Tarheel%20Consultancy%20Services

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Tarheel Consultancy Services

• Manipal, Karnataka

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Corporate Training and Consulting
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Course on Fixed Income Securities

• For
• XIM -Bhubaneshwar

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For

• PGP-II
• 2003-2005 Batch
• Term-V September-December 2004

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Module-I

• Part-I
• Financial Markets, Institutions, and Instruments

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Why Markets?

• Consider a world without markets for goods and
  services. What would be the consequences?
• Most of our time and energy would be expended in
  seeking out a party who
• Firstly has the assets that we want, and
• Secondly is willing to exchange his assets for
  what we have to offer.

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Implicit Assumption

• The kind of transaction that we have described is
  a barter transaction.
• Prior to the advent of money, barter was the only
  means of trade.
• The reason why we have assumed the absence of
  money is because historically, the development of
  a unit of currency has gone hand in hand with the
  evolution of markets.

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Barter

• Barter, more technically known as countertrade
  continues to exist even today, but is observed
  much less.
• It is typically observed in those cases where the
  buyer of a good or a service is unable to pay the
  seller in hard or freely convertible currency.
• A currency is said to be freely convertible if it
  is easily accepted as a unit of value in other
  countries.

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Example of Barter

• Here is an example of barter.
• ATT arranged a sale of switching equipment to
  Sevtelecom, the local telephone company for
  Murmansk, Russia.
• Because of exchange control regulations in
  Russia, the company could pay only one-half of
  the purchase price in convertible currency.

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Example (Cont)

• For the remainder, ATT agreed to accept apatite
  concentrate, a rock phosphate that is an
  ingredient in fertilizer.
• ATT then contracted with a German trading firm,
  Helm A.G. to sell the apatite.
• After subtracting their commissions, Helm paid a
  part of the sale proceeds to the apatite
  manufacturer, and the balance to ATT.

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Money

• The advent of money made trade a lot easier.
• Everything could firstly be denominated in units
  of the currency.
• Secondly the currency also served as the medium
  of exchange.
• More importantly money gave you the freedom to
  save.

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Money Savings(Cont)

• Prior to the advent of money one had essentially
  two choices
• One could either consume all the goods at his
  disposal
• Or else exchange them for other goods and then
  consume them.
• With money, people who would rather consume later
  than now could simply lend money to those who
  would rather consume more now than later.

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Markets

• Markets exist to facilitate the exchange of
  things of value.
• The items exchanged could be
• Goods
• Services
• Physical assets with a capacity to produce goods.
• Financial assets.

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Categories of Economic Units

• Economic units which transact in financial
  markets may be classified as
• The Government Sector
• The term government includes
• The Federal or Central government
• State
• And local governments like
• Municipalities.

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Categories (Cont)

• The Business Sector

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Categories (Cont)

• The Household Sector

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Relationship Between Income and Expenditure

• There are three possible relationships between
  income and expenditure
• Balanced Budget Units
• Income Expenditure
• Surplus Budget Units (SBUs)
• Income gt Expenditure
• Deficit Budget Units (DBUs)
• Income lt Expenditure

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Function of a Financial System

• To channelize purchasing power from SBUs to DBUs.
• SBUs Lend Money DBUs

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Sector-Specific Characteristics

• Households traditionally are the largest
  suppliers of funds.
• That is units consisting of individuals as well
  as families are usually savers.
• Governments and business entities tend to have
  budget deficits, that is, they tend to be net
  borrowers.
• A nation as a whole may be a borrower or a lender.

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Balance of Trade

• The relationship between the imports into a
  country and exports out of a country is termed as
  its Balance of Trade.
• If a country has a Trade Deficit
• Its imports will exceed its exports
• And it will be a net borrower from abroad.
• If a country has a Trade Surplus
• Its exports will exceed its imports
• And it will tend to invest abroad.

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Financial Claims

• When an SBU transfers funds to a DBU, the DBU
  will issue a financial claim.
• SBU Money DBU
• DBU Claim SBU

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Claims (Cont)

• If the transaction takes the form of a loan, the
  claim is said to constitute a Debt Instrument.
• DBU IOU SBU
• Such an instrument is a promise to pay the
  interest at periodic intervals
• And to repay the principal at maturity.

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Claims (Cont)

• However if the provider of the fund were to seek
  an ownership stake in the venture, the claim
  would be classified as an Equity Share.
• Equity shares represent a claim on the profits of
  the firm
• They entitle the owner to the assets remaining
  after all debtors have been paid, in the event of
  liquidation of the firm.

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Claims (Cont)

• To the issuer of the claim or the borrower the
  claim is a liability
• Thus the claims issued by a DBU irrespective of
  whether Debt or Equity will show up as a
  Liability on the Balance Sheet of the firm.

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Balance Sheet
Assets
Liabilities
Plant Machinery 100 MM
Share Capital 100 MM
Bank Deposit 100 MM
Bonds 100 MM
Total Liabilities 200 MM
Total Assets 200 MM
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Balance Sheet (Cont)

• Salient features
• A firm acquires capital in two forms
• Debt or borrowed capital
• Equity or owners capital
• The two sides of a balance sheet must always
  match
• That is the total of assets must always equal the
  total of liabilities

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Claims (Cont)

• To the holder of the claim or the lender of
  money, the claim is an asset.
• Obviously every financial asset held by an
  investor will be backed by a corresponding
  liability on the part of the firm that has issued
  the financial claim.
• So the sum total of assets and liabilities in the
  world will always be zero.

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Debt Securities

• Debt instruments are financial claims issued by
  borrowers to the lenders of funds.
• The ownership of a debt security does not
  constitute part ownership of a business venture.
• It is merely an IOU.

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Debt (Cont)

• Issuers of debt promise to pay interest at
  periodic intervals, and to repay the principal at
  maturity.

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Debt (Cont)

• Long term debt securities (with a time to
  maturity of one year or more) issued by the
  government or by corporations, are called Bonds
  or Debentures.
• In the U.S a debenture is a bond for which no
  assets of the firm have been specified as
  collateral.
• Thus debentures constitute unsecured debt
• Firms also issue debt securities for which
  specific assets are designated as collateral.
• These are called Bonds in the U.S

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Debt (Cont)

• In India the terms are often used interchangeably
• Thus both the terms, bonds as well as debentures,
  could refer to secured as well as unsecured debt.

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Debt (Cont)

• In the U.S the Treasury Department issues long
  term bonds (with a time to maturity of 10-30
  years) called Treasury Bonds or T-bonds.
• The Treasury also issues medium term debt (with
  maturities ranging from 1 to 10 years) called
  T-notes.
• These are otherwise similar to T-bonds.

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Debt (Cont)

• Companies and governments also issue short term
  debt instruments (with a time to maturity at the
  time of issue of one year or less).
• T-bills are short term debt instruments issued by
  the Treasury Department and have a maturity of
  either 13, 26, or 52 weeks.

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Debt (Cont)

• Corporations issue Commercial Paper to meet their
  Working Capital requirements.
• Terminology often differs across countries.
• T-notes in Australia, for instance, correspond to
  T-bills in the U.S.

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Debt (Cont)

• Interest payments on debt securities are
  contractually guaranteed.
• That is, they are not a function of the profits
  made by a firm.
• In other words a firm is obligated to pay
  interest on its outstanding debt irrespective of
  whether or not it has made profits
• Consequently all interest payments have to be
  made, before any payments can be made to equity
  shareholders.

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Debt (Cont)

• Similarly in the event of bankruptcy, the claims
  of the bondholders have to be settled first.
• Consequently if a company defaults on a scheduled
  interest payment, or principal repayment, the
  bond holders can stake a claim on its assets.
• After liquidating the assets of the firm the
  claims of the bondholders will be settled.
• Only if something were to remain will the equity
  shareholders be entitled to stake a claim.

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Debt (Cont)

• Debt instruments can be Negotiable or
  Non-negotiable.
• Negotiable instruments can be freely traded
  because they can be endorsed by one party to
  another.
• A Treasury Bond is an obvious example.
• Non negotiable securities cannot be transferred.
• Examples include bank loans and bank time
  deposits.

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Size of the U.S. Debt Market in 1999
Security Type Amount Outstanding in Billions of USD
Municipal Bonds 1,532.50
Treasury Bonds 3,281.00
Corporate Bonds 3040.00
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Pre-Tax versus Post-Tax Payments

• Equity and preferred dividends are paid out of
  post-tax profits.
• However interest paid by the company on debt can
  be deducted from the profits while computing its
  tax liability.
• This reduces the tax burden for the firm or in
  other words gives it a tax shield.

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Example of a Tax Shield

• Consider two companies both of which have a
  pre-tax profit of 100,000.
• Company A has a nil interest liability
• Company B has an interest expense of 20,000.
• The tax rate is 30.

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Example (Cont)
Company A Company B
PBIT 100,000 100,000
Interest 0 20,000
PBT 100,000 80,000
Tax _at_ 30 30,000 24,000
PAT 70,000 56,000
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Example (Cont)

• The impact of the interest expenditure on company
  B is a reduction of profits by 14,000.
• Thus the effective interest paid in 14,000 and
  not 20,000.
• The effective interest14000
  20000(1-.3) I(1-T)

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Mortgages

• A mortgage is a loan backed by real estate as
  collateral.
• The borrower is called the Mortgagor
• The lender is called the Mortgagee.
• The mortgagor is required to make periodic
  payments to retire the debt.
• If he defaults the lender can take over the
  property for recovery of dues.
• This is called foreclosure.

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Required Attributes for an Investor

• When an investor invests or trades in a security,
  he is essentially concerned with the following
  issues.
• What is the rate of return on the security?
• The rate of return from a security is known as
  the Yield from the asset?
• How risky is the rate of return?
• How liquid is the asset?
• What is the time pattern of returns?

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Returns or Yields

• In the case of equity shares, returns accrue in
  the form of
• Dividends
• And/or capital gains/losses.
• Dividends are paid out in the form of cash
  periodically.

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Returns (Cont)

• Capital gains/losses arise when an asset is sold.
• If the subsequent selling price of an asset is
  greater than the original cost of acquisition,
  the profit is termed a capital gain.
• However, if the subsequent selling price is less,
  it will give rise to a capital loss.

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Returns (Cont)

• In the case of bonds, the investor gets returns
  by way of periodic interest payments known as
  coupon payments
• In addition there can be capital gains/losses
  when the bond is sold.

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Risk

• The risk associated with investments in financial
  assets is that they may firstly not pay dividends
  or interest as anticipated.
• Secondly the level of capital appreciation may be
  less than expected, or worse there may be a
  capital loss.
• Finally a firm may go into bankruptcy, in which
  case a part or all of the investment would be
  lost.

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Liquidity

• Liquidity may be defined as follows
• It is the ability of market participants to
  transact quickly at prices that are close to the
  true or fair value of the asset.
• It refers to the ability of buyers and sellers
  to discover each other quickly and without having
  to induce a transaction by offering a large
  premium or discount.

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Liquidity (Cont)

• In liquid markets there will always be plenty of
  potential buyers and sellers available.
• So traders will not be required to spend precious
  time and money in locating counterparties.
• If a market is liquid, large trades will not have
  a significant price impact.

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Liquidity (Cont)

• In the absence of liquidity, large purchase
  orders will send prices shooting up, while large
  sale orders will end up depressing prices
  substantially.
• Liquid markets in other words have a lot of
  depth.
• Securities which trade in illiquid markets are
  said to be thinly traded.

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Time Pattern of Cash Flows

• Cash flows from bonds, at least from those
  carrying fixed rates of interest, are fairly
  predictable.
• However the dividends received from shares can be
  substantially volatile, depending on the
  financial performance of the company, and its
  dividend policy.

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Rational Investors

• A rational investor would prefer assets which
  give a high rate of return and are highly liquid.
• Everything else remaining the same, he would
  prefers an asset whose return is less risky.

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Rational Investors (Cont)

• However all investors are not identical.
• A particular investor may be willing to take on a
  greater degree of risk as compared to another
  risk averse investor.
• He would of course demand adequate compensation
  by way of higher expected returns.

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Rational Investors (Cont)

• The requirements in terms of time patterns of
  cash flows also differs across investors.
• Young people are more likely to prefer equities,
  for they may not require regular cash flows
  immediately, and may be content with the
  possibilities of substantial capital gains.

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Rational Investors (Cont)

• Retired persons usually prefer to invest in
  bonds.
• For them, the key issue is the availability of
  predictable periodic cash flows from the asset.

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Classification of Markets

• There are various ways in which markets can be
  classified
• Primary versus Secondary Markets
• Direct versus Indirect Markets
• Money versus Capital Markets

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Primary versus Secondary Markets

• A primary market is one where the company offers
  new financial instruments to the investing
  public.
• Thus companies issue shares and bonds in the
  primary market.
• The very first issue of shares by a company is
  called an Initial Public Offering or IPO.

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Primary Secondary Markets (Cont)

• Once an asset has been bought by an investor from
  the company, subsequent transactions in the
  instrument take place in the secondary market.
• Primary markets therefore enable borrowers to
  raise funds.
• Secondary markets merely represent the transfer
  of ownership of an asset from one investor to
  another.

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Illustration

• TCS is issuing shares for the first time to the
  public at Rs 4000 per share.
• Assume that Ravi applies for 1000 shares and is
  allotted 200 shares at a price of Rs 4000.
• This is a primary market transaction.
• Assume that six months later Ravi sells these
  shares on the National Stock Exchange for
  Rs 5500 per share.
• This represents a secondary market transaction.
  

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Are Primary Markets Alone Sufficient?

• In order to facilitate savings and investment in
  the economy we need both primary as well as
  secondary markets.

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Sufficiency? (Cont)

• What would be the consequences if we had only
  primary markets?
• If we were to subscribe to a bond in such
  conditions, we would have no option but to hold
  it to maturity.
• In the case of equity shares the problem would be
  even more serious.
• We and our heirs would have to hold on to the
  shares forever.

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Sufficiency? (Cont)

• This will not be a satisfactory arrangement!
• In real life we like assets which can be easily
  liquidated or converted into cash.
• Since liquidity needs can never be perfectly
  anticipated, we need developed and active
  secondary markets, where assets can be bought and
  sold.
• Secondly nobody typically invests in a single
  asset.
• That is, everyone likes to hold a portfolio of
  assets.

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Sufficiency? (Cont)

• This is because putting all your eggs in one
  basket is a very risky proposition.
• Consequently investors like to spread out or
  diversify their risk by investing in a basket of
  securities.
• Quite obviously, all the companies will not
  experience difficulties at the same time.

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Sufficiency? (Cont)

• However our risk propensity will not remain
  constant during our lifetimes.
• Young people are more risk taking, while old
  people are more risk averse.
• Consequently investors need the freedom to
  periodically adjust their portfolios over a
  period of time.
• Once again, secondary markets are critical.

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Direct versus Indirect Markets

• In a direct market, borrowers deal directly with
  individual and institutional investors who are
  the ultimate lenders.
• For instance, if IBM were to issue debt and you
  were to subscribe to it, you would be
  participating in the direct market.
• Borrowers can issue claims in the direct market
  either through a Public Issue or through a
  Private Placement.

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Direct Indirect Markets (Cont)

• In a Public Issue securities are sold to a large
  and diverse body of investors, both individual
  and institutional.
• In a Private Placement, the entire issue is
  placed with a single institution or a group of
  institutions.
• In either case market intermediaries are involved
  who facilitate a process of matchmaking.

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Why do we need intermediaries?

• When an investor seeks to trade, the issue is
  essentially one of identifying a counterparty.
• A potential buyer has to find a seller and vice
  versa.
• Not only should a counterparty be available,
  there should be compatibility in terms of price
  expectations and quantities sought to be traded.

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Price Compatibility

• Every trader seeks to trade at a good price.
• What is a good price?
• Buyers are on the lookout for sellers who are
  willing to offer securities at a price which is
  less than or equal to what they are willing to
  pay.
• Sellers seek buyers willing to offer prices
  greater than or equal to what they expect.

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Quantity Compatibility

• The quantity being offered should match the
  quantity being demanded.
• Often a large sell order may require more than
  one buyer to take the opposite position before
  getting fully executed.
• The same is true for large buy orders.

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Market Intermediaries

• We will look at three types of market
  intermediaries.
• Brokers
• Dealers
• Investment Bankers

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Brokers

• Brokers are intermediaries who buy and sell
  securities on behalf of their clients.
• Their job is to arrange trades by helping their
  clients to locate suitable counterparties.
• They receive a processing fee or commission for
  performing this task.
• A broker does not finance the transaction.
• He merely enables others to execute their trades

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Dealers

• Dealers maintain an inventory of assets and stand
  ready to buy and sell at any point in time.
• Thus dealers unlike brokers have funds that are
  tied up in the asset.
• A dealer effectively takes over the trading
  problem of the client.

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Dealers (Cont)

• If a client is seeking to sell, the dealer will
  buy the asset from him in the hope of selling it
  later at a higher price.
• If a client is seeking to buy, the dealer will
  sell the asset in the hope of being able to
  replenish his inventory at a lower price.
• Dealers have to be expert traders.
• Some dealers may act in the capacity of a dealer
  as well as that of a broker.
• They are called Dual Traders.

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Bid and Ask

• The price at which a dealer is willing to acquire
  an asset from a trader will obviously be less
  than the price at which he is willing to sell the
  same asset to a trader.
• The price at which a dealer is willing to buy is
  called the Bid.
• The price at which he is willing to sell is
  called the Ask or Offer.

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Dealers (Cont)

• The difference between the two prices is the
  profit margin for the dealer and is called the
  bid-ask spread or simply the spread.
• Consider a trader who buys at the ask and
  immediately sells it back at the bid.
• He will incur a loss equal to the spread.
• In the U.S. dealers specialize in particular
  segments of the market like T-bills, Commercial
  Paper etc.

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Investment Bankers

• They are people who specialize in helping
  companies bring issues to the primary market.
• They help issuers comply with legal and
  procedural requirements.
• These include preparing a prospectus or offer
  document.
• Such a document gives full details about the
  issue and the potential risk factors for
  investors to take into account.

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Investment Bankers (Cont)

• They also provide advice on compliance with the
  listing requirements of the stock exchange where
  the shares are proposed to be listed for trading.
• Finally, they usually underwrite the issue.

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Underwriting

• What is underwriting?
• An underwriter undertakes to buy that part of the
  issue which remains unsubscribed if the issue is
  under subscribed.
• Underwriting helps in two ways.
• Firstly it reduces the risk for the issuer.
• Secondly it sends a positive signal to potential
  investors.

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Underwriting (Cont)

• This is because, in the case of an underwritten
  issue, a potential investor knows that the banker
  is willing to take whatever portion of the issue
  is left unsubcribed.
• An investment banker may not however like to take
  on the entire risk.
• Sometimes a group of investment bankers may
  underwrite an issue.
• This is called Syndicated Underwriting.

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Best Efforts

• At times, an investment bank, instead of
  underwriting the issue may offer to sell it on a
  best efforts basis.
• That is, it will try and do everything to ensure
  that the issue is fully subscribed to.
• However it does not undertake to pick up the
  unsubscribed portion in the event of
  undersubscription.
• Thus the role of the investment bank in these
  cases is purely a marketing function.

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Underwritten Issue or Best Efforts?

• Most issues are underwritten in practice.
• Issuers prefer this, because there is a greater
  incentive for the banker to sell when there is a
  risk of devolvement.
• What is Devolvement Risk?
• It is the risk that the bank has to buy the
  unsold securities in the event of
  undersubscription.

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Devolvement

• Devolvement is a clear signal of negative market
  sentiments.
• It will lead to a loss for the investment banker
  because the acquired shares will inevitably have
  to be disposed off at a lower price.

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Underwriting (Cont)

• The fee for underwriters in the U.S. is about 7
  of the issue amount.
• Sometimes the bank may also be offered an option
  to buy additional shares at the original issue
  price.
• These options can become very valuable if the
  issue succeeds, for the stock price will then
  rise perceptibly.
• Companies who seek to retain an option to issue
  additional shares in the event of
  oversubscription are said to have a Greenshoe
  option.

85
Underwriting (Cont)

• For instance the CIT Group came out with an IPO
  in 2000 that offered 200 million shares plus a
  greenshoe of 20 million shares that could be
  purchased by the members of the underwriting
  syndicate at the offer price of 23 within 30
  days from the date of the issue.
• The greenshoe option is also called the
  overallotment option.

86
Underwriting (Cont)

• The underwriting fee compensates the investment
  bank for the sales effort as well as for the
  insurance service provided to the issuing
  company.
• Since a best efforts offer does not involve the
  insurance component, the corresponding fees and
  commissions tend to be lower.

87
Underwriting (Cont)

• Underwriting fees are negotiated between the
  investment bank and the client.
• The fee is a function of the risks involved, and
  the amount of capital required to be deployed.

88
The Glass-Steagall Act

• This act, known more formally as the Banking Act
  of 1933 segregated investment banking activities
  and commercial banking activities.
• During the Great Depression of 1929-1933 many
  commercial banks went bankrupt when the stock
  markets collapsed because they they had
  significant exposure in the market.
• Once the Act was enacted following the
  depression, bankers were given a clear choice
  between deposit taking and lending on one hand,
  and underwriting and securities dealing on the
  other.

89
Glass-Steagall (Cont)

• The Act thereby segregated Investment Banking
  Brokerage Operations from Commercial Banking.
• In 1971 the Supreme Court passed a ruling
  allowing commercial banks to set up holding
  companies, which could then set up a separate
  subsidiary for brokerage operations.
• Brokerage companies set up by such holding
  companies came to be known as section 20
  brokerage firms.

90
Glass-Steagall (Cont)

• The Glass-Steagall Act was repealed in 1999, with
  the passage of the Financial Services
  Modernization Act.
• This Act is referred to as the Gramm-Leach-Bliley
  Act.

91
Top Underwriters of U.S. Debt and Equity as of
1996
FIRM Amount in Billions Market Share
Merrill Lynch 155.90 16.40
Lehman Brothers 100.70 10.60
Goldman Sachs 98.50 10.30
Salomon Brothers 96.20 10.10
Morgan Stanley 83.70 8.8
J.P. Morgan 68.70 7.20
CS First Boston 60.00 6.30
Bear Stearns 41.70 4.40
Donaldson, Lufkin 34.80 3.60
Smith Barney 29.90 3.10
Top 10 Firms 770.10 80.80
Industry Total 953.40 100.00
92
Indirect Markets

• A classic example of an indirect market involves
  a commercial bank.
• Take the case of a commercial bank like Citibank.
• It pools together the savings of various lenders,
  who are mainly individuals and families.
• To such depositors it issues its own financial
  claims.
• These as far as these lenders are concerned the
  bank is the borrower.
• These depositors are therefore exposed to the
  risk of failure of the bank.

93
Indirect Markets (Cont)

• The bank will then lend to corporate and
  non-corporate borrowers, who will in turn issue
  financial claims to it.
• As far as the borrowers are concerned, the bank
  is the lender.
• The banks is therefore exposed to the risk that
  these borrowers could fail.
• Thus the link between the ultimate lenders and
  the ultimate borrowers is broken by an
  intermediary such as a commercial bank.

94
Indirect Markets (Cont)

• Such markets are therefore called Indirect
  Markets.
• The depositors have no claim on the ultimate
  borrowers in this case.
• Only the bank does.
• How does the bank make money?
• It does so by raising deposits at a rate that is
  lower than the interest rate charged by it on
  loans made to borrowers.
• Other intermediaries in indirect markets include
  insurance companies, mutual funds, and pension
  funds.

95
Benefits of Direct Markets

• When a borrower and a lender interact directly,
  they can share the profit which will otherwise be
  made by the intermediary.
• We will illustrate this with a numerical example.

96
Illustration

• Commonwealth Bank is accepting deposits at 4 per
  annum.
• It is lending money to companies like Telstra at
  5.5.
• The profit or spread for the bank is 1.5.
• Now assume that Telstra can directly issue bonds
  to the public, with a coupon rate of 4.75.

97
Illustration (Cont)

• Investors will therefore get 0.75 extra as
  compared to the bank deposit.
• The company too will save 0.75 as compared to
  borrowing from the bank.
• Effectively the banks margin of 1.5 has been
  shared by the company and the investors.

98
Disadvantages of Direct Markets

• One of the typical problems is that the claims
  issued by the borrowers may not match the
  requirements of the individual lenders.
• The problem could be with respect to
• Denomination
• And/or maturity.
• For instance if a firm issues bonds with a face
  value of 100,000, small investors will be unable
  to subscribe.
• Secondly borrowers like to borrow long term
  whereas lenders like to lend short term.

99
Disadvantages (Cont)

• Thus a company issuing 20 year bonds may not find
  many takers if it directly approaches the public.
• These problems do not exist for financial
  institutions.
• Since they have access to funds deposited by many
  investors, large denominations pose no problems
  for them.
• Secondly deposits keep getting rolled over.
• Consequently these intermediaries can afford to
  borrow short term and lend long term.
• Thus, these intermediaries are said to engage in
  denomination transformation as well as maturity
  transformation.

100
Disadvantages (Cont)

• Another problem with direct markets is that they
  are critically dependent on active secondary
  markets.
• Besides the cost of a public issue can be very
  high in practice.
• What are these costs?

101
Public Issue Costs

• Such costs include
• Prospectus printing costs
• Share application printing costs
• Legal fees
• Fees paid to advisors

102
The Role of Intermediaries in Indirect Markets

• Banks, mutual funds etc. have access to large
  pools of money.
• They also accept deposits ranging from a few
  dollars to a few million dollars.
• They can therefore easily subscribe to large
  denomination assets.

103
The Role of Intermediaries (Cont)

• Secondly, they can also accept short term
  deposits and lend long term.
• This is because deposits keep getting rolled
  over, either due to renewals, or due to new
  clients.

104
The Role of Intermediaries (Cont)

• Financial institutions also facilitate risk
  diversification.
• Diversification means that dont put all your
  eggs in one basket.
• It is costly for an individual investor to
  diversify across assets because of transactions
  costs.
• In practice, each time a security is bought or
  sold, the trader incurs transactions costs.
• Banks however indirectly diversify because every
  deposit is invested across a spectrum of
  projects.
• Banks can also afford to employ professionals who
  can assess risk related issues.

105
The Role of Intermediaries (Cont)

• Finally financial institutions are able to take
  advantage of economies of scale.
• That is, the fixed costs of their operations tend
  to get spread over a vast pool of transactions
  and assets.
• This leads to cost efficiency as compared to an
  individual borrower/lender.

106
Money versus Capital Markets

• Money market instruments have a time to maturity
  at the time of issue, of one year or less.
• Money market instruments by definition have to be
  debt instruments.
• Capital markets are markets for medium to long
  term instruments.
• Capital market securities include both long and
  medium term debt as well as equities.

107
Money Capital Markets (Cont)

• The functions of the two markets are
  fundamentally different.
• Money markets are used to adjust temporary
  liquidity imbalances.
• In practice, for any company, inflows and
  outflows at any point in time will rarely match.
• Thus money markets help firms to borrow short
  term and also to deploy surplus funds on a short
  term basis.

108
Money Capital Markets (Cont)

• Money markets tend to be wholesale markets.
• That is, these instruments have high
  denomination.
• Consequently small investors usually do not
  participate in such markets.
• Small investors can however participate
  indirectly by investing in Money Market Mutual
  Funds (MMMFs).
• These funds primarily invest in money market
  securities.

109
Monet Capital Markets (Cont)

• These securities carry relatively low default
  risk.
• The logic is simple
• The odds of a firm getting into financial
  difficulties in the short run are definitely less
  than such an event occurring over a longer term
  horizon
• Money markets tend to be very liquid
• That is, the trading volumes are very high.

110
Money Capital Markets (Cont)

• Capital markets serve a different economic
  purpose.
• They channelize funds from those who wish to save
  to those who seek to make long term productive
  investments.
• Thus capital markets are where companies source
  funds for their long term investment needs.

111
Secondary Markets

• Financial assets are usually traded on exchanges.
• What is an exchange?
• It is a trading system where traders can interact
  to buy and sell securities.
• In order for a trader to trade he has to be a
  member of the exchange.

112
Secondary Markets (Cont)

• Non members have to consequently route their
  orders through a member.
• For instance if you want to trade on the National
  Stock Exchange, you have to approach a registered
  broker or a sub-broker.
• He will then feed your order into the system.

113
Secondary Markets (Cont)

• Historically trading on exchanges has taken place
  on trading rings or floors.
• This is called the Open-Outcry method of trading.
• The BSE used to have this system until it
  introduced online trading.
• Many older exchanges, for instance the NYSE, have
  a combination of floor based and electronic
  trading.
• These days most exchanges are essentially
  electronic communications networks.
• Consequently most traders no longer interact face
  to face.

114
Secondary Markets (Cont)

• Traditionally exchanges have been owned by the
  member brokers and dealers.
• Of late many exchanges are characterized by
  corporate ownership.
• Such exchanges are said to be Demutualized.
• For instance the NSE is owned by a number of
  institutions such as IDBI, LIC etc.

115
Examples of Demutualized Exchanges

• The NASDAQ
• The Stockholm Stock Exchange
• The Toronto Stock Exchange
• The Deutsche Borse
• The National Stock Exchange
• The Chicago Mercantile Exchange

116
Bond Markets

• The number of different corporate and municipal
  bond issues far exceeds the number of available
  stocks.
• Consequently bond markets are not very liquid.
• In practice many bonds never trade after issue,
  because investors who buy them, choose to hold
  them till maturity.

117
Bond Markets (Cont)

• The number of government bond issues is less,
  but the issue sizes are much larger.
• Consequently these bonds are more actively
  traded.
• Most corporate and municipal bonds trade OTC in
  investment and commercial banks.

118
Bond Markets (Cont)

• Some stock exchanges list corporate bonds, but
  trading volumes are much higher in OTC markets.
• Less than 0.10 of all corporate bond trading
  volume occurs on the NYSE and the AMEX bond
  markets.

119
Bond Markets (Cont)

• Secondary trading of Treasury bonds is also
  primarily on OTC markets.
• Many brokers however organize markets in which
  large government bond dealers and traders trade
  with each other.
• These inter dealer brokers facilitate anonymous
  trading.
• The largest of them is Cantor Fitzgerald.

120
Actors or Players

• Traders in the market can be divided into two
  categories.
• There are those who trade on their own account
  and those that arrange trades for others.
• Proprietary traders trade on their own account.

121
Actors (Cont)

• Agency traders act on behalf of or as agents of
  others who wish to trade.
• They are also known as brokers, commission
  traders, or commission merchants (in futures
  markets).

122
Long Positions

• A trader who owns an asset is said to have a Long
  position.
• People with long positions have the ability to
  sell on a future date.
• Consequently, they will gain if prices rise
  subsequently and will lose if they subsequently
  fall.
• Thus those desirous of taking long positions
  attempt to buy low and sell high.

123
Short Positions

• A trader is said to have a short position in the
  stock market when he has sold an asset that was
  not owned by him.
• How can you sell something that you do not own?
• Simple. Borrow it from someone else and sell it.
• In such cases he has to eventually buy the asset
  and return it to the investor who lent it to him
  to facilitate the sale.
• The hope is that prices would have declined by
  then.

124
Short Positions (Cont)

• When a person with a short position re-acquires
  the asset, he is said to be covering his
  position.
• The objective of a short seller is to sell high
  and buy low.

125
Buy Side and Sell Side

• The trading industry can be classified into a buy
  side and a sell side.
• The buy side consists of traders who seek to buy
  the services offered by the exchange.
• The traders on the sell side are those who offer
  the services of the exchange.

126
Buy Side and Sell Side (Cont)

• What are these services?
• The most important of these services is
  liquidity.
• Thus buy side traders are those in search of
  liquidity while sell side traders are those who
  supply liquidity.

127
Buy Side and Sell Side (Cont)

• Consequently the terms buy side and sell side
  have nothing to do with the actual buying and
  selling of securities.
• Traders on both sides regularly buy as well as
  sell securities.

128
The Buy Side

• The buy side refers to the portion of the
  securities business in which primarily
  institutional orders originate.
• This includes
• Funds (mutual and pension)
• Firms
• Governments
• Insurance Companies
• Charitable and Legal Trusts

129
The Sell Side

• The sell side consists of brokers and dealers who
  help buy side traders to trade at their
  convenience.
• This is what is meant by selling liquidity.

130
The Sell Side (Cont)

• Dealers come in various forms.
• Some of the terms used for them are
• Market makers
• Specialists
• Floor Traders
• Locals
• Day Traders
• Scalpers

131
Definitions

• Who is a market maker?
• He is a person or firm who on a continuous basis
  buys and sells securities on his own account.
• Market makers usually try and profit from a rapid
  turnover in securities positions.
• Therefore they do not hold open positions for
  long in anticipation of gradual price movements

132
The Sell Side (Cont)

• Broker dealers in the U.S. include well known
  investment banks like
• Goldman Sachs
• Salomon Smith Barney
• Morgan Stanley Dean Witter
• Credit Suisse First Boston

133
Clearing Agents

• What is clearing?
• When a trade occurs, either on the exchange
  floor, or over the telephone, both parties will
  make a record of the terms of the trade and the
  identity of the counterparty.
• Before the trade is settled, the two records must
  be compared to ensure that the facts and figures
  tally.
• This is called clearing.

134
Clearing Agents (Cont)

• Clearing agents are entities which match and
  verify records, in order to confirm that both the
  parties have agreed on the same terms and
  conditions.
• If the records match, the trade is said to clear
  and can then be settled.
• If there is a discrepancy, it will be reported to
  the traders who will then try and resolve the
  problem.

135
Clearing Agents (Cont)

• Trades with discrepancies are called DKs (Dont
  Knows).
• In the futures markets they are called Out
  Trades.
• The largest clearing agency in the U.S is the
  National Securities Clearing Corporation (NSCC).

136
Clearing Agents (Cont)

• Clearing is a very important exercise in the
  context of conventional manual exchanges.
• In electronic systems, the orders are matched by
  the computer, which contains all the required
  information about the orders.
• Consequently clearing becomes a trivial exercise.

137
Settlement Agents

• What do we mean by settling?
• Settling entails the payment of cash by the
  purchaser and the delivery of securities by the
  seller.
• The job of a settlement agent is to receive the
  cash from one party, and the securities from the
  other, ensure that the amounts are in order, and
  pass the cash/securities to the counterparty.

138
Settlement Agents (Cont)

• The largest settlement agent in the U.S is the
  NSCC, which is not surprising since clearing and
  settlement are related functions.

139
Settlement (Cont)

• Normal-way settlement in the U.S occurs 3
  business days after the day of trade.
• This is called T3 settlement.
• There are also special settlements like cash
  settlements.
• Cash settlement means that the trade is cleared
  and settled on the day of trade itself.

140
Depositories

• What is a Depository?
• It is a centralized location in which security
  certificates are placed and stored for later
  transfer.
• Such transfers usually take place by book entry
  rather than by physical movement.
• The largest depository in the world is the
  Depository Trust Company (DTC), which holds
  nearly 20 trillion dollars in assets.

141
Custodians

• Who is a custodian?
• It is an organization, typically a commercial
  bank, that holds in custody and safekeeping
  assets belonging to its customers.
• For a fee, the institution will collect
  dividends, interest, and proceeds from security
  sales and will disburse funds according to the
  clients instructions.

142
Depositories and Custodians (Cont)

• They facilitate the settlement process by quickly
  transferring cash and securities to settlement
  agents upon receiving instructions from the
  traders.

143
Arbitrage

• What is arbitrage?
• Arbitrage may be described as the existence of
  the potential to make riskless profits by
  transacting in multiple markets.

144
An Illustration

• We will illustrate arbitrage using an example
  from financial markets.
• Assume that IBM shares are trading in New York
  (on the NYSE)and London (on the LSE).
• Let the price be 180 in New York and
• 100 in London, at a time when the exchange
  rate is 2 / .

145
Illustration (Cont)

• Take the case of a person who borrows
  18,000 for an instant and buys 100 shares
  in New York.
• He can immediately sell the shares in London for
  10,000 which can be remitted back to
  New York to yield 20,000.
• After returning the 18,000 that he borrowed he
  is left with a profit of 2000.
• This transaction is costless and risk-less in a
  perfect setting.

146
Arbitrage (Cont)

• These opportunities cannot persist for long.
• As investors rush to buy shares in New York, the
  price on the NYSE will rise.
• As everyone starts selling shares in London the
  price on the LSE will fall.
• As people start selling pounds and buying
  dollars, the dollar will appreciate relative to
  the pound.
• Thus the rate will come down from 2 /
• Consequently equilibrium will be restored.

147
Arbitrage and Market Imperfections

• In practice investors have to incur transactions
  costs.
• Brokerage fees have to be paid when shares are
  bought and sold.
• Commissions have to be paid while buying and
  selling foreign exchange.
• Such costs will certainly reduce and may even
  eliminate profit opportunities for small
  investors.

148
Imperfections (Cont)

• Institutional investors however face much lower
  transactions costs.
• Since they can arrange their own trades, they
  need not pay brokerage fees while trading.
• More importantly they have substantial capital at
  their disposal which can be deployed for such
  activities.
• Thus the kind of arbitrage described is often
  feasible for such investors, who will
  consequently exploit such situations till they
  cease to exist.

149
Illustration of Arbitrage in a Market with
Imperfections

• Consider the following information.
• Price of IBM on the NYSE 180.75/181.25
• Price of IBM on the LSE 100.25/100.50
• Obviously the first price in the quotation is the
  bid
• The second is the ask which is obviously greater
  than the bid.
• Let the rates in the Forex market be 2.05/2.15
• What this means is that when the dealer is buying
  pounds he will give away 2.05 dollars
• However when he is selling pounds, he will charge
  2.15 dollars

150
Illustration (Cont)

• Consider the following strategy
• Borrow 18125 and buy 100 shares on the NYSE
• Notice that one has to buy at the ask price.
• Simultaneously sell 100 shares in London at
• 100.25 each
• Notice that the shares will have to be sold at
  the bid price in London.

151
Illustration (Cont)

• The arbitrageur will receive 10025
• He will have to sell these pounds and buy
  dollars.
• Since he is selling pounds to the dealer the
  applicable rate is 2.05.
• Thus the proceeds in dollars will be
  20551.25
• After returning 18125 the arbitrageur will be
  left with a profit of 2426.25.

152
Illustration (Cont)

• Now assume that a commission of 10 cents a share
  is payable in New York
• Let the commission in London be 5 pence per share
• Assume that the dealer charges a flat
  transactions fee of 25 pounds while selling
  dollars.
• What will be the consequences?

153
Illustration (Cont)

• Firstly the amount required to buy 100 shares in
  New York will be 18125 10 18135
• When the shares are sold in London the proceeds
  will be 10025 5 10020
• When this amount is converted into dollars the
  trader will receive
• 9995 x 2.05 20489.75
• Thus the profit will come down to
  2354.75

154
The Eurocurrency Market

• What is a Eurocurrency?
• It is a freely traded currency deposited in a
  bank outside its country of origin.
• Examples
• Dollars traded outside the U.S. are Eurodollars.
• Yen traded outside Japan are Euroyen.
• The rupee is not a freely convertible currency
• Otherwise if a bank in Dubai were to accept rupee
  deposits they would constitute Eurorupees
• Now we can also have Euroeuros.

155
Eurocurrency (Cont)

• The term Euro simply means outside the country of
  origin.
• These deposits need not be with European banks.
• Although originally most banks which accepted
  such deposits were located in Europe.
• Banks in Tokyo, Singapore and Hong Kong also
  accept dollar deposits.
• These are often called Asian Dollar markets.

156
Why Eurocurrency Markets?

• Let us take the case of Eurodollars first.
• Why should a bank outside the U.S accept deposits
  denominated in U.S. dollars?
• The reasons are the following
• Firstly, after World War II, the U.S. dollar
  became the preferred currency for global trade.
• Consequently everyone wished to hold dollar
  balances.
• Secondly during the cold war, Warsaw Pact
  countries were reluctant to hold dollar balances
  with American banks.

157
Eurocurrency Markets (Cont)

• So on one hand they needed such balances to
  finance imports.
• On the other hand, there was a fear that such
  deposits could be impounded by the U.S.
  government.
• European banks began to realize that such funds
  could be profitably lent out, and consequently
  began to accept such deposits.