant improvement in various
parameters of efficiency, especially intermediation costs, suggest that
competition in the banking industry has intensified. The efficiency of various
segments of the financial system also increased.
The major challenges facing the banking sector are the judicious
deployment of funds and the management of revenues and costs. Concurrently,
the issues of corporate governance and appropriate disclosures for enhancing
market discipline have received increased attention for ensuring transparency
and greater accountability. Financial sector supervision is increasingly becoming
risk based with the emphasis on quality of risk management and adequacy of
risk containment. Consolidation, competition and risk management are no doubt
critical to the future of Indian banking, but governance and financial inclusion
have also emerged as the key issues for the Indian financial system.
(Issues facing the banking sector are presented in Slide 18).
The capital market in India has become efficient and modern over the
years. It has also become much safer. However, some of the issues would need
to be addressed. Corporate governance needs to be strengthened. Retail
investors continue to remain away from the market. The private corporate debt
market continues to lag behind the equity segment.
Indian Financial System and Capital Market
Nature of Costs in Finance
Nature of Costs
The term cost is used in a wide variety of ways. As a result, the term can become quite confusing.In ordinary speech, we often equate costs with effort, regardless of whether there is a dollar
component. For instance, we say that it costs a lot to run a marathon, meaning that it takes a lot
of energy measured in gallons of sweat and sore, aching muscles afterwards.
Economists like to equate the term with opportunity costs. In this approach, costs are defined by
alternative actions. By choosing action A one has chosen not to take action B. The cost of
choosing A, economists say, is the value of the benefit that one could have enjoyed from
choosing B.
Example: By electing to come to school, one has chosen not to be a full-time employee. The
opportunity cost of being in school is the salary you could have been earning.
Accountants focus their attention on the dollar cash costs of an activity. Using the previous
example, they would ignore the personal costs associated with the pain of learning, staying up late
before an examination, and the like. They would ignore the salary that a full-time student
foregoes. The only costs that the accountant tracks are the tuition and fees that one pays.
Instead of making alternative B, the road not taken, a cost of alternative A, accountants tend to
list the two alternatives side by side and to see which dollar costs change as one considers one
alternative and then the other. Those costs that change are called differential costs. Those costs
that increase are called incremental costs.
In financial accounting, the costs that the accountant tracks are recognized when incurred. An
elaborate system of accruing revenues and expenses is set up to do this. In managerial accounting,
for reasons that are not entirely clear, there is a tendency to focus on cash costs only i.e., on
receipts and disbursements. This makes things a little easier but, as we shall see later, is not
necessary. Even though it is unusual, one can handle accrued costs in managerial accounting just
like cash costs.
Financial accounting is oriented more towards the past than is managerial accounting. For
instance, the depreciation expense on a machine acquired years ago is included in the calculation
of net income. Managerial accountants tend to exclude past costs on grounds that they are sunk
costs, meaning that they are done and gone and have no effect on a decision. All decisions should
be based upon future costs, not past costs. Sunk costs are irrelevant.
Example: A meal plan, once paid for, is a sunk cost. Its cost should have no effect on one’s
decision to eat a hamburger in the school cafeteria rather than a pizza. The cost of the meal plan
should have no bearing on whether one chooses to eat a hamburger or a pizza off campus either.
In fact, since the decision to eat on or off campus will have absolutely no effect on the cost of the
meal plan already paid for, that decision too is independent of the initial cost. The meal plan is in
every way a sunk cost.
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It is often convenient in accounting to distinguish between direct costs and indirect costs. Direct
costs are those that can be traced directly to a product, a service, a person, a business department,
and activity or more generally a cost object, which is an accounting term for the “object” that one
is trying to cost. The ingredients that go into a meal are a direct cost of that meal as is the labor of
the chef. Indirect costs are costs that are associated with a product or service but only indirectly.
The maitre d’ at a restaurant is an important part of the ambience of a meal, but his or her salary
is not a direct cost of any particular meal. Indirect costs are often called overhead.
Whether a particular cost is direct or indirect depends upon the object that one is costing. Our
Dean is a direct cost of the School, but an indirect cost of the accounting department. The
President is a direct cost of the University, but an indirect cost of the School. All costs that are
direct costs of a lower level object, such as a department, remain direct costs of higher level
objects, such as the School. Costs that are indirect to a higher level object, such as the School,
remain indirect to a lower level object, such as a department in the School.
For financial accounting reasons, more than managerial accounting reasons, accountants
distinguish between product costs and period costs. Essentially, product costs are those that are
associated with making a product or preparing a service; period costs are those that are associated
with administering the business or selling the product or service. Advertising is a classic period
cost; the raw material that goes into a product is a classic product cost.
The terms product and period as well as direct and indirect derive from the world of
manufacturing. The goal is to produce an income statement that has a cost of goods sold,
consisting of all product costs, segregated from selling, administrative and financial expenses,
making up all the period costs. This is the origin of the terms – we argue by analogy when using
these terms in a service business such as a hospital.
As a general rule, all manufacturing costs are product costs i.e., all costs incurred inside the factory
are product costs. This includes the labor of all factory employees, including the Vice-President of
Manufacturing; all the materials and supplies that are used; the cost of trucking materials to the
factory; insurance, light, rent and so on for the factory. It also includes things like cafeteria costs
in the factory and the salaries of managerial accountants employed in the factory. All costs that
are incurred in the business but outside the walls of the factory are period costs. The salaries of
financial accountants, for instance, are period costs and part of administrative expenses.
The result of these classifications is a 2 x 2 of product versus period costs and direct versus indirect
costs. The material used in making a product is a direct, product cost as is the labor of the worker
who actually shapes the product. The salary of a factory foreman is an indirect, product cost. Most
period costs are by definition indirect costs although the advertizing associated with a specific
product is a direct cost as is the commission paid to a sales person for selling a specific product. In
the parlance of textbook accounting:
Direct material = Cost of material used in making a product
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Direct labor = Cost of labor of a person making a product
Indirect labor = Cost of labor of a person supervising the making of products
Indirect material = Cost of supplies used making products e.g., cleaning rags
Overhead = All indirect costs, typically referring just to manufacturing costs
Direct material and direct labor are called prime costs. Direct labor and manufacturing overhead,
that is all the costs incurred in turning raw material into finished goods, are called conversion costs.
Direct materials, direct labor and manufacturing overhead constitute what accountants call the
full cost of a product and are all charged to inventory. They are, therefore, also called inventoriable
costs. Inventoriable costs make their way into the income statement at the time a product is sold
in the form of cost of goods sold.
Task: Classify the following costs as product or period costs.
1. Secretarial support to sales department.
2. Magazine subscriptions for factory lunch room.
3. Depreciation on delivery vans.
4. Insurance on finished goods.
5. Fringe benefits of factory workers.
Task: Classify the following costs as direct or indirect costs. In each case, state to what cost object
the cost is direct or indirect.
1. Rent on factory building.
2. Syrup used in soft-drinks.
3. Janitorial supplies in a factory.
4. Office supplies for the Vice-President of Finance.
5. Cost of workers installing a picture tube in a TV set.
How the Stock Market Works
How the Stock Market Works
Why Do Companies Issue Stock?Companies throughout the world issue new stock shares every day. But what is stock, and why does a company issue it? To help you to better understand these important concepts in this tutorial we will discuss:
• What is Capital?
• Equity vs. Debt
• Why Do Corporations Issue Stock?
• Advantages for Stock Holders
Let us begin by defining the word capital.
What Is Capital?
Let's imagine that you decide to start up your own ice cream shop business. You will need to invest in equipment, food supplies and property. All the money that you invest to start your business is called capital. Essentially, the capital of a business consists of all of its assets (or items to assist in the creation of wealth).
What if it dawns on you that you don't have enough cash to buy all the needed assets? Let's see how new businesses and companies deal with this problem.
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Equity vs. Debt
To start a new business (or fund a new project) a company can raise money in two ways - by selling shares of equity or by incurring debt. If the owner of our ice cream parlor invested all their own savings to buy the materials necessary to start the business, they made an equity investment in the company. Equity is simply ownership of a corporation. Typically, ownership units in a corporation are referred to as stock.
However, if our owner did not have necessary funds to start their own business they could finance their operation in one of two ways:
1. Issue stock (or certificates of partial ownership in his company) to people who may be interested in helping their venture out in return for a proportional share of the profits that the company might generate.
2. Borrow money that will need to be paid back with interest.
So, what are the advantages of selling stock?
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Why Do Corporations Issue Stock?
Businesses issue stock to raise capital.
Advantages of issuing stock:
1. A Company can raise more capital than it could borrow.
2. A Company does not have to make periodic interest payments to creditors.
3. A Company does not have to make principal payments.
Disadvantages of Issuing Stock:
1. The principal owners have to share their ownership with other shareholders.
2. Shareholders have a voice in policies that affect the company operations.
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Advantages for Stockholders
As part owner of a corporation, you may be entitled to share in the profits of the company. There is also a chance that the company will grow and the price of the stock may rise.
If the company achieves economic success, the stock value will go up and stockholders will benefit. For example, if you invested $1,000 to buy 100 shares of a company at $10 each and the shares rose to $13 each you would gain $300. This is equivalent to a 30% return. In cases like this, both the stockholders and the business would be pleased.
Initial Public Offerings (IPOs)
The very first sale of stocks to the public is called an initial public offering (IPO), and occurs on the primary market. This tutorial will cover the following factors involved in initial public offerings:
• The Process of Issuing Securities
• The Basics of Underwriting
• Types of Underwriting Arrangements
• The Prospectus
• Ways a Stock May Be Advertised Before it is Sold
• Newly Issued Stocks: Getting the Names Straight
The Process of Issuing Securities
Corporations sell stock to the public as one way to raise capital. Before it can issue new stock, a corporation must first file registration statements with the Securities and Exchange Commission (SEC) www.sec.gov. A twenty-day wait is required before it can sell the stocks.
The issuing company may make their registration statement public with a preliminary prospectus called a red herring that summarizes the registration statement. Basic information about the new offering is also provided, including how many shares are being offered and which brokerage companies will distribute the stock to the public. At the time of issue, a final prospectus is presented. This includes the price of the stock (its offering price).
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The Basics of Underwriting
A Corporation going public hires an investment banker to help it sell its stock. This process is called underwriting. The investment banker functions as an intermediary between the issuing corporation and the public. In most cases, the underwriter (investment banker) purchases the stocks from the company for resale to the public. To reduce its own risk, the investment banker may form an underwriting syndicate of other investment bankers to co-purchase the shares. The underwriting syndicate forms a selling group to sell specified allotments of the issue. The investment banker (underwriting syndicate) then marks up the price of the offering. This markup represents the fee for the syndicate's service. The difference between the price the underwriter pays and the price the public pays is called the underwriting spread.
The syndicate manager may bid on the stock in the offering to "stabilize" the price. This bid must be less than or equal to the offering price. By law, the prospectus must make this attempt to stabilize the stock price known to the public.
The SEC also requires the underwriter to investigate the issuing company-particularly any audits, how it uses proceeds, its financial statements and the management team. This process is called due diligence.
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Types of Underwriting Arrangements
A stock issue can be underwritten by several methods.
The underwriter can act as an agent, in which it tries to sell as much of the issue as it can at market prices. This is a best effort arrangement.
The issuing company can also agree to issue new stock on the condition that all of it is sold. If all of the stock is not sold, then it will withdraw the issue. This is an all-or-none arrangement.
A negotiated underwriting is when the issuer and the corporation negotiate the terms of the issue, the price, the size and other details.
The issue may be subject to competitive bids from investment bankers. The top bidder underwrites the issue and resells it to the public.
When a public company issues more of its stock, it must first offer that stock to existing shareholders; that is their preemptive right. A standby is the public sale of whatever stock the existing shareholders have not yet purchased.
A firm commitment arrangement is when an investment banker buys all of the stock from the corporation and then resells it to the public at a higher price.
A private placement is an offering in which the company sells to private investors and not to the public. Private placements do not have registration fees.
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The Prospectus
Prospectuses are legal documents that explain the financial facts important to an offering. They must precede or accompany the sale of a primary offering. The law requires companies selling
primary offerings to send prospectuses to anyone who wants to buy a primary offering. Prospectuses may also be used to solicit orders. Customers should read a prospectus carefully before purchasing any primary offering.
Prospectuses include but are not limited to the following:
• Offering price
• Legal opinions about the issue
• Underwriting method
• The history of the company
• Other costs related to investing in the stock
• The management team
• The handling of proceeds
The prospectus must be provided to customers before they complete any transactions. It must also include the SEC's disclaimers that it does not approve or disapprove of the stock being offered, and that it does not judge the prospectus' statements for accuracy.
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Ways an Issue May Be Advertised Before it is Sold
A new issue of stock is allowed to be advertised before it is actually sold, although it may not be sold during the actual registration period.
Registered representatives are allowed to accept oral solicitations from clients. They are not allowed to sell any shares of the new stock. Neither are they allowed to affirm any offers of sale.
Registered representatives may send red herrings, or preliminary prospectuses, to clients. Information in these documents will discuss why the stock is being sold and the offering timetable. Red herrings are only issued for information purposes.
Tombstone advertisements are ads that announce the new stock. Their sole purpose is to function as communication. They are not prospectuses. They are called tombstones because they provide prospective buyers with the "bare bones" information: the name of the stock, the issuer and how to obtain a red herring.
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Newly Issued Stocks: Getting the Names Straight
Two aspects of IPOs deserve special attention: hot issues and the so-called "when, as, and if-issued" stocks.
A hot issue is a security sold by broker-dealers on the secondary market just after it is first issued.
New stock may not be sold until after the registration period has expired. If the stock has not been issued by that time, it may be sold conditionally as a "When, as, and if-issued" stock. Should it fail to be issued, all buys, sells, earnings and losses will be canceled.
This concludes the introductory tutorial on initial public offerings. For more information on investing in IPOs check out the tutorial titled Investing in Initial Public Offerings.
Stock Market Players
As an investor, you need to be familiar with the different players in the investment arena and how they buy and sell securities. Broker-dealers, registered representatives and the others have specific roles in clearing the way for commerce in securities.
This tutorial will cover the following topics:
• Broker-Dealers
• What Broker-Dealers Are Not Allowed to Do
• Other Broker Services
• Registered Representatives, Market Makers and Specialists
Broker-Dealers
A broker is a person or firm that facilitates trades between customers. A broker acts as a go-between and, in doing so, does not assume any risk for the trade. The broker does, however, charge a commission. A dealer is a person or firm that buys and sells for his or her own inventory of securities and for others. A dealer therefore assumes risk for the transactions. Dealers may mark securities up or down to make a profit on their transactions.
Many publications or websites use the term broker-dealer. A broker-dealer is allowed to operate in either role, but never as both at the same time.
To be involved in the buying, selling or trading of securities, a person or firm must be registered with the National Association of Securities Dealers (NASD). The NASD is a self-regulatory organization created by the Securities and Exchange Commission (SEC). Brokers and dealers must follow all rules of the NASD and SEC, including the NASD's Conduct Rules and its rules for arbitration, complaints and dealings with the public.
Broker-dealer status can be revoked for freely breaking securities rules; for having been expelled or suspended from any self-regulatory organization; for making misleading statements to the SEC or the NASD; or for having committed felonies or misdemeanors in the securities industry.
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What Broker-Dealers Are Not Allowed to Do
The following are practices that broker-dealers are forbidden to do:
• Churning: Excessive trading of a client's discretionary account to increase the broker's commissions.
• Use deception or manipulation to trade securities, or failing to state material facts
• Recommending low-priced, speculative securities without determining whether they are suitable for the customer
• Make unauthorized transactions
• Guarantee that loss will not occur
• Try to talk clients into buying mutual funds inappropriate for their means and goals
• Use fictitious accounts to disguise trades
• State that the SEC has approved or judged positively either the security or the broker
• Not promptly transmitting the client's money or securities
Broker-dealers convicted of any of these actions may be expelled or suspended by the NASD.
Because brokers have so much control over other people's money, their activities are highly regulated.
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Other Broker Services
Brokers, when authorized by the client, may set up discretionary accounts. These accounts allow brokers to buy and sell securities for a client's account without contacting the client for each transaction. The authorized broker may determine the security traded, how much of it may be traded, the price and the time of transaction.
Brokers may lend funds to customers who have margin accounts. With margin accounts, customers can buy additional securities with money borrowed from a broker.
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Registered Representatives, Market Makers and Specialists
Registered Representatives
A registered representative is an individual who has passed the NASD's registration process and is therefore licensed to work in the securities industry. The process includes an examination that tests the candidate's knowledge of securities and markets. Further, the registration agreement requires that the candidate agree to follow the rules of the NASD.
Registered representatives sell to the public; they do not work on exchange floors.
Market Makers
Market makers are firms that maintain a firm bid and offer price in a given security by standing ready to buy or sell at publicly-quoted prices. The Nasdaq is a decentralized network of competitive market makers. Market makers process orders for their own customers, and for other NASD broker/dealers; all NASD securities are traded through market maker firms. Market makers also will buy securities from issuers for resale to customers or other broker/dealers. About 10 percent of NASD firms are Market Makers; a broker/dealer may become a Market Maker if the firm meets capitalization standards set down by the NASD.
Specialists
Specialists keep markets for securities orderly and continuous. This means they must buy when there are others selling without buyers, and they must sell when others are buying without sellers. They must maintain their own inventories of securities that are large enough for sizable trades. Specialists both buy and sell out of these inventories and mediate between other customers.
Specialists work on the exchanges where they hold seats. Among their duties is buying and selling odd-lots (trades of less than 100 shares) for exchange members. To trade a security, a specialist must be able to keep a position on it with at least 5,000 shares. Specialists, like others, who buy and sell for the public, are subject to rules and regulations. Specialists often choose to keep inventories in multiple securities, often in more than one market sector.
This concludes our tutorial on brokers, specialists and market makers.
The Life of a Trade
The life of a trade can vary a great deal depending on whether the trade involves a listed, Nasdaq or over-the-counter bulletin board security. The following description is intended to give you a general idea of how the process of trading stocks works.
Trading is based on supply and demand. When you buy or sell a stock, you are literally trading with another investor — someone in your city, across the country or on the other side of the world. An order from you to buy a stock must be matched with a seller's order to sell. If you place an order on the Nasdaq, or one of the many other exchanges, this match may be done electronically.
If your order is sent to the trading room floor of one of the exchanges, the auction process begins. A member of the stock exchange walks to the appropriate trading area where your stock is traded and presents your order. Sometimes there will be a broker in the crowd with a sell order at the same price. In this case your order will be completed or filled. Brokers must often act quickly or risk missing the market. If a broker hesitates, a competitive bid could be placed, driving up the market price for the next trade.
The broker may also hand your order to a specialist. The specialist is a person in each trading area, whose job is to guarantee a fair and orderly market by matching buys and sells or by buying or selling themselves if needed. When an order is away from the market, it can be placed under a specialist's care. From this point on the specialist is in charge of representing your order.
If you placed a GTC order with us, it would stay open until it is filled, canceled by you, or until the last day of the next calendar month. If the order is filled, the broker or specialist will report the fill to us. You can choose to be contacted by phone, fax or e-mail. Of course, if you monitor the Order Status section of the website, you can also see when the order is filled. You will also receive a U.S. Mail copy of your order confirmation and fill. You should check your order confirmation carefully no matter how it is received.
Once the order is filled another process kicks into place; one which is generally invisible to you. First the fill is reported to the Market Data System of the exchange. This system transmits the trade details such as the stock name, the number of shares traded and the price of the trade to all interested parties through the ticker tape. The trade can be seen online, TV or through other media by the investor and other interested parties. The ticker tape will also update the information (sometimes with a time lag) on your Quote Monitor.
The tickets sent to your brokerage firm and the brokerage firm of the person who bought or sold the stock from you is entered into a computer. Over the next few hours, the two trades are matched to make sure they agree. If they do not agree, the brokers meet again to settle any differences. This will not affect your fill. Once agreement is ensured, the settlement process begins. Settlement of the trade generally occurs three business days from the actual trade date. Upon settlement the brokerage firms exchange (usually electronically) the stock certificates and the money for the stock.
Understanding Bull & Bear Markets
Simply put, bull markets are movements in the stock market in which prices are rising and the consensus is that prices will continue moving upward. During this time, economic production is
high, jobs are plentiful and inflation is low. Bear markets are the opposite--stock prices are falling, and the view is that they will continue falling. The economy will slow down, coupled with a rise in unemployment and inflation. In either scenario, people invest as though the trend will continue. Investors who think and act as though the market will continue to rise are bullish, while those who think it will keep falling are bearish.
The basics of bull and bear markets will be reviewed in this tutorial. Specifically we will cover the following:
• What Drives Bull and Bear Markets?
• Predicting Bull and Bear Markets
• Investing During Bull Markets
• Investing During Bear Markets
What Drives Bull and Bear Markets?
What causes bull and bear markets? They are partly a result of the supply and demand for securities. Investor psychology, government involvement in the economy and changes in economic activity also drive the market up or down. These forces combine to make investors bid higher or lower prices for stocks.
To qualify as a bull or bear market, a market must have been moving in its current direction (by about 20% of its value) for a sustained period. Small, short-term movements lasting days do not qualify; they may only indicate corrections or short-lived movements. Bull and bear markets signify long movements of significant proportion.
There are several well-known bulls and bears in American history. The longest-lived bull market in U.S. history is the one that began about 1991 and is still climbing. Other major bulls occurred in the 1920s, the late 1960s and the mid-1980s. However, they all ended in recessions or market crashes.
The best-known bear market in the U.S. was, of course, the Great Depression. The Dow Jones Industrial Average lost roughly 90 percent of its value during the first three years of this period. There were also numerous others throughout the twentieth century, including those of 1973-74 and 1981-82.
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Predicting Bull and Bear Markets
Investors turn to theories and complex calculations to try to figure out in advance when the market will scream upward or tumble downward. In reality, however, no perfect indicator has been found.
In their attempts to predict the market, economists use technical analysis. Technical analysis is the use of market data to analyze individual stocks and the market as a whole. It is based on the ideas that supply and demand determine stock prices and that prices, in turn, also reflect the moods of investors. One tool commonly used in technical analysis is the advance-decline line, which measures the difference between the number of stocks advancing in price and the number declining in price. Each day a net advance is determined by subtracting total declines from total advances. This total, when taken over time, comprises the advance-decline line, which analysts use to forecast market trends.
Generally, the A/D line moves up or down with the Dow. However, economists have noted that when the line declines while the Dow is moving upward, it indicates that the market is probably going to change direction and decline as well.
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Investing During Bull Markets
A key to successful investing during a bull market is to take advantage of the rising prices. For most, this means buying securities early, watching them rise in value and then selling them when they reach a high. However, as simple as it sounds, this practice involves timing the market. Since no one knows exactly when the market will begin its climb or reach its peak, virtually no one can time the market perfectly. Investors often attempt to buy securities as they demonstrate a strong and steady rise and sell them as the market begins a strong move downward.
Portfolios with larger percentages of stocks can work well when the market is moving upward. Investors who believe in watching the market will buy and sell accordingly to change their portfolios.
Speculators and risk-takers can fare relatively well in bull markets. They believe they can make profits from rising prices, so they buy stocks, options, futures and currencies they believe will gain value. Growth is what most bull investors seek.
The opposite of all this is true when the market moves downward.
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Investing During Bear Markets
Successful investing in bear markets can involve many different strategies. Some investors try to secure their assets in less volatile securities such as fixed-income bonds or money market securities. Others wait for the downward trend of prices to subside. When it does, they begin buying. Still others seek to take advantage of the falling prices.
When the market goes down, portfolios with a greater percentage of bonds and cash fare well because their returns are fixed. Many financial advisors emphasize the value of fixed income and cash equivalent investments during market downturns.
Another strategy is to simply wait for the downward prices to reverse themselves. Investors who wish to remain invested in stocks may seek out companies in industries that perform well in both bull and bear markets -- shares in these companies are called defensive stocks. The food industry, utilities, debt collection and telecommunications are popular defensive stocks. However, there is no guarantee that a defensive stock will perform well during any market period.
Finally, some investors attempt to exploit profits from the downward price movements. One method is to sell at the beginning of a downward turn, when prices are still high. Proponents of this strategy wait for prices to bottom out before reinvesting in the market. However, as simple as it sounds, this process involves the nearly impossible task of timing the market. Another, more complicated way to attempt to profit from falling prices is called selling short.
Concluding Remarks
There are many investment methods that seasoned investment professionals use to take advantage of opportunities during bull or bear markets. Methods such as dollar-cost averaging, selling short, and diversification exist. Understanding well-founded strategies will help you to improve your chances for superior performance in either market environment. However, there is no surefire way to always succeed. The best weapon you can employ is education. Do your homework!
Fast Markets
You've probably heard about "fast markets" in the news. But what does it really mean? What are the dangers of a fast market? How can you protect yourself as an investor?
We will discus the following topics related to fast markets:
• A Fast Market in Action
• How It Starts
• Protecting Yourself in a Fast Market
• Market Order, Stop Order, Limit Order...What's the Difference?
• Be Aware of How the Trading Process Works
• Timing is Everything
A Fast Market in Action
A fast market is an event that's becoming increasingly common: A hot new technology company goes public. Within minutes of opening the Initial Public Offering (IPO) on secondary markets, investors from around the country are online trying to get a piece of the action. With only a limited number of shares of the small company available, the stock price skyrockets.
Or there's the opposite scenario: A popular stock disappoints investment analysts or fails to meet projected earnings. By the close of market, its stock price has been sent tumbling by investors eager to unload it from their portfolios.
Up and down, volatile stocks have been spiking in both directions — sometimes as much as 10% to 50% — in the course of a day or even a few hours. While this kind of fast market activity has spelled success for some investors, it has meant disastrous results for others.
In a fast, high-volume trading environment, the price of a stock can change so quickly that by the time a real-time quote on the computer screen is updated, it's already history. The result can be market order execution prices drastically different from what an investor expected.
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How It Starts
News about a company hits the wires, like:
• An Initial Public Offering (IPO).
• Change in a company's earnings, positive or negative.
• Recommendation by an analyst or publication.
Trading Gets Heavy
• Internet, phone and broker orders pour in.
• The balance of trade orders is upset with more "buys" than "sells" or vice versa.
Order Executions Are Delayed
• Orders are placed so fast, a backlog may develop.
• Trades are lined up in a queue and executed in the order received.
Systems Can Overload
• Market Makers turn off auto-execution systems and revert to manual order handling procedures in which execution of trades is on a "best efforts" basis. The trading process slows down and the "reasonable time" it takes to execute an order can greatly increase.
• Orders are often subject to partial fills at various prices.
• Trade reports are delayed so investors checking their accounts don't know if their trade was executed. Trying to change or cancel orders may result in duplicate orders or orders that arrive too late to halt the trade.
• Sometimes volume is so heavy that access to brokerage web sites can slow down or be unavailable.
Prices Fluctuate
• Price of the limited number of shares available can change quickly as demand grows.
• Trades executed first in the queue can influence the price of subsequent orders waiting behind them.
• Quotes — including real-time quotes — can't keep up with the huge trading volume and lag far behind actual market prices.
By the time a market order is executed, the stock price may have skyrocketed or plummeted far beyond what the investor expected — as much as 50% or more.
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Protecting Yourself in a Fast Market
The only surefire way to protect yourself in a fast market is to stay out of it. If you feel you must trade during a fast market there are a few things you can do to protect yourself.
Place a Limit Order
When trading a volatile or new stock, you can reduce your risk by placing a limit order specifying the maximum you're willing to pay to buy a stock or the minimum you'll accept to sell a stock.
Unlike a market order, which is an order to buy or sell at the best available price when the order is received in the marketplace, a limit order gives you price protection by ensuring you get your limit price or better. There's no guarantee your trade will be executed, but it's the most effective strategy for limiting your risk.
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Market Order, Stop Order, Limit Order . . . What's the Difference?
A market order is an order to buy or sell a stock as soon as possible at the best price available. In a fast market situation, a market order can be very risky.
A stop order is an order to buy or sell a stock when the price reaches or passes a specified point (the stop price). When that happens, a stop order automatically becomes a market order and is executed at the best price available. In fast markets, however, after a stop order hits the stop price and becomes a market order, it can keep climbing or drop sharply - and ultimately be executed much higher or lower than originally specified.
A limit order is the safest way to trade in a fast market because it's an order to buy or sell a stock only at the specified price (the limit price) or better.
Know What You're Buying
What do you know about the company you're buying? Have you researched it? Buying a stock on impulse or hearsay isn't smart investing. Be sure the company you're buying a piece of is one you really want.
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Be Aware of How the Trading Process Works
Educating yourself about investing is an ongoing process. If you're a new investor or need a review of trading procedures, pick up a book like The Wall Street Journal Guide to Understanding Money and Investing, take a virtual trip to the New York Stock Exchange on the Web at www.nyse.com (click on Education), or locate an investing club in your area through the American Association of Individual Investors at www.aaii.com.
Stay on Track with Your Investment Strategy
When you're considering a stock, first see if the company meets your investment objectives. If you haven't formulated an investment strategy yet, now is a good time to start. Begin by determining your goals and your time horizon, then choose the investments that will best meet them.
Weigh the Risk . . . Before You Click
Before you place a market order for a volatile stock, ask yourself how much you could afford to lose in the event of sweeping price fluctuations. Don't risk spending more than you can afford.
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Timing Is Everything
If you're planning to place an opening market order, make sure your order is entered before 9:20 a.m. Eastern Time. Otherwise, your order may not queue until after the pre-open is completed. At the end of the day, enter market orders at least 10 minutes before closing or your order may not be executed.
Why Watch Market Indicators?
A common and effective way to gain perspective on stock price fluctuations is to compare the movement of your stocks to that of indices or market indicators. About 100 years ago, as the number of individual stocks grew, the need to measure how the stock market performed became obvious. In 1896 The Dow Jones Company took groups of stocks and averaged their prices to create the first indices, the Dow Jones Averages. They created four different indices: one for industrial companies, one for utilities, one for transportation companies and a composite that included the three other indices.
In the 1920s, Standard & Poor's Corporation (S&P) created separate indices. These indices also measured the market as a whole in addition to some sectors of the market. In 1957, when technology enabled the companies to start calculating their indices on an hourly basis, S&P created the S&P 500 Index, which measured the performance of a larger proportion of the market compared to the more popular Dow Jones Industrial Index.
Over the years, the S&P and Dow Jones indices have remained popular, leading both companies to create other indices. In addition, other companies and even the exchanges themselves have created more indices.
Different indices are calculated in different ways. Few remain as simple averages. An index moves when the stocks in it move. When a stock in an index goes up or down, so does the index. Hence, when you hear that the Dow Jones closed at 10,500, down 20 points for the day, it means that the average of the prices of the 30 stocks that comprise the Dow is 10,500 and the combined value of these 30 stocks (as calculated by the index) dropped 20 points during that day's trading.
Calculation method aside, all indices measure the performance of the stock market or some subsection of it on a continuing basis throughout each trading day. By tracking an index, or a variety of indices, investors can quickly gauge market trends that may impact investment decisions.
What is the point of following the indices when what you care about is your own stock portfolio performance?
Indices often reflect trends in the market and in the economy. Watching overall market performance can be the key to making smart decisions about your individual investments. For example:
• Indices can function as benchmarks to compare the performance of the stocks you own against the market in general.
• Comparing today's market movement with similar market movements from the past may help you become aware of trends, and the best times to buy or sell.
You may want to create an index of your own stocks so you can measure your own investments against the performance of the more established indices. As an illustration of how to do this we have created the following hypothetical index.
Stock
12/17 Close
12/18 Close
12/19 Close
ABC
52
51
52
DEF
25-1/2
23 ¾
25
GHI
49
46
47-1/2
JKL
15
15 ¼
15-1/2
Total
141.50
136
140
Average
35.375
34
35
Percent Move
-4%
+3%
Now, you can compare the movement of your index to some of the big market indicators, like the S&P 500, the Dow Jones Industrial Average (DJIA) or the Nasdaq.
There are a couple of ideas to keep in mind when analyzing indices. First, the percentage move is often more meaningful than the move in points. It means a lot more when the DJIA moves 50 points if it is at 1,000 than if it is at 10,000. Second, while individual stock prices, at least for the time being, are generally expressed as fractions, indices are displayed in decimals.
Dow Jones Industrial Average
One of the best-known market indicators, the Dow Jones Industrial Average, is comprised of 30 leading companies. Calculated by adding the prices of these 30 stocks, the Dow is now considered a figure that indicates the general state of the market. Originally, the Dow divided the sum of the prices of the 30 stocks by 30, giving a true average. However, to be consistent every time a stock split or paid a dividend, the number 30 had to be adjusted. Now, over 100 years later, the sum of the prices of the 30 stocks is divided by a number less than one! Since a $1 movement in the price of a $100 stock counts equally with a $1 movement in the price of a $20 stock, the Dow Jones is considered a price weighted index.
Dow Jones Chart
9/13/99 1:37 PM
Last:
11,033.49
Change:
+5.06
Open:
11,027.40
High:
11,042.36
Low:
10,982.20
Volume:
35,816,500
Percent Change:
+0.05%
Yield:
1.58%
P/E Ratio:
27.99
52 Week Range:
7,399.38 to 11,428.94
Charles Dow designed the average to represent the current business market, which in 1896 included industries such as sugar, leather, tobacco, gas, rubber and coal. Today the DJIA is led by retailers, oil, technology, pharmaceutical and entertainment companies. The only company on the original list that is still included today is General Electric.
S & P 500 Index
Created in the 1920s by the Standard and Poor's Corporation (S & P), this index tracks 500 companies in leading industries: transportation, utilities, financial services, technology, health care, energy, communications, services, capital goods, basic materials, consumer products, cyclicals and more. Many consider it the most accurate reflection of the U.S. stock market today. This high regard has led many money managers and pension plan administrators to use it as a benchmark for judging the overall performance of their fund against the stock market.
Since the calculation for this index equals the price of each stock multiplied by the number of shares held by the public, the companies with the most shares make the greatest impact. This is known as a market weighted index.
Nasdaq Index
This index tracks the stocks on the National Association of Securities Dealers Automated Quotation System (Nasdaq) stock market. Since many new companies elect to join the Nasdaq, the number of stocks on the Nasdaq has grown from 100 to more than 5,500 today. Because this index includes many companies in the technology sector where market trends change quickly, this index can be volatile
Ameritrade Online Investor Index
The Ameritrade Online Investor Index tracks the daily buying and selling activity of individual online investors at Ameritrade, Inc.
While most major market indices include the activity of institutions and mutual fund companies, the Online Investor Index is unique in that it helps you understand what individual investors are doing in relation to the stock market.
The Online Investor Index does not measure price changes or volume-other indices do that. Instead, the Index measures buyer participation as a behavioral indicator related to investor confidence.
To learn more about the Ameritrade Online Investor Index, visit our website at www.ameritradeindex.com.
Sensex Calculation Methodology Free Float Market Capitalization
Sensex Calculation Methodology Free Float Market Capitalization
BSE Sensex (or Sensitive Index) is the prime and older indicator of stock market trend in India (the other being the Nifty Fifty). It consists of 30 stocks representing a wide cross-section of industries. It is calculated using a well attested method called free float market capitalization.
What is Free Float Market Capitalization?
Simply put its the market capitalization of all shares in "free float!!!" Free float shares are those that are available for trading in the open market. They rest may be FDI holdings, promoter holdings, locked in shares, strategic stakes, ESOPs etc. Suppose 40% of all shares is openly available. A free float factor is decided by BSE which would be 0.4 (anything in the band of above 35% -40% would have this factor). This factor is multiplied with the total market capitalization of the company (which is the prevailing share price * total no. of shares issued by the company) to get the free float market capitalization.
How to Calculate Sensex??
You know how to find the free float market cap of a company. Now add these for all the 30 companies that constitute the Sensex. You have the total free float market capitalization for the Sensex. The Sensex value is this value relative to a base period. The Base period is 1978-79 and the Base value is 100. The Free-float market Cap is divided by a number called the index divisor to arrive at the right value of Sensex. This divisor factors in changes in scrips, dividend paid, etc right from the base period. A simple way to find the current index divisor would be calculating the previous day's free-float market cap / previous day's sensex.
Here's an example to calculate the sensex
Free Float Market cap (prev day) = 320000 cr
Sensex Value = 16000
Div = 320000 / 16000 = 20
Current Free Float Market Cap = 336000
Current Sensex Value = 336000/20 = 16800
Bingo! You can find out the Sensex Value!.
For the premier Bombay Stock Exchange that pioneered the stock broking activity in India, 128 years of experience seems to be a proud milestone. A lot has changed since 1875 when 318 persons became members of what today is called The Stock Exchange, Mumbai by paying a princely amount of Re 1.
Since then, the country's capital markets have passed through both good and bad periods. The journey in the 20th century has not been an easy one. Till the decade of eighties, there was no scale to measure the ups and downs in the Indian stock market. The Stock Exchange, Mumbai in 1986 came out with a stock index that subsequently became the barometer of the Indian stock market.
Sensex is not only scientifically designed but also based on globally accepted construction and review methodology. First compiled in 1986, Sensex is a basket of 30 constituent stocks representing a sample of large, liquid and representative companies.
The base year of Sensex is 1978-79 and the base value is 100. The index is widely reported in both domestic and international markets through print as well as electronic media.
The Index was initially calculated based on the "Full Market Capitalization" methodology but was shifted to the free-float methodology with effect from September 1, 2003. The "Free-float Market Capitalization" methodology of index construction is regarded as an industry best practice globally. All major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the Free-float methodology. (See below: Explanation with an example)
Due to is wide acceptance amongst the Indian investors; Sensex is regarded to be the pulse of the Indian stock market. As the oldest index in the country, it provides the time series data over a fairly long period of time (From 1979 onwards). Small wonder, the Sensex has over the years become one of the most prominent brands in the country.
The growth of equity markets in India has been phenomenal in the decade gone by. Right from early nineties the stock market witnessed heightened activity in terms of various bull and bear runs. The Sensex captured all these events in the most judicial manner. One can identify the booms and busts of the Indian stock market through Sensex.
Sensex Calculation Methodology
Sensex is calculated using the "Free-float Market Capitalization" methodology. As per this methodology, the level of index at any point of time reflects the Free-float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization.
The base period of Sensex is 1978-79 and the base value is 100 index points. This is often indicated by the notation 1978-79=100. The calculation of Sensex involves dividing the Free-float market capitalization of 30 companies in the Index by a number called the Index Divisor.
The Divisor is the only link to the original base period value of the Sensex. It keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips etc. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate Sensex every 15 seconds and disseminated in real time.
Dollex-30
BSE also calculates a dollar-linked version of Sensex and historical values of this index are available since its inception.
Understanding Free-float Methodology
Free-float Methodology refers to an index construction methodology that takes into consideration only the free-float market capitalisation of a company for the purpose of index calculation and assigning weight to stocks in Index. Free-float market capitalization is defined as that proportion of total shares issued by the company that are readily available for trading in the market.
It generally excludes promoters' holding, government holding, strategic holding and other locked-in shares that will not come to the market for trading in the normal course. In other words, the market capitalization of each company in a Free-float index is reduced to the extent of its readily available shares in the market.
In India, BSE pioneered the concept of Free-float by launching BSE TECk in July 2001 and Bankex in June 2003. While BSE TECk Index is a TMT benchmark, Bankex is positioned as a benchmark for the banking sector stocks. Sensex becomes the third index in India to be based on the globally accepted Free-float Methodology.
Example (provided by rediff.com reader Munish Oberoi):
Suppose the Index consists of only 2 stocks: Stock A and Stock B.
Suppose company A has 1,000 shares in total, of which 200 are held by the promoters, so that only 800 shares are available for trading to the general public. These 800 shares are the so-called 'free-floating' shares.
Similarly, company B has 2,000 shares in total, of which 1,000 are held by the promoters and the rest 1,000 are free-floating.
Now suppose the current market price of stock A is Rs 120. Thus, the 'total' market capitalisation of company A is Rs 120,000 (1,000 x 120), but its free-float market capitalisation is Rs 96,000 (800 x 120).
Similarly, suppose the current market price of stock B is Rs 200. The total market capitalisation of company B will thus be Rs 400,000 (2,000 x 200), but its free-float market cap is only Rs 200,000 (1,000 x 200).
So as of today the market capitalisation of the index (i.e. stocks A and B) is Rs 520,000 (Rs 120,000 + Rs 400,000); while the free-float market capitalisation of the index is Rs 296,000. (Rs 96,000 + Rs 200,000).
The year 1978-79 is considered the base year of the index with a value set to 100. What this means is that suppose at that time the market capitalisation of the stocks that comprised the index then was, say, 60,000 (remember at that time there may have been some other stocks in the index, not A and B, but that does not matter), then we assume that an index market cap of 60,000 is equal to an index-value of 100.
Thus the value of the index today is = 296,000 x 100/60,000 = 493.33
This is how the Sensex is calculated.
The factor 100/60000 is called index divisor.
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