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HL Commerce College (Autonomous) – Self Finance Programme

B.S. Fintech Curriculum


(2024-25)
Semester – I
Sub: Indian Financial System

UNIT – 2 FINANCIAL MARKETS

2.1 Introduction to Financial Markets


2.2 Types of Financial Markets
2.3 Money Market - Meaning and Characteristics of Money Market
2.4 Constituents and Instruments of organized money market
2.5 Capital market - Meaning and Characteristics of Capital Market
2.6 Functions and history of Capital market
2.7 Primary Market
2.8 Types of primary issues
2.9 Secondary market
2.10 Functions of Secondary Market
2.11 Organizations of Secondary Market
2.12 Management of Secondary Market
2.13 Indexes of Secondary Market Financial Markets:

2.1 Introduction and Meaning to Financial Markets

Introduction

Financial markets are essential pillars of the global economy, acting as organized
platforms where individuals, businesses, and governments can engage in the exchange
of financial assets. These markets are vital for the proper functioning of any economy
because they facilitate the movement of capital.

Financial markets are indispensable elements of the global economy, serving as


structured venues where a wide range of financial assets are bought and sold. These
markets facilitate the transfer of funds from savers to borrowers, enabling businesses to
grow, governments to fund public projects, and individuals to manage their wealth and
investments. The role of financial markets extends beyond simple transactions; they
help in price discovery, providing liquidity, and managing risks, all of which are
essential for economic stability and growth.

The financial market ecosystem can be broadly categorized into two main segments:
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the capital market and the money market. The capital market is focused on long-term
financial instruments such as stocks and bonds, which are crucial for funding long-term
investments. Companies and governments leverage the capital market to raise
substantial amounts of money needed for large projects with long-term benefits, such
as infrastructure development, business expansion, and research and development
initiatives. In contrast, the money market deals with short-term financial instruments
and addresses the immediate liquidity needs of various market participants. The money
market is vital for managing short-term financial requirements, such as payrolls,
inventory purchases, and other operational expenses. By providing quick access to
funds, the money market ensures that the financial system remains fluid and efficient.

Financial markets also play a critical role in the broader economy by influencing
monetary policy and interest rates. Central banks often engage in the money market to
control money supply and implement monetary policy, affecting overall economic
activity. The interaction between the capital market and the money market helps in
balancing long-term investment needs with short-term liquidity requirements, fostering
a stable and dynamic financial environment.

Meaning

A financial market is essentially a marketplace where buyers and sellers engage in the
trading of financial assets and securities, such as stocks, bonds, currencies, and
derivatives. These markets provide a structured environment for the exchange of these
assets, ensuring that capital flows efficiently from those with surplus funds to those in
need of funds. The main purpose of financial markets is to facilitate the allocation of
resources, which is crucial for supporting economic activities and fostering growth. By
providing platforms for the issuance and trading of financial instruments, financial
markets enable businesses to raise capital, investors to diversify their portfolios, and
governments to finance their operations.

The financial market can be divided into two primary types: the capital market and the
money market, each serving distinct functions and addressing different financial needs.
The capital market is dedicated to the trading of long-term securities, including stocks
and bonds. This market allows companies to raise long-term capital needed for growth
and expansion by issuing equity (stocks) or debt (bonds). Investors in the capital market
can buy and sell these securities, providing a mechanism for the redistribution of capital
based on market conditions and investor preferences. The capital market is further
divided into the primary market, where new securities are issued and sold to investors,
and the secondary market, where existing securities are traded among investors. The
primary market is crucial for initial capital raising, while the secondary market provides
liquidity, enabling investors to buy and sell securities easily.

The money market, on the other hand, deals with short-term debt instruments that

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typically mature in less than one year. The money market is essential for managing
short-term financial needs and ensuring liquidity in the financial system. Common
instruments traded in the money market include Treasury bills, commercial paper,
certificates of deposit, and repurchase agreements. These instruments are generally low-
risk and provide a means for organizations to meet their short-term funding
requirements, such as covering operational costs or managing cash flow. The money
market also plays a significant role in the implementation of monetary policy, as central
banks use money market operations to influence interest rates and control the money
supply.The Indian Financial System is one of the most important aspects of the
economic development of our country. This system manages the flow of funds between
the people (household savings) of the country and the ones who may invest it wisely
(investors/businessmen) for the betterment of both the parties.

Characteristics of Financial Markets

 High Volume and Speed of Transactions

Financial markets are characterized by a significant volume of transactions and


the rapid movement of financial resources. This high level of activity facilitates
the swift transfer of capital from one market to another, ensuring that funds can
be allocated efficiently and promptly to where they are needed most.

 Diverse Market Segments

Financial markets consist of various segments, including stock markets, bond


markets, and both primary and secondary markets. Investors have the autonomy
to choose where and when to invest their money, allowing for a wide range of
investment opportunities. This diversity helps in catering to the different
preferences and risk appetites of investors.

 Arbitrage Opportunities

The scope for instant arbitrage exists across different markets and instruments.
Investors can exploit price differences between markets or financial instruments
to make risk-free profits, contributing to the overall efficiency and liquidity of the
markets.

 Volatility and Susceptibility to Panic

Financial markets are inherently volatile and can be prone to panic and distress
selling. The actions of a limited group of market participants can often lead to
widespread market movements, reflecting the interconnected nature of market
sentiment and behavior.

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 Dominance of Financial Intermediaries

Financial intermediaries, such as banks and investment firms, play a dominant


role in financial markets. They make investment decisions and manage risks on
behalf of their clients, acting as crucial agents in the allocation of financial
resources.

 Negative Externalities

Failures in one segment of the financial markets can have ripple effects on other
segments and even on non-financial markets. This interconnectedness means that
issues in one area can lead to broader economic consequences, making financial
markets sensitive to systemic risks.

 Global Integration

Domestic financial markets are increasingly integrated with international


markets. As a result, disturbances in one country’s financial market can have
global implications, and vice versa. This global interconnectedness necessitates
vigilant monitoring and regulation to manage potential risks and vulnerabilities.

Functions of Financial Markets

 Time Preference Facilitation

Financial markets allow economic units to express their time preferences,


enabling them to choose between current and future consumption. This function
supports savings and investment decisions, balancing present needs with future
goals.

 Risk Separation, Distribution, Diversification, and Reduction

Financial markets offer mechanisms to separate, distribute, diversify, and reduce


risk. By trading various financial instruments, investors can spread their risk
across different assets, sectors, and geographies, thereby minimizing potential
losses.

 Efficient Payment Mechanism

The financial markets provide an efficient payment system that facilitates the
smooth transfer of money and financial assets. This function is essential for both
day-to-day transactions and large-scale financial activities, supporting the overall

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economy.

 Information Provision

Financial markets serve as a key source of information about companies and the
economy. They encourage investors to conduct their own inquiries and monitor
the activities of firms, aiding in informed decision-making and efficient stock
trading.

 Transformation of Financial Claims

Financial markets enable the transformation of financial claims to match the


preferences of both savers and borrowers. This function helps in creating a variety
of financial instruments that cater to different investment and funding needs.

 Liquidity Enhancement

Through the trading of securities, financial markets enhance the liquidity of


financial claims. This liquidity allows investors to quickly buy or sell assets,
providing flexibility and security in managing their financial portfolios.

 Portfolio Management Services

Financial markets offer portfolio management services, helping investors manage


their assets effectively. These services include asset allocation, investment
strategy development, and continuous monitoring, ensuring that investments are
aligned with investors' goals and risk tolerance.

2.2 Types of Financial Markets

Financial markets play a pivotal role in the global economy by facilitating the
exchange of financial instruments and capital. They are categorized into two primary
types:

 Money market
 Capital market.

Each of these markets serves distinct purposes and caters to different financial needs,
impacting both short-term liquidity and long-term investment strategies.

Money Market

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The money market is a segment of the financial market where short-term borrowing
and lending occur. This market deals with financial instruments that have maturities
of one year or less, providing liquidity for short-term funding needs. It encompasses
various instruments like call money, certificates of deposit, commercial paper, and
treasury bills. The primary function of the money market is to help manage short-
term liquidity needs and provide a mechanism for redistributing cash balances among
participants. This segment is crucial for the efficient functioning of the economy, as
it allows financial institutions and businesses to manage their short-term funding
requirements effectively.

Capital Market

The capital market is another essential component of the financial system, dealing
with long-term securities. Unlike the money market, which focuses on short-term
instruments, the capital market involves the trading of long-term investments such as
equities and debt securities. The primary purpose of the capital market is to mobilize
long-term savings to finance long-term investments, provide risk capital to
entrepreneurs, and encourage broader ownership of productive assets. This market is
further divided into the primary market, where new securities are issued, and the
secondary market, where existing securities are traded. Both markets are
interdependent, with the primary market generating new instruments and the
secondary market providing liquidity for these instruments.

2.3 Meaning and Characteristics of Money Market

The money market is a sector of the financial market where short-term borrowing
and lending take place, typically involving instruments with maturities of less than
one year. This market is characterized by its high liquidity and the ability to handle
large-denomination transactions efficiently. The money market is crucial for the daily
financial operations of governments, financial institutions, and corporations,
providing a platform for managing short-term funding needs and ensuring stability in
the financial system.

Characteristics of the Money Market

 Short-Term Instruments: Deals with instruments that have maturities ranging


from overnight to less than one year. This short duration ensures that the
instruments are highly liquid and less sensitive to interest rate fluctuations.

 High Liquidity: Transactions in the money market involve large denominations


and are executed quickly, ensuring high liquidity. This liquidity is crucial for
meeting the immediate financial needs of institutions and governments.

 Low Risk: Instruments in the money market, such as Treasury bills and certificates
of deposit, are generally considered low-risk due to their short maturity periods
and the high credit quality of issuers.
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 Interest Rates: Interest rates in the money market are typically lower compared to
the capital market, reflecting the lower risk and shorter duration of the instruments.
Rates are influenced by central bank policies and economic conditions.

 Major Instruments: Includes call money, certificates of deposit (CDs),


commercial paper (CP), and Treasury bills (T-bills). These instruments are used
for various purposes, such as managing short-term liquidity, funding operational
needs, and meeting regulatory requirements.

 Regulation and Oversight: Often regulated by central banks and monetary


authorities to ensure stability and control money supply. The regulatory framework
helps maintain confidence in the financial system and facilitates effective monetary
policy implementation.

 Role in Monetary Policy: The money market plays a crucial role in the conduct
of monetary policy by enabling central banks to manage liquidity and influence
short-term interest rates. It helps in the implementation of policy measures and
stabilization of the financial system.

Functions of the Money Market

 Liquidity Management: The money market redistributes cash balances among


participants based on their liquidity needs, ensuring that funds are available
where they are most needed.

 Monetary Policy Implementation: It serves as a mechanism for monetary


authorities to manage the overall liquidity in the economy and implement
monetary policy.

 Short-Term Financing: Provides businesses and financial institutions with


access to short-term funding at competitive prices, helping them meet their
operational and financial requirements efficiently.

2.4 Constituents and Instruments of organized money market

The organized money market is a segment of the financial system where short-term
borrowing and lending occur, typically involving instruments with maturities of less than
one year. It facilitates the management of liquidity and short-term funding needs for
various participants, including banks, corporations, and governments. Here’s a detailed
look at the key constituents and instruments of the organized money market:

Constituents of the Organized Money Market

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 Financial Institutions

 Commercial Banks: Play a central role in the money market by participating


in interbank lending, issuing certificates of deposit, and managing short-term
liquidity.

 Investment Banks: Engage in money market transactions and help in


underwriting money market instruments.

 Central Banks: Regulate and manage the money market through monetary
policy tools, such as open market operations and repo agreements.

 Money Market Mutual Funds: Invest in short-term money market


instruments, providing liquidity and investment options for individuals and
institutions.

 Corporations: Often use the money market for short-term funding needs and
to manage their cash flow.

 Government Agencies: Issue short-term securities and engage in money


market operations for managing public finances.

 Regulatory Bodies

 Central Banks: Oversee the money market to ensure stability and liquidity. They
implement monetary policy and provide emergency funding if needed.

 Securities Regulators: Ensure transparency and compliance with regulatory


standards for money market instruments.

 Investors

 Institutional Investors: Such as pension funds and insurance companies, invest in


money market instruments for short-term, low-risk returns.

 Retail Investors: Participate through money market mutual funds or other


investment vehicles.

Instruments of the Organized Money Market

1. Treasury Bills (T-Bills)

 Description: Short-term government securities issued by the central government


with maturities ranging from a few days to one year.
 Purpose: Used for raising short-term funds and managing government cash flow.

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 Features: Sold at a discount to face value and redeemed at par on maturity.
Considered low-risk due to government backing.

2. Certificates of Deposit (CDs)

 Description: Time deposits issued by commercial banks with specific maturity


dates and interest rates.
 Purpose: Banks use CDs to attract short-term deposits from individuals and
institutions.
 Features: Offer a fixed interest rate and can be traded in the secondary market.
Early withdrawal may incur penalties.

3. Commercial Paper (CP)

 Description: Unsecured short-term promissory notes issued by corporations to


meet short-term liabilities.
 Purpose: Used by companies for funding working capital and managing liquidity.
 Features: Typically issued at a discount and redeemed at face value upon maturity.
The creditworthiness of the issuer affects the interest rate.

4. Repurchase Agreements (Repos)

 Description: Short-term borrowing agreements where one party sells securities to


another with an agreement to repurchase them at a later date at a higher price.
 Purpose: Used for short-term funding and liquidity management.
 Features: The difference between the sale and repurchase price represents the
interest paid. Considered low-risk due to collateral backing.

5. Call Money

 Description: Short-term loans provided by banks to each other, typically repayable


on demand.
 Purpose: Used by banks to manage short-term liquidity needs.
 Features: Interest rates are typically influenced by market conditions and central
bank policies.

6. Banker’s Acceptances

 Description: Short-term credit instruments issued by a bank on behalf of a


borrower, guaranteeing payment at maturity.
 Purpose: Used in international trade to finance transactions.
 Features: Provide a guarantee of payment and are often used for trade financing.
Can be traded in the secondary market.

7. Repurchase Agreements (Repos)

 Description: Short-term borrowing agreements where one party sells securities


with a promise to repurchase them at a later date at a higher price.
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 Purpose: Provides liquidity to the financial system and is used for short-term
funding needs.
 Features: The difference between the sale and repurchase price represents the
interest rate. Repos are collateralized by securities, reducing risk.

8. Commercial Paper (CP)

 Description: Unsecured short-term promissory notes issued by corporations to


meet their short-term financing needs.
 Purpose: Provides a flexible and cost-effective way for corporations to raise short-
term funds.
 Features: Typically issued at a discount and redeemed at face value. The credit
rating of the issuer impacts the interest rate.

2.5 Capital market - Meaning and Characteristics of Capital Market

The capital market is dedicated to the trading of long-term securities, including equity
(stocks) and debt instruments (bonds). Unlike the money market, which focuses on short-
term financial needs, the capital market is concerned with long-term investments and
capital formation. It plays a vital role in mobilizing savings for productive uses, providing
risk capital, and fostering economic growth.

Characteristics of the Capital Market

 Long-Term Instruments: Involves financial instruments with longer maturities,


typically ranging from one year to several decades. These instruments include
stocks, bonds, and long-term loans, which provide funding for extended periods.

 Higher Risk and Return: Securities in the capital market generally exhibit higher
risk compared to money market instruments due to their longer duration and
sensitivity to economic changes. However, they also offer the potential for higher
returns.

 Investment and Financing: The capital market enables businesses and


governments to raise funds for long-term investments, such as infrastructure
projects, research and development, and corporate expansion. It also provides
investors with opportunities for capital growth and income generation.

 Price Discovery: The capital market facilitates the determination of market prices
for securities based on supply and demand dynamics. This price discovery process
helps in the efficient allocation of capital and resources.

 Liquidity: While the capital market provides liquidity through the secondary
market, its liquidity is generally lower compared to the money market. The ease of
buying and selling securities can vary depending on the size and activity of the

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market.

 Market Segments: Comprises primary and secondary markets. The primary


market is where new securities are issued, while the secondary market involves the
trading of existing securities. The interaction between these markets influences
overall market activity and pricing.

 Regulation and Oversight: Subject to regulatory frameworks designed to ensure


transparency, protect investors, and maintain market integrity. Regulators oversee
trading practices, disclosure requirements, and corporate governance to foster
investor confidence and market stability.

 Economic Impact: Plays a significant role in economic growth by channeling


long-term savings into productive investments. The capital market supports
innovation, job creation, and overall economic development through its various
financing mechanisms.

Key Components of the Capital Market


 Primary Market: This is where new securities are issued and sold for the first
time. It is crucial for raising fresh capital for companies and governments, enabling
them to fund expansion projects, research, and development.

 Secondary Market: This market deals with the trading of previously issued
securities. It provides liquidity to investors by allowing them to buy and sell
existing securities, thereby facilitating price discovery and enhancing market
efficiency.

2.6 Functions and history of Capital market

Functions of the Capital Market in India

 Mobilization of Savings: The capital market channels domestic and foreign


savings into productive investments. This process accumulates substantial funds,
which are then invested in various sectors of the economy, facilitating economic
growth by providing businesses and government entities with access to capital for
expansion, infrastructure development, and long-term projects.

 Provision of Risk Capital: The market offers equity and quasi-equity instruments
to entrepreneurs and businesses, allowing them to raise capital without incurring
debt. This promotes entrepreneurship and innovation, supports start-ups, and helps
businesses finance new projects and expansions.

 Facilitation of Investment Opportunities: Provides a platform for investors to

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buy and sell a variety of financial instruments, such as stocks, bonds, and mutual
funds. This enables investors to diversify their portfolios, manage investment risks,
and contributes to the efficient allocation of capital.

 Price Discovery: Ensures fair prices for securities through market mechanisms of
supply and demand. This enhances transparency and fairness in the market, helping
investors make informed decisions based on current market conditions.

 Liquidity Provision: Offers mechanisms for the buying and selling of securities,
ensuring that investors can convert their investments into cash quickly and
efficiently. This provides confidence to investors and supports market stability and
attractiveness.

 Efficient Allocation of Resources: Directs funds to the most productive uses by


investing in high-return projects and ventures. This optimizes resource allocation,
leading to increased economic efficiency and growth.

 Risk Management: Provides financial instruments such as derivatives to help


businesses and investors manage various types of financial risks. This reduces
uncertainty and enhances financial stability by allowing for effective risk
mitigation strategies.

 Support for Economic Growth: Facilitates long-term financing for infrastructure


projects, industrial expansion, and other growth initiatives. This contributes to
overall economic development, job creation, and an improved quality of life.

History of the Indian Capital Market

 Early Beginnings

 July 9, 1875: The Native Share and Stock Brokers' Association was established in
Bombay (now Mumbai), marking the beginning of organized securities trading in
India. This association was crucial in formalizing trading practices and setting
standards for the market.

 1899: The Bombay Stock Exchange (BSE) acquired its own premises, signaling a
significant development in the formal infrastructure of the Indian capital market.
This provided a dedicated space for trading and helped in managing the growing
number of transactions.

 1921: As the volume of trading increased, clearing houses were established to


handle the settlement of trades. This was an essential step in ensuring the smooth
functioning of transactions and maintaining market integrity.

 1923: K. R. P. Shroff became the honorary president of the BSE, underscoring the
growing importance of the exchange and its influence in the Indian financial
markets.
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 1925: The Bombay Securities Contracts Control Act (BSCCA) was enacted. This
legislation provided a regulatory framework for the trading of securities, aiming to
bring order to the market and protect investors.

 Pre-Independence Developments

 December 1, 1939: The BSE acquired a new building, reflecting its expanding role
and the increasing significance of stock trading in India.

 1943: During World War II, forward trading was banned until 1946. This was a
measure to stabilize the market and prevent speculative practices that could lead to
market instability during the war period.

 Post-Independence Era

 1956: The Securities Contracts (Regulation) Act was introduced, mirroring the
BSCCA. This Act aimed to regulate stock exchanges and provide a legal
framework to ensure transparency and fairness in trading activities.

 1957: The BSE was granted permanent recognition by the Indian government,
solidifying its status as a major stock exchange and enhancing its credibility in the
financial markets.

 1964: The Unit Trust of India (UTI) was established, introducing the concept of
mutual funds to Indian investors. This development expanded investment options
and provided a new avenue for public participation in the capital markets.

 June 29, 1969: The Indian government imposed a ban on forward trading to curb
speculative practices and stabilize the market. This was part of broader efforts to
ensure market stability.

 1970s

 1973: Construction of the P J Towers began, named after Phiroze Jamshedji


Jeejeebhoy, reflecting the BSE's growth and its expanding infrastructure. This new
building symbolized the exchange’s evolving role in the financial sector.

 July 6, 1974: The Dividend Restriction Ordinance was enacted, which limited the
dividends companies could pay out. This led to a sharp decline in stock market
values and demonstrated the impact of regulatory measures on market performance.

 1977: Dhirubhai Ambani’s Reliance Textiles made a notable entry into the capital
market, setting a precedent for large-scale public offerings and highlighting the
growing dynamism of the Indian stock market.

 1980s

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 1986: The BSE launched the Sensex, the first stock market index in India. The
Sensex provided a benchmark for measuring market performance and became an
important tool for investors and analysts.

 November 1987: The SBI Mutual Fund launched the Magnum Regular Income
Scheme, marking a significant development in the mutual fund industry and
expanding investment opportunities for Indian investors.

 April 1988: The Securities and Exchange Board of India (SEBI) was established
to regulate and oversee the capital markets. SEBI's creation was a crucial step
toward enhancing market transparency, protecting investors, and ensuring fair
trading practices.

 1990s

 January 1992: SEBI received statutory powers, strengthening its role as the
regulator of the capital markets and empowering it to enforce regulations and
oversee market activities.

 May 1992: The Harshad Mehta securities scam, one of the largest financial
scandals in Indian history, exposed significant issues in the market and led to
widespread reforms aimed at improving market integrity and investor protection.

 May 27, 1992: Reliance Industries became the first Indian company to issue Global
Depository Receipts (GDRs), enabling it to raise capital from international
investors and marking a significant milestone in India's integration with global
financial markets.

 September 1992: Foreign institutional investors (FIIs) were allowed to invest in


Indian securities, increasing foreign participation and bringing more liquidity into
the Indian capital markets.

 October 1993: The Kothari Pioneer Mutual Fund commenced operations as the
first private sector mutual fund, introducing more diversity and choice in
investment options for Indian investors.

 June 1994: The National Stock Exchange (NSE) began operations in the wholesale
debt market, marking an important development in market infrastructure and
expanding the range of trading activities.

 March 1995: The NSE overtook the BSE in trading volume, reflecting its growing
influence and the success of its electronic trading systems.

 April 1995: The National Securities Clearing Corporation Limited (NSCC) was
established to improve the clearing and settlement of trades, enhancing the
efficiency and reliability of the market.

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 November 1996: The National Securities Depository Limited (NSDL) was created
to manage dematerialized trading, streamlining the trading process and reducing
the risks associated with physical certificates.

 2000s

 February 2000: The NSE introduced internet trading, and the BSE Sensex reached
an all-time high of 6,150, reflecting a peak in market activity and the growing role
of technology in trading.

 July 9, 2000: The BSE celebrated its 125th anniversary, marking over a century of
stock trading in India and highlighting its long-standing role in the country's
financial markets.

 March 2001: The Ketan Parekh scam led to the discontinuation of carry-forward
trades and the implementation of rolling settlements to improve market stability
and prevent future manipulations.

 September 28, 2015: The Forward Markets Commission (FMC) merged with
SEBI, extending SEBI’s regulatory oversight to include commodity futures and
enhancing its role in overseeing all financial markets.

 Recent Developments

 January 23, 2017: The BSE became the first Indian stock exchange to issue an
Initial Public Offering (IPO), which was also listed on the NSE. This milestone
demonstrated the ongoing evolution and modernization of India's capital markets.

 Ongoing Evolution: The Indian capital market continues to evolve with


advancements in technology, increased global integration, and the expansion of
electronic and internet-based trading platforms. The market is now recognized as
one of the most dynamic and sophisticated in the world, with a growing base of
both domestic and international investors. The integration with global markets and
the adoption of cutting-edge trading technologies have positioned the Indian capital
market as a prominent player on the international stage.

2.7 Primary Market

Introduction to the Primary Market

The primary market, often referred to as the new issues market, is a crucial segment
of the financial markets where new securities are created and sold to investors for the
first time. This market is fundamental for companies, governments, and other entities
to raise fresh capital for various purposes, such as expanding operations, funding new
projects, or refinancing existing debt. Unlike the secondary market, where previously

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issued securities are traded among investors, the primary market is where securities
are issued directly by the company or entity to investors.

Key Features of the Primary Market

 Issuance of New Securities: The primary market is the platform for the initial sale
of securities such as equity shares, preference shares, bonds, and debentures. These
securities are offered to the public or selected investors, and the proceeds from the
sale go directly to the issuer.

 Raising Fresh Capital: The primary purpose of the primary market is to raise new
capital. Companies, governments, and other entities use this market to obtain the
funds needed for various business activities. This fresh capital can be used for
business expansion, research and development, debt repayment, or other financial
needs.

 Instruments Issued: The primary market deals with various types of instruments,
including:
o Equity Shares: Ownership stakes in a company, which entitle shareholders
to voting rights and dividends.
o Preference Shares: A hybrid form of equity that typically offers a fixed
dividend and has priority over common shares in asset liquidation.
o Debentures: Long-term debt instruments that are not secured by physical
assets or collateral.
o Bonds: Debt securities issued by companies or governments, promising to
pay the holder a fixed interest over a specified period.

 Pricing Mechanisms:
o Fixed Price Issue: In a fixed price issue, the price at which the securities
will be offered is determined and disclosed in advance.
o Book Building Process: In this process, the price is determined through bids
received from investors. A price band is provided, and investors place their
bids within this range. The final price is set based on the demand generated
during the bidding process.

Participants in the Primary Market

 Issuers: These are the entities that need to raise capital. Issuers can be
corporations, government bodies, public sector undertakings, banks, or financial
institutions. They offer securities in the primary market to mobilize funds for
various purposes.

 Investors: Investors are individuals or institutions that purchase the new securities.
Investors in the primary market include retail investors, institutional investors,
mutual funds, insurance companies, pension funds, and hedge funds.

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 Intermediaries: Various intermediaries facilitate the process of issuing securities
in the primary market. These include:

o Merchant Bankers/Lead Managers: Merchant bankers are registered


with SEBI and play a critical role in managing the issue process. They assist
in preparing the prospectus, conducting due diligence, ensuring compliance
with regulatory requirements, marketing the issue, and managing post-issue
activities.
o Underwriters: Underwriters are entities that guarantee the purchase of
securities in the event that the public does not subscribe to the full issue.
They assume the risk of undersubscription and help ensure that the issuer
raises the intended amount of capital.
o Registrars to the Issue: Registrars manage the process of allotting shares,
crediting them to investors' demat accounts, and handling refunds if
necessary.
o Bankers to the Issue: These are banks that facilitate the collection of
application money, manage escrow accounts, and handle the transfer of
funds.

 Regulatory Bodies: Regulatory bodies like the Securities and Exchange Board of
India (SEBI) oversee the primary market in India. SEBI sets the rules and
regulations governing the issuance of securities to protect investors and ensure
transparency and fairness in the market.

Functions of the Primary Market

 Capital Formation: The primary market is pivotal in the process of capital


formation. By facilitating the issuance of new securities, it helps channel savings
from individuals and institutions into productive investments, thus contributing to
economic growth.

 Price Discovery: In the primary market, the price of new securities is often
determined through mechanisms like the book-building process. This process of
price discovery is crucial for setting a fair market value for the securities.

 Resource Mobilization: The primary market enables companies and governments


to mobilize resources from the public or specific investors. This mobilization of
resources is vital for funding new projects, expanding operations, or meeting other
financial needs.

 Promoting Innovation: By providing a platform for raising capital, the primary


market encourages companies to innovate and expand their operations. Startups
and growing companies often rely on the primary market to secure the funds
necessary for innovation and development.

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Advantages of the Primary Market

 Access to Capital: The primary market provides companies with access to capital
that is essential for growth, expansion, and other business activities. It enables
companies to raise large amounts of funds without relying solely on internal cash
flows or bank loans.

 Diversification of Investor Base: By issuing securities in the primary market,


companies can attract a diverse group of investors, including retail investors,
institutional investors, and foreign investors. This diversification can enhance the
company's financial stability and investor confidence.

 Transparency and Regulation: The primary market operates under strict


regulatory oversight, ensuring that the process of issuing securities is transparent,
fair, and in compliance with legal requirements. This helps protect investors and
maintain confidence in the financial markets.

 Economic Growth: The funds raised through the primary market are often used
for productive purposes, such as expanding businesses, creating jobs, and
developing infrastructure. This contributes to overall economic growth and
development.

Challenges in the Primary Market

 Market Volatility: The primary market is sensitive to overall market conditions.


Economic downturns, political instability, or global events can lead to reduced
investor confidence and lower participation in new issues, making it challenging
for companies to raise capital.

 High Costs: Issuing securities in the primary market can be expensive due to the
costs associated with underwriting, legal fees, marketing, and compliance. Smaller
companies may find these costs prohibitive, limiting their access to the market.

 Regulatory Compliance: The stringent regulations governing the primary market


can be complex and time-consuming for issuers. Compliance with these
regulations requires significant effort and resources, which can be a barrier for
some companies.

 Risk of Undersubscription: If an issue is not fully subscribed, it can create


financial challenges for the issuer. Although underwriters may mitigate this risk,
undersubscription can lead to a shortfall in the desired capital.

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2.8 Types of primary issues

The primary market is where companies and other entities raise capital by issuing new
securities for the first time. These securities can be in the form of equity, debt, or other
financial instruments, and their issuance allows the issuer to raise funds for various
purposes, such as expansion, debt repayment, or new projects. The types of primary
issues can be broadly categorized based on the nature of the offering and the target
investors. Below are the different types of primary issues:

A. Public Issue

1. Initial Public Offering (IPO)

An Initial Public Offering (IPO) marks the first time an unlisted company offers its
shares to the public. Through an IPO, a privately held company transitions to a
publicly traded entity, thereby opening its ownership to public investors. The process
involves the issuance of new shares or the sale of existing shares by the current
shareholders. The primary objectives of an IPO include:

 Raising Capital: The funds raised can be used for expansion, debt repayment,
research and development, or other corporate purposes.
 Liquidity for Founders and Early Investors: An IPO provides an opportunity
for founders, early investors, and employees to liquidate some or all of their
holdings.
 Market Visibility and Prestige: Being publicly traded enhances the company's
profile and can lead to increased business opportunities.

Process:

 Preparation: Includes hiring underwriters, legal advisors, and auditors. The


company undergoes due diligence, prepares the prospectus, and complies with
regulatory requirements set by bodies like SEBI.
 Filing and Approval: The company files a draft prospectus with the regulatory
authority, which reviews and approves the offering.
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 Pricing and Allocation: The price of the shares is either fixed or determined
through a book-building process. Shares are then allocated to investors.

2. Follow-on Public Offering (FPO)

A Follow-on Public Offering (FPO) refers to the issuance of additional shares by an


already publicly listed company. Unlike an IPO, where the company is unlisted before
the offering, an FPO involves a company that is already trading on the stock exchange.
The objectives of an FPO can include:

 Raising Additional Capital: For further expansion, debt reduction, or other


strategic initiatives.
 Increasing Public Float: By issuing more shares, the company can increase the
number of shares available for trading, thereby enhancing liquidity.

Types of FPOs:

 Dilutive FPO: New shares are issued, which dilutes the ownership of existing
shareholders.
 Non-Dilutive FPO: Existing shareholders (such as promoters) sell their shares,
leading to no dilution of ownership.

Process:

 Similar to an IPO, but generally quicker as the company is already listed and has
a track record of compliance with regulatory norms.

B. Rights Issue

A Rights Issue is a method by which a company offers additional shares to its existing
shareholders in proportion to their current holdings, usually at a discounted price. This
type of issue allows companies to raise capital without diluting the ownership structure
since the new shares are offered first to the current shareholders.

Key Features:

 Proportionate Allocation: Shareholders receive the right to purchase additional


shares in proportion to their existing shareholding.
 Discounted Price: The shares are typically offered at a price lower than the market
value.
 Renounceable and Non-Renounceable Rights: Shareholders can either take up the
rights (renounceable) or decline them (non-renounceable), with the renounced rights
being sold in the market.

Objectives:

 Strengthening the Balance Sheet: Companies may use the proceeds to pay down
debt, finance new projects, or enhance working capital.
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 Rewarding Loyal Shareholders: By offering shares at a discount, the company
provides existing shareholders with an opportunity to increase their holdings at a
favorable price.

Process:

 Announcement: The company announces the rights issue, specifying the ratio,
price, and record date.
 Subscription Period: Shareholders decide whether to exercise their rights within
the specified period.
 Allotment: Shares are allotted based on the subscription, with any unsubscribed
shares often being offered to other investors or underwriters.

C. Private Placement

Private Placement involves the sale of securities directly to a small, select group of
investors, such as financial institutions, high-net-worth individuals, or other qualified
investors. This method is typically faster and less expensive than public offerings, as it
involves fewer regulatory requirements.

1. Private Placement for Unlisted Companies

For unlisted companies, private placement serves as a way to raise capital without going
through the complex and time-consuming process of a public offering. This type of
issuance is often used by companies at various stages of development, including startups
and mature businesses.

Features:

 Select Investors: The securities are sold to a pre-identified group of investors, rather
than the general public.
 Confidentiality: The terms of the offering and the identity of the investors can often
remain confidential.
 Flexibility: Companies have the flexibility to negotiate terms directly with investors,
including pricing, maturity, and covenants.

Process:

 Identification of Investors: The company identifies potential investors who align


with its strategic goals.
 Negotiation: Terms are negotiated directly between the company and the investors.
 Issuance: Securities are issued, and the proceeds are used for the company’s
objectives.

2. Preferential Issue

A Preferential Issue involves the allotment of shares or convertible securities to a specific


group of investors on a preferential basis. This method is governed by the provisions of
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Chapter XIV of the SEBI (DIP) Guidelines and is often used to bring in strategic
investors who can provide more than just capital.

Key Features:

 Strategic Investment: Preferential issues are often made to investors who can add
strategic value, such as industry expertise or access to markets.
 Premium Pricing: Shares may be issued at a price higher than the current market
price, reflecting the strategic value of the investment.
 Regulatory Compliance: Companies must comply with specific guidelines set by
SEBI, including disclosures, pricing norms, and lock-in periods for the allotted
shares.

Objectives:

 Infusion of Capital: For expansion, acquisitions, or other strategic initiatives.


 Strengthening Control: Issuing shares to friendly investors to maintain or
strengthen control over the company.

Process:

 Board Approval: The board of directors must approve the preferential issue,
followed by shareholder approval.
 Regulatory Filings: Necessary filings are made with SEBI and stock exchanges.
 Allotment: Shares are allotted to the identified investors, and the proceeds are
utilized as per the company’s objectives.

3. Qualified Institutions Placement (QIP)

A Qualified Institutions Placement (QIP) is a capital-raising tool for listed companies,


allowing them to issue equity shares, fully convertible debentures, or other securities to
qualified institutional buyers (QIBs). QIPs are a quick and efficient way for listed
companies to raise capital without undergoing the elaborate regulatory process required
for public issues.

Key Features:

 Targeted at Institutional Investors: QIPs are exclusively offered to qualified


institutional buyers, such as mutual funds, banks, insurance companies, and pension
funds.
 Reduced Regulatory Burden: The process is streamlined with fewer regulatory
requirements compared to public offerings.
 Pricing Flexibility: The price of the securities is determined by the issuer in
consultation with the merchant banker, within the regulatory framework.

Objectives:

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 Quick Capital Access: QIPs allow companies to quickly raise substantial capital for
strategic needs such as acquisitions, expansion, or debt repayment.
 Maintaining Market Confidence: By issuing securities to reputable institutional
investors, companies can enhance market confidence and stability.

Process:

 Board Approval: The board of directors must approve the QIP, and the company
must comply with SEBI regulations.
 Investor Engagement: The company engages with institutional investors to gauge
interest and determine pricing.
 Issuance and Allotment: Securities are issued and allotted to the qualified
institutional buyers, with the funds being used for the company’s stated objectives.

2.9 Secondary market

The secondary market is a vital component of the financial system, serving as a


platform where existing securities, such as stocks, bonds, and other financial
instruments, are traded among investors. Unlike the primary market, where securities
are issued for the first time, the secondary market provides liquidity and a mechanism
for price discovery, allowing investors to buy and sell previously issued securities. This
market plays a crucial role in ensuring that financial assets are continuously tradable,
contributing to the overall efficiency of the capital markets.

In India, the secondary market is composed of recognized stock exchanges, which


operate under stringent regulations and guidelines approved by the government. These
exchanges provide a structured and regulated environment where securities issued by
the central and state governments, public sector undertakings, and private companies
are actively traded.

Features of the Secondary Market

 Liquidity: The secondary market provides high liquidity, enabling investors to


quickly buy or sell securities without significant price changes.

 Price Discovery: It facilitates the continuous valuation of securities, reflecting the


market's perception of a company's performance and prospects.

 Regulation: Stock exchanges in the secondary market operate under well-defined


rules and regulations, ensuring transparency and fairness in transactions.

 Marketability: Securities can be easily bought and sold in the secondary market,
enhancing their marketability and attractiveness to investors.

 Diverse Participants: The market includes a wide range of participants, such as


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individual investors, institutional investors, brokers, and market makers,
contributing to the depth and dynamism of the market.

 Information Dissemination: The secondary market provides real-time


information on prices, trading volumes, and market trends, aiding informed
decision-making by investors.

Participants in the Secondary Market

 Individual Investors: Retail investors who buy and sell securities for personal
investment purposes.

 Institutional Investors: Entities such as mutual funds, insurance companies, and


pension funds that invest large sums of money in securities.

 Brokers and Dealers: Intermediaries who facilitate the buying and selling of
securities on behalf of investors.

 Market Makers: Firms or individuals that provide liquidity by being ready to buy
or sell securities at publicly quoted prices.

 Regulatory Bodies: Organizations like the Securities and Exchange Board of India
(SEBI) that oversee and regulate market activities to protect investors and maintain
market integrity.

Advantages of the Secondary Market

 Enhanced Liquidity: The ability to buy and sell securities quickly enhances their
attractiveness to investors.

 Efficient Price Discovery: The market's continuous trading mechanism ensures


that securities are accurately priced based on current information and market
sentiment.

 Increased Market Accessibility: The secondary market allows a broader range of


investors, including small retail investors, to participate in the trading of securities.

 Encouragement of Investment: The ability to easily exit investments encourages


more individuals and institutions to invest in securities.

 Monitoring and Regulation: The market's regulatory framework protects


investors and ensures transparency, fostering confidence in the financial system.

Challenges of the Secondary Market

 Market Volatility: Prices in the secondary market can fluctuate significantly,

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leading to potential losses for investors.

 Information Asymmetry: Not all investors have access to the same information,
which can lead to unfair advantages and market manipulation.

 Systemic Risks: The interconnected nature of financial markets means that a


failure in one part of the system can lead to broader economic issues.

 Speculation: Excessive speculation can lead to price bubbles, which may


eventually burst, causing significant financial damage.

 Regulatory Challenges: Keeping up with technological advancements and market


innovations requires continuous updates to regulatory frameworks, which can be
complex and resource-intensive.

2.10 Functions of Secondary Market

 Liquidity Provision: The secondary market plays a crucial role in ensuring


liquidity for investors by providing a platform where securities can be bought and
sold with ease. Liquidity refers to the ability to quickly convert assets into cash
without causing a significant impact on the asset's price. In the secondary market,
the continuous trading of securities ensures that investors can readily find buyers
or sellers for their assets. This function is vital because it allows investors to
manage their portfolios dynamically, adjusting their investments in response to
changes in market conditions, personal financial needs, or investment strategies.
The high liquidity in secondary markets enhances the appeal of securities, as
investors are more likely to invest in assets that they can easily liquidate when
necessary. Moreover, the presence of liquidity reduces the risk associated with
holding securities, as investors can exit their positions with minimal cost or delay,
thereby fostering a more vibrant and resilient financial market.

 Capital Allocation: The secondary market plays a pivotal role in the efficient
allocation of capital within the economy. When investors trade securities in the
secondary market, capital flows from entities where it may be less effectively
utilized to those where it can be put to more productive use. This process is
facilitated by the price mechanism, where the value of securities is determined by
market forces based on the perceived future earnings and growth potential of the
issuing entities. As investors sell securities in companies or sectors with lower
expected returns and reinvest in those with higher potential, capital is reallocated
in a way that supports economic growth. This function of the secondary market is
particularly important because it ensures that resources are directed toward
enterprises that are most likely to use them efficiently, thus contributing to overall
economic development. In essence, the secondary market serves as a conduit
through which the economy's scarce financial resources are optimally distributed,
enabling the most promising companies and sectors to thrive.

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 Valuation of Securities: One of the primary functions of the secondary market is
the continuous valuation of securities. As securities are bought and sold, their prices
fluctuate based on a multitude of factors, including company performance, industry
trends, economic indicators, and investor sentiment. This ongoing process of price
determination is known as price discovery. The secondary market provides a
transparent and accessible platform where these prices are established through the
interactions of buyers and sellers. Accurate valuation of securities is essential for
several reasons. It provides investors with a benchmark for assessing the
performance of their investments, helps in determining the cost of capital for
companies, and influences corporate decisions related to financing, investment, and
dividend distribution. Furthermore, the valuation function of the secondary market
contributes to the overall stability of the financial system by ensuring that prices
reflect the true underlying value of securities, thereby reducing the likelihood of
mispricing and market inefficiencies.

 Investor Protection: The secondary market is governed by a comprehensive


regulatory framework designed to protect investors from unfair practices and to
ensure the integrity of the market. Regulatory bodies, such as the Securities and
Exchange Board of India (SEBI), enforce rules and guidelines that promote
transparency, fairness, and accountability in market transactions. These regulations
are crucial in maintaining investor confidence, which is the foundation of a well-
functioning secondary market. Investor protection measures include the
requirement for companies to disclose accurate and timely information, the
monitoring of insider trading, and the enforcement of ethical standards among
market participants. By safeguarding investors' interests, the secondary market not
only attracts more participants but also promotes a level playing field where all
investors, regardless of their size or influence, can trade securities with confidence.
This function is integral to the long-term health and sustainability of the financial
markets, as it helps prevent fraud, market manipulation, and other forms of
malpractice that could undermine investor trust and market stability.

 Performance Pressure on Companies: The secondary market exerts significant


pressure on publicly traded companies to perform well, as their stock prices are
continuously monitored by a wide range of market participants. The price of a
company's stock in the secondary market reflects investors' collective assessment
of its current performance and future prospects. As a result, companies are
motivated to improve their operational efficiency, profitability, and growth
potential to maintain or enhance their stock prices. This market-driven performance
pressure can lead to more disciplined management practices, greater transparency
in financial reporting, and a stronger focus on long-term strategic goals.
Additionally, companies with higher stock prices are often able to raise capital
more easily and at lower costs, providing them with the resources needed to invest
in innovation, expand their operations, and achieve sustainable growth. On the
other hand, companies that underperform may face declining stock prices, which
can lead to a loss of investor confidence, difficulties in securing financing, and even
the risk of takeover. Therefore, the secondary market serves as a powerful
mechanism for ensuring that companies remain accountable to their shareholders
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and continue to strive for excellence in their business activities.

2.11 Organizations of Secondary Market

The secondary market in India comprises various recognized stock exchanges that
facilitate the trading of securities. These stock exchanges are organized under
different legal and structural forms, reflecting the diversity in their governance and
operational frameworks.

 Organizational Forms:

 Voluntary Non-Profit-Making Associations: Stock exchanges like Bombay


(now Mumbai), Ahmedabad, and Indore were initially organized as
voluntary, non-profit-making associations of individuals. These exchanges
operated with the primary goal of assisting in the buying, selling, and dealing
of securities, rather than generating profits.

 Public Limited Companies: Stock exchanges in cities such as Kolkata,


Delhi, Bangalore, Cochin, Kanpur, Guwahati, Ludhiana, and Chennai were
structured as public limited companies. These exchanges are incorporated
entities that offer their shares to the public and operate under the governance
of a board of directors.

 Companies Limited by Guarantee: The stock exchanges in Coimbatore and


Pune are examples of companies limited by guarantee, where members'
liability is limited to the amount they have agreed to contribute to the
company’s assets if it is wound up.

 Section 25 Companies: The Over the Counter Exchange of India (OTCEI)


was incorporated under Section 25 of the Companies Act, 1956 (now
Section 8 under the Companies Act, 2013). These companies are non-profit
entities with objectives promoting commerce, art, science, religion, charity,
or any other useful purpose.

 Regional Stock Exchanges: Regional stock exchanges in India were traditionally


managed by a governing body comprising elected and nominated members. These
governing bodies held extensive powers to manage the exchange’s operations,
including electing office-bearers, forming committees, admitting and expelling
members, managing properties and finances, resolving disputes, and overseeing
day-to-day activities.

 Demutualized Exchanges: The OTCEI and the National Stock Exchange (NSE)
are examples of demutualized exchanges, where ownership and management are
separated from the trading rights. In these exchanges, the separation ensures that
the exchange operates independently, focusing on its responsibilities without any
conflict of interest arising from trading activities.

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 National Stock Exchange: The NSE is unique among Indian stock exchanges as
it is a tax-paying company incorporated under the Companies Act. It was promoted
by leading financial institutions and banks, emphasizing its role as a major player
in the Indian financial markets.

2.12 Management of Secondary Market

The management of secondary markets in India involves a complex system of


governance, regulations, and participant oversight to ensure the smooth functioning
of trading activities.

 Role of Brokers:

o Membership and Certification: Brokers are essential intermediaries in the


secondary market, facilitating trades between buyers and sellers. They are
registered members of the stock exchanges and must obtain a certificate of
registration from the Securities and Exchange Board of India (SEBI). Brokers
are required to comply with a prescribed code of conduct, which ensures the
quality and integrity of their services.

o Types of Brokers: Brokers in the Indian stock exchanges are categorized into
three classes: proprietary, partnership, and corporate. Historically, most
brokers in older exchanges operated as proprietors, while newer exchanges,
like the NSE and OTCEI, have seen a shift towards corporate membership.

o Evolution and Standards: Over time, many brokers have transitioned from
proprietary or partnership firms to corporate entities. Both the NSE and OTCEI
have set strict standards for member admission, focusing on capital adequacy,
track record, education, and experience to maintain high standards in broking
services.

 Brokerage Fees and Charges:

o Registration Fees: Brokers are required to pay an annual registration fee, with
the amount varying based on their turnover. If a broker's turnover exceeds ₹1
crore, additional fees are levied. After five years from initial registration, a
broker must pay a fee for a block of five financial years.

o Transaction Charges and Brokerage: Brokers charge transaction fees and


brokerage on trades, with the maximum brokerage capped at 2.5% of the
contract price, exclusive of statutory levies. They are also responsible for
paying exchange transaction charges and securities transaction taxes (STT) on
all trades.

 Direct Market Access (DMA):

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o Innovative Trading Facilities: Brokers can now offer Direct Market Access
(DMA) to institutional clients, allowing them to access the exchange trading
system directly through the broker's infrastructure. This facility enhances
trading efficiency by reducing manual intervention, increasing order execution
speed, improving transparency, and providing better audit trails. DMA also
supports sophisticated trading strategies through the use of algorithms and
decision-support tools.

 Industry Consolidation:

o Structural Changes: The Indian broking industry has undergone significant


structural changes in recent years, with consolidation becoming increasingly
important. Larger broking entities have captured a substantial share of the
market, leading to the closure of smaller brokerages. This trend reflects the
growing importance of scale, technology, and efficiency in the competitive
landscape of the secondary market.

2.13 Indexes of Secondary Market

Stock market indices are fundamental tools in the financial markets, serving as
indicators of market sentiment and economic health. These indices reflect the overall
behavior of specific market segments, providing insights into daily fluctuations in stock
prices and the broader market direction. In this comprehensive overview, we will
explore the definition, importance, functions, characteristics, and methodologies for
calculating stock market indices, along with a focus on major global and Indian indices.

Definition and Importance of Stock Market Indices

A stock market index is a statistical measure that tracks the performance of a specific
group of stocks, representing a particular segment of the market. It acts as a barometer
of market behavior, indicating day-to-day fluctuations in stock prices and providing a
snapshot of the broader market's direction.

Importance:

 Market Sentiment: Stock market indices provide valuable insights into the
average share price in the market, reflecting the overall sentiment of investors and
traders.

 Economic Indicator: A well-constructed index captures the market's overall


behavior and serves as a leading economic indicator, reflecting future expectations
of economic performance.

 Investment Benchmark: Investors use indices as benchmarks to evaluate the


returns on their portfolios against the market's average return, guiding investment
strategies and decisions.

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Functions of Stock Market Indices

 Market Sentiment:

o Stock market indices provide a snapshot of market sentiment by


reflecting the average share price and overall investor confidence.
o They offer insights into how the market is performing, helping investors
gauge whether the market is bullish or bearish.

 Economic Indicator:

o A well-constructed index serves as a leading economic indicator,


capturing the market's overall behavior and reflecting expectations about
future economic performance.
o Indices are often used to predict economic cycles, providing early signals
of economic expansion or contraction.

 Investment Benchmark:

o Investors use indices as benchmarks to evaluate the performance of their


investment portfolios against the broader market.
o Indices help investors identify whether their investments are
outperforming or underperforming the market, guiding their investment
strategies.

Ideal Characteristics of a Stock Market Index

 Representative of Market Behavior:

o An ideal stock market index should accurately reflect changes in scrip


prices and represent typical share price movements, offering a better
representation of the overall market.

 High Market Capitalization and Liquidity:

o A good index includes scrips with high market capitalization and liquidity,
ensuring that the index reflects the market's investible opportunities
accurately.
o High market capitalization ensures that the index is representative of the
largest and most influential companies in the market.
o Liquidity ensures that the included stocks are actively traded, making the
index a reliable indicator of market performance.

Methodologies for Calculating Stock Market Indices

Stock market indices serve as benchmarks that reflect the overall performance of the
stock market or specific sectors within it. The methodologies used to calculate these
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indices are crucial for accurately representing market movements. Here, we delve into
the different methodologies used to calculate stock market indices, with a focus on
Indian indices as examples.

1. Market Capitalization-Weighted Index

A Market Capitalization-Weighted Index gives more weight to companies with a higher


market capitalization, meaning that larger companies have a more significant influence
on the index's movement.

a. Full Market Capitalization Method

 Definition: In this method, the index is calculated by multiplying the number of


outstanding shares of each company by its current market price. The market
capitalization of each company is then summed up to determine the total market
value of the index.
 Example: The S&P CNX Nifty in India, now known as the Nifty 50, uses this
methodology. It includes 50 of the largest companies listed on the National Stock
Exchange (NSE) and reflects their performance.

b. Free-Float Market Capitalization Method

 Definition: The Free-Float Market Capitalization method adjusts the market


capitalization by considering only the shares that are freely available for trading
in the market, excluding shares held by promoters, the government, and other
strategic shareholders.
 Advantages:
o Rational Representation: It better reflects the investable market
capitalization, offering a more accurate representation of a company's
influence on the index.
o Broad-Based Index: It reduces the concentration of large-cap stocks and
ensures a more diversified index.
o Global Adoption: This method is widely used globally, including by
indices such as the BSE Sensex in India.
 Example: The BSE Sensex, which transitioned to a free-float methodology in
September 2003, is a prime example. It uses a free-float factor to adjust the weight
of each company in the index, leading to a more accurate reflection of market
conditions.

2. Modified Capitalization-Weighted Index

In this method, adjustments are made to limit the influence of the largest stocks,
ensuring that no single stock or group of stocks dominates the index. This method is
used when an index needs to represent a broader market without being overly influenced
by the largest companies.

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Example: The NASDAQ-100 Index employs this methodology. While the index
includes the 100 largest non-financial companies listed on the NASDAQ, the modified
weighting prevents a few tech giants from skewing the index disproportionately.

3. Price-Weighted Index

In a Price-Weighted Index, the index is calculated by adding the prices of the constituent
stocks and then dividing by a divisor. The stocks with higher prices have a more
significant impact on the index, regardless of the company's size or market
capitalization.

Example: The Dow Jones Industrial Average (DJIA) in the United States is the most
famous price-weighted index. While there is no direct Indian equivalent, the concept is
similar to certain historical indices in India, where high-priced stocks had more
influence.

4. Equal-Weighted Index

An Equal-Weighted Index assigns equal weight to all constituent stocks, ensuring that
each stock has the same influence on the index movement, regardless of its price or
market capitalization.

Example: The Value Line Composite Index in the United States is an example of an
equal-weighted index. Though not widely used in India, this methodology highlights an
alternative approach to index calculation.

Major Indices in India

India's stock market is home to several key indices that serve as barometers of the
country's economic and financial health. These indices are crucial for investors,
policymakers, and economists alike.

1. BSE Sensex

Overview:

 Launched: 1986
 Constituents: 30 of the largest and most actively traded stocks on the Bombay Stock
Exchange (BSE).
 Base Year: 1978-79
 Significance: The Sensex is often seen as the pulse of the Indian stock market,
reflecting the overall market sentiment and economic outlook.

Calculation Methodology:

 Initial Methodology: Initially, the Sensex was a market capitalization-weighted


index.

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 Current Methodology: Since 2003, it has used the free-float market capitalization
method, where only the shares available for public trading are considered for index
calculation.
 Sector Representation: The index is designed to represent various sectors of the
Indian economy, with a focus on those that are market leaders in their respective
industries.

Impact:

 Market Indicator: The Sensex is a leading economic indicator, often used to gauge
the health of the Indian economy. Movements in the Sensex are closely watched by
investors and policymakers alike.
 Investor Benchmark: It serves as a benchmark for portfolio performance, with
many mutual funds and ETFs tracking its performance.

2. NSE Nifty 50

Overview:

 Launched: 1996
 Constituents: 50 of the largest and most liquid stocks listed on the National Stock
Exchange (NSE).
 Base Year: 1995
 Significance: The Nifty 50 is another critical index in India, providing a
comprehensive view of the Indian stock market.

Calculation Methodology:

 Full Market Capitalization: Initially, Nifty 50 used the full market capitalization
method, similar to the Sensex.
 Free-Float Adjustment: It also uses the free-float market capitalization method,
reflecting only the freely available shares for trading.
 Liquidity and Impact Cost: Stocks in the Nifty 50 are selected based on their
liquidity and the impact cost, ensuring that the index accurately represents the most
traded stocks.

Impact:

 Benchmark Index: The Nifty 50 is widely used as a benchmark for mutual funds,
ETFs, and other financial products. It represents a significant portion of the total
market capitalization of the NSE.
 Global Recognition: The Nifty 50 is internationally recognized and tracked by
investors worldwide, often used in global comparisons.

3. Other Major Indices

a. BSE 500 Index

CS KOMAL KEWALRAMANI Page 33


 Overview: This index includes 500 stocks representing nearly all sectors of the
Indian economy, providing a broad market perspective.
 Significance: It captures over 90% of the total market capitalization on the BSE,
making it one of the most comprehensive indices in India.

b. Nifty Midcap 100

 Overview: Focuses on mid-sized companies listed on the NSE.


 Significance: It provides insights into the performance of the midcap segment, often
seen as a barometer for economic growth and innovation in India.

c. Nifty Smallcap 100

 Overview: Comprises 100 small-cap companies listed on the NSE.


 Significance: This index is crucial for investors seeking exposure to emerging and
smaller companies with high growth potential.

d. BSE Bankex

 Overview: Tracks the performance of the leading banking sector stocks listed on the
BSE.
 Significance: It is a sectoral index providing insights into the health of the banking
sector, which is a key driver of the Indian economy.

e. Nifty IT Index

 Overview: Includes top IT companies listed on the NSE.


 Significance: The index reflects the performance of India's globally recognized IT
sector, a significant contributor to the country's GDP.

Global Stock Market Indices

Global stock market indices are essential for tracking the performance of different
markets and sectors worldwide. Below are some of the most significant global indices:

 Dow Jones Industrial Average (DJIA):

o Overview: One of the oldest and most widely watched indices in the USA,
comprising 30 large-cap stocks. It is a price-weighted index.

o Significance: The DJIA serves as a barometer for the overall health of the
U.S. stock market and economy.

 NASDAQ Composite Index:

o Overview: A market capitalization-weighted index that includes all stocks


listed on the NASDAQ stock market, primarily technology companies.

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o Significance: The NASDAQ Composite Index is a key indicator of the
performance of the technology sector and growth stocks.

 S&P 500 Index:

o Overview: Comprising 500 large-cap U.S. companies, this index represents a


broad cross-section of the American economy.

o Significance: The S&P 500 is widely regarded as the best single gauge of the
U.S. equities market, used as a benchmark by investors and fund managers.

 FTSE 100:
o Overview: A market-capitalization-weighted index of the largest 100
companies listed on the London Stock Exchange.

o Significance: The FTSE 100 is a key indicator of the health of the UK


economy and its global exposure.

 MSCI Indices:

o Overview: These indices include a range of global and regional indices, such
as the MSCI World Index, MSCI EAFE (Europe, Australasia, and Far East),
and MSCI Emerging Markets Index (EMF).

o Significance: MSCI indices are widely used to track the performance of


global equities and to guide investment decisions in international markets.

CS KOMAL KEWALRAMANI Page 35

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