Markets and Financial Instruments

TYPES OF MARKETS

Efficient transfer of resources from those having idle resources to others who have a pressing need for them is achieved through financial markets. Stated formally, financial markets provide channels for allocation of savings to investment. These provide a variety of assets to savers as well as various forms in which the investors can raise funds and thereby decouple the acts of saving and investment. The savers and investors are constrained not by their individual abilities, but by the economy's ability, to invest and save respectively. The financial markets, thus, contribute to economic development to the extent that the latter depends on the rates of savings and investment. 

The financial markets have two major components:

• Money market
• Capital market.

The Money market refers to the market where borrowers and lenders exchange short-term funds to solve their liquidity needs. Money market instruments are generally financial claims that have low default risk, maturities under one year and high marketability.

The Capital market is a market for financial investments that are direct or indirect claims to capital. It is wider than the Securities Market and embraces all forms of lending and borrowing, whether or not evidenced by the creation of a negotiable financial instrument. The Capital Market comprises the complex of institutions and mechanisms through which intermediate term funds and long-term funds are pooled and made available to business, government and individuals. The Capital Market also encompasses the process by which securities already outstanding are transferred.

The Securities Market, however, refers to the markets for those financial instruments/claims/obligations that are commonly and readily transferable by sale. 

The Securities Market has two interdependent and inseparable segments, the new issues (primary) market and the stock (secondary) market.

The Primary market provides the channel for sale of new securities. The issuer of securities sells the securities in the primary market to raise funds for investment and/or to discharge some obligation.

The Secondary market deals in securities previously issued. The secondary market enables those who hold securities to adjust their holdings in response to charges in their assessment of risk and return. They also sell securities for cash to meet their liquidity needs.

The price signals, which subsume all information about the issuer and his business including associated risk, generated in the secondary market, help the primary market in allocation of funds.

This secondary market has further two components.

First, the spot market where securities are traded for immediate delivery and payment.

The other is forward market where the securities are traded for future delivery and payment. This forward market is further divided into Futures and Options Market (Derivatives Markets).

In futures Market the securities are traded for conditional future delivery whereas in option market, two types of options are traded. A put option gives right but not an obligation to the owner to sell a security to the writer of the option at a predetermined price before a certain date, while a call option gives right but not an obligation to the buyer to purchase a security from the writer of the option at a particular price before a certain date.

EQUITY MARKET

Before discussing the equities market, we should first understand the basic meaning of markets, their functions and classification.

What is a Market? A market is a location where buyers and sellers come into contact to exchange goods or services. Markets can exist in various forms depending on various factors.

Can Markets Exist in Different Forms? Yes, the markets do exist in different forms depending on the nature of location and mode of contact. It can have a physical location where buyers and sellers come in direct contact with each other or a virtual location where the buyers and sellers contact each other employing advance means of communication. There is another form of market where actual buyers and sellers achieve their objectives through intermediaries.

Securities Markets in India: An Overview: The process of economic reforms and liberalization was set in motion in the mid-eighties and its pace was accelerated in 1991 when the economy suffered severely from a precariously low foreign exchange reserve, burgeoning imbalance on the external account, declining industrial production, galloping inflation and a rising fiscal deficit. The economic reforms, being an integrated process, included deregulation of industry, liberalization in foreign investment, regime, restructuring and liberalization of trade, exchange rate, and tax policies, partial disinvestments of government holding in public sector companies and financial sector reforms. The reforms in the real sectors such as trade, industry and fiscal policy were initiated first in order to create the necessary macroeconomic stability for launching financial sector reforms, which sought to improve the functioning of banking and financial institutions (FIs) and strengthen money and capital markets including securities market. The securities market reforms specifically included:

·         Repeal of the Capital Issues (Control) Act, 1947 through which Government used to expropriate and allocate resources from capital market for favored uses;

·         Enactment of the Securities and Exchange Board of India Act, 1992 to provide for the establishment of the Securities and Exchange Board of India (SEBI) to regulate and promote development of securities market;

·         Setting up of NSE in 1993, passing of the Depositories Act, 1996 to provide for the maintenance and transfer of ownership of securities in book entry form;

·         Amendments to the Securities Contracts (Regulation) Act, 1956 (SCRA) in 1999 to provide for the introduction of futures and option.

·         Other measures included free pricing of securities, investor protection measures, use of information technology, dematerialization of securities, improvement in trading practices, evolution of an efficient and transparent regulatory framework, emergence of several innovative financial products and services and specialized FIs etc.

These reforms are aimed at creating efficient and competitive securities market subject to effective regulation by SEBI, which would ensure investor protection.

A Profile: The corporate securities market in India dates back to the 18^th century when the securities of the East India Company were traded in Mumbai and Kolkotta. The brokers used to gather under a Banyan tree in Mumbai and under a Neem tree in Kolkota for the purpose of trading those securities. However the real beginning came in the 1850’s with the introduction of joint stock companies with limited liability. The 1860’s witnessed feverish dealings in securities and reckless speculation. This brought brokers in Bombay together in July 1875 to form the first formally organized stock exchange in the country viz. The Stock Exchange, Mumbai. Ahmedabad stock exchange in 1894 and 22 others followed this in the 20th century. The process of reforms has led to a pace of growth almost unparalleled in the history of any country. Securities market in India has grown exponentially as measured in terms of amount raised from the market, number of stock exchanges and other intermediaries, the number of listed stocks, market capitalization, trading volumes and turnover on stock exchanges, investor population and price indices. Along with this, the profiles of the investors, issuers and intermediaries have changed significantly. The market has witnessed fundamental institutional changes resulting in drastic reduction in transaction costs and significant improvements in efficiency, transparency and safety, thanks to the National Stock Exchange. Indian market is now comparable to many developed markets in terms of a number of parameters.

Structure and Size of the Markets: Today India has two national exchanges, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Each has fully electronic trading platforms with around 9400 participating broking outfits. Foreign brokers account for 29 of these. There are some 9600 companies listed on the respective exchanges with a combined market capitalization near $125.5bn. Any market that has experienced this sort of growth has an equally substantial demand for highly efficient settlement procedures. In India 99.9% of the trades, according to the National Securities Depository, are settled in dematerialized form in a T+2 rolling settlement The capital market is one environment. In addition, the National Securities Clearing Corporation of India Ltd (NSCCL) and Bank of India Shareholding Ltd (BOISL), Clearing Corporation houses of NSE and BSE, guarantee trades respectively. The main functions of the Clearing Corporation are to work out (a) what counter parties owe and (b) what counter parties are due to receive on the settlement date.

Furthermore, each exchange has a Settlement Guarantee Fund to meet with any unpredictable situation and a negligible trade failure of 0.003%. The Clearing Corporation of the exchanges assumes the counter-party risk of each member and guarantees settlement through a fine-tuned risk management system and an innovative method of online position monitoring. It also ensures the financial settlement of trades on the appointed day and time irrespective of default by members to deliver the required funds and/or securities with the help of a settlement guarantee fund.

Style of Operating: Indian stock markets operated in the age-old conventional style of fact-to-face trading with bids and offers being made by open outcry. At the Bombay Stock Exchange, about 3,000 persons would mill around in the trading ring during the trading period of two hours from 12.00 noon to 2.00 p.m. Indian stock markets basically quote-driven markets with the jobbers standing at specific locations in the trading ring called trading posts and announcing continuously the two-way quotes for the scrips traded at the post. As there is no prohibition on a jobber acting as a broker and vice versa, any member is free to do jobbing on any day. In actual practice, however, a class of jobbers has emerged who generally confine their activities to jobbing only. As there are no serious regulations governing the activities of jobbers, the jobbing system is beset with a number of problems like wide spreads between bid and offer; particularly in thinly traded securities, lack of depth, total absence of jobbers in a large number of securities, etc. In highly volatile scrips, however, the spread is by far the narrowest in the world being just about 0.1 to 0.25 percent as compared to about 1.25 per cent in respect of alpha stocks, i.e. the most highly liquid stocks, at the International Stock Exchange of London. The spreads widen as liquidity decreases, being as much as 25 to 30 per cent or even more while the average touch of gamma stocks, i.e. the least liquid stocks at the International Stock Exchange, London, is just about 6 to 7 per cent. This is basically because of the high velocity of transactions in the active scrips. In fact, shares in the specified group account for over 75 percent of trading in the Indian stock markets while over 25 percent of the securities do not get traded at all in any year. Yet, it is significant to note that out of about 6,000 securities listed on the Bombay Stock Exchange, about 1,200 securities get traded on any given trading day.

The question of automating trading has always been under the active consideration of the Bombay Stock Exchange for quite sometime. It has decided to have trading in all the non-specified stocks numbering about 4,100 totally on the computer on a quote-driven basis with the jobbers, both registered and roving, continuously keying in their bids and offers into the computer with the market orders getting automatically executed at the touch and the limit orders getting executed at exactly the rate specified.

In March 1995, the BSE started the computerized trading system, called BOLT - BSE on-line trading system. Initially only 818 scripts were covered under BOLT. In July 1995, all scripts (more than 5,000) were brought under the computerized trading system. The advantages realized are: (a) improved trading volume; (b) reduced spread between the buy-sell orders; c) better trading in odd lot shares, rights issues etc.

Highlights of the Highly Attractive Indian Equity Market: Two major reasons why Indian securities are now increasingly regarded as attractive to international investors are the relatively high returns compared with more developed global markets as well as the low correlation with world markets.

DEBT MARKET

The National Stock Exchange started its trading operations in June 1994 by enabling the Wholesale Debt Market (WDM) segment of the Exchange. This segment provides a trading platform for a wide range of fixed income securities that includes central government securities, treasury bills (T-bills), state development loans (SDLs), bonds issued by public sector undertakings (PSUs), floating rate bonds (FRBs), zero coupon bonds (ZCBs), index bonds, commercial papers (CPs), certificates of deposit (CDs), corporate debentures, SLR and non-SLR bonds issued by financial institutions (FIs), bonds issued by foreign institutions and units of mutual funds (MFs).

To further encourage wider participation of all classes of investors, including the retail investors, the Retail Debt Market segment (RDM) was launched on January 16, 2003. This segment provides for a nation wide, anonymous, order driven, screen based trading system in government securities. In the first phase, all outstanding and newly issued central government securities were traded in the retail debt market segment. Other securities like state government securities, T-bills etc. will be added in subsequent phases. The settlement cycle is same as in the case of equity market i.e., T+2 rolling settlement cycle.

DERIVATIVES MARKET

The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking–in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices.

However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

Derivatives Defined: Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines “derivative” to include –

·         A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.

·         A contract, which derives its value from the prices, or index of prices, of underlying securities.

Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

Products, Participants and Functions: Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants - hedgers, speculators, and arbitrageurs trade in the derivatives market. Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

The derivatives market performs a number of economic functions. First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Fourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Finally, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

Types of Derivatives: The most commonly used derivatives contracts are forwards, futures and options, which we shall discuss these in detail in the FMM-II later. Here we take a brief look at various derivatives contracts that have come to be used.

·         Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.

·         Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

·         Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

·         Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

·         LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.

·         Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.

·         Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

   Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency and

   Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

·         Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

COMMODITIES MARKET

Derivatives as a tool for managing risk first originated in the commodities markets. They were then found useful as a hedging tool in financial markets as well. In India, trading in commodity futures has been in existence from the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Over a period of time, other commodities were permitted to be traded in futures exchanges. Regulatory constraints in 1960s resulted in virtual dismantling of the commodities future markets. It is only in the last decade that commodity future exchanges have been actively encouraged. However, the markets have been thin with poor liquidity and have not grown to any significant level. Let’s look at how commodity derivatives differ from financial derivatives.

Difference between Commodity and Financial Derivatives: The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features, which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlying is concerned. However in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed. We have a brief look at these issues.

Physical Settlement - Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations.

Warehousing - One of the main differences between financial and commodity derivatives is the need for warehousing. In case of most exchange traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. Similarly the person, who sold this futures contract at Rs.100, does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash. In case of commodity derivatives however, there is a possibility of physical settlement. Which means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset. This requires the exchange to make an arrangement with warehouses to handle the settlements. The efficacy of the commodities settlements depends on the warehousing system available. Most international commodity exchanges used certified warehouses (CWH) for the purpose of handling physical settlements. Such CWH are required to provide storage facilities for participants in the commodities markets and to certify the quantity and quality of the underlying commodity. The advantage of this system is that a warehouse receipt becomes a good collateral, not just for settlement of exchange trades but also for other purposes too. In India, the warehousing system is not as efficient as it is in some of the other developed markets. Central and state government controlled warehouses are the major providers of agri-produce storage facilities. Apart from these, there are a few private warehousing being maintained. However there is no clear regulatory oversight of warehousing services.

Quality of Underlying Assets - A derivatives contract is written on a given underlying. Variance in quality is not an issue in case of financial derivatives as the physical attribute is missing. When the underlying asset is a commodity, the quality of the underlying asset is of prime importance. There may be quite some variation in the quality of what is available in the marketplace. When the asset is specified, it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable. Commodity derivatives demand good standards and quality assurance/certification procedures. A good grading system allows commodities to be traded by specification.

Currently there are various agencies that are responsible for specifying grades for commodities. For example, the Bureau of Indian Standards (BIS) under Ministry of Consumer Affairs specifies standards for processed agricultural commodities whereas AGMARK under the department of rural development under Ministry of Agriculture is responsible for promulgating standards for basic agricultural commodities. Apart from these, there are other agencies like EIA, which specify standards for export oriented commodities.