User:Alexkachanov/Finance/Capital Markets

What is a Capital Market?

A capital market is the part of a financial market where companies in need of capital come forward and look for people to invest in them in search of returns. Companies raise money either through bonds or through stocks. Bonds are issued against an interest-bearing loan that the company takes. The loan assures that bondholders will get periodic interest payments, which are more or less guaranteed by the company that issues the bonds. Investors who are risk averse or who want to diversify their portfolios in safer areas invest in bonds. Stocks do not assure periodic payments like bonds do. Hence, stocks are considered riskier than bonds. Companies raise money to fund a new venture, an existing operation, or a new takeover; to purchase new equipment; to open new facilities; to expand into new markets; to launch new products; and so on. Companies list their stocks on stock exchanges to create a market for them and to allow their shares to be traded subsequently. (We discuss listings in more detail in a moment.) Sometimes companies can issue stocks even when the company is not listed but has the intention of getting listed.

Note: Stocks of companies are also popularly called scrips, instruments, and securities.

Sometimes a company directly approaches a market in search of investors and issues securities. The company hooks up with agencies called lead managers, or merchant bankers, that help the company raise money. In cases where investors are directly providing money to companies, the process is called a public offering. If it's the first time the company is raising money from the public, the process is called an initial public offering (IPO). A market where a public offering is made and companies raise money directly from investors is called a primary market.

Once the public offering takes place, investors have the securities, and the company has the money. The company then lists the securities on one or multiple stock exchanges. Companies apply to the exchange to get their stocks listed. They pay a listing fee to the exchange for listing and comply with the exchange’s specified listing requirements. Listing makes the securities available for subsequent buying and selling through current and potential investors. This enables investors to make profits, cut risks, invest in potential growth areas, and so on. A market where shares are subsequently traded after issuance is called a secondary market.

What is Equity, and What are Equity Shares?

Equity is the capital that is deployed to start a company. It has all the risk and gives a share in the profit that the corporation makes. Equity shares are instruments that grant ownership on equity and thus the underlying company. Shareholders are owners of a company. Their ownership is proportional to the percentage of shares held in the company. Usually shareholders and managers of the company are different, but they can also be the same. Shareholders appoint the company’s board and chief executive officers (CEOs). The company makes profits and losses in the usual course of its business. The profit that the company makes is distributed amongst the shareholders in proportion to the number of shares they hold. The profit shared with shareholders is a dividend. When the company incurs a loss, no dividend is paid, and shareholders have to wait for a better year that brings in profits.

Owning stocks has some other benefits. If you buy stocks at an attractive price in a profit-making company, chances are you will witness capital appreciation as stock prices rise. Prices rise because people are willing to pay higher prices in anticipation of an increase in a company’s profit. Simply put, these shares are not merely pieces of paper—they have real companies behind them. When the fortunes of these companies improve because of improved business conditions or an increase in the demands of a company’s products, the value of shares representing the company also rises, resulting in profits for shareholders. However, during times of losses, the share prices can decline; and at times these declines can be substantial. These declines can hurt shareholders by eroding their holding values. Buying and holding shares thus requires patience, insight, and risk-taking ability on the part of the shareholder.

When a company whose securities are traded on a stock exchange tries to issue stock, its already prevailing prices determine how much money the company can raise per share for its fresh issue. Investors and researchers do an inherent valuation of the company’s stock to arrive at the price the shares will trade at after the stock issue and then, depending on the offer price, invest accordingly. A company whose offer price is lower than the intrinsic value will receive a good response in terms of investor participation, and a company whose offer price is at a premium will receive a lukewarm response.

This form of financing is not available to sole proprietorships and partnerships.

Why do People Trade?

Several entities—such as banks, mutual funds, pension funds, brokering firms, insurance companies, corporations, and individuals who possess resources for investments—classify as investors, or traders. Throughout the book, we will use the words investors, traders, and dealers interchangeably because they are more or less the same. They access the markets with a motive of making profits; the differences are in their approaches, frequency of trading, and aggression of trading. Although dealers and traders are the same, the term investor implies people who are a tad risk averse and whose trading frequency is less. Investors usually remain with a specific position for a longer term than dealers/traders. We will ignore these differences, however, because these are general distinctions. Investors trade to invest in an asset class, to speculate, or to hedge their risks. Investors trade with an objective of profiting from the transaction by buying and holding securities in the case of rising prices and by selling and protecting themselves from price declines in the case of a falling market.

Trading is a two-person, zero-sum game. In each transaction, one party makes money, and the other loses money. Since the prices of shares or any asset traded is bidirectional, you generally have a 50 percent chance of making a profit and a 50 percent chance of losing money. Traders know this, yet they trade. This is because they have a price and value forecast/view of the security that they believe is correct, and they want to profit from the view.

Transactions are normally driven by two factors:

• Information: The purchaser/seller genuinely thinks the prices will go up/down. This understanding is usually backed by some commercial development, news, research, or belief. An asset is undervalued when the ongoing market price is less than the intrinsic worth of the asset and overvalued when the ongoing market price is higher than the intrinsic worth.

• Buyers buy and hold securities because they think prices will go up. This simple strategy is called going long, and this position is called a long position. Buyers of securities may or may not have the money to finance their purchases. Buyers who don’t have the money to pay can look out for financing their positions. Similarly, investors sell securities if they anticipate a price decline. They usually sell and deliver securities to the buyer. However, certain categories of sellers sell but don’t have the securities to deliver. These types of sellers are called short sellers, and this position is called a short position. Short sellers either close out their position by accepting profit/loss or look for a securities lender to lend them securities so they can meet their delivery obligations.

• Liquidity: Holders of securities know they need to hold securities longer in order to make a reasonable profit but are unable to hold them because they need money urgently for some other reason. Traders keep shuffling between assets in search of superior returns. If they know one particular security gives them a better opportunity to earn, they might liquidate investments made in another security even if their investment objective in that particular security has not matured. Such transactions are liquidity-driven transactions. Even when traders are not shuffling between asset classes, they may be forced to liquidate positions simply because they have monetary obligations that they can no longer postpone.

It is not difficult to visualize that most trades happen because of differences in opinion about a stock’s price (see Figure 1-1). Therefore, the value of securities fluctuates from time to time. Buyers are thinking a particular security has a potential upside, and sellers are thinking the opposite. In certain extreme conditions, no difference in opinion exists. In such cases, markets really become illiquid, and it becomes difficult to push through transactions. One such example was the condition of stock markets worldwide after the September 11 disaster.

Although traders knew for certain there would be value erosion in most securities because of the loss and resultant slowdown in the economy, they did not agree on the quantum, and no one was even willing to hazard a guess. More specifically, no one knew what the economic impact would be on the share prices of companies and at what levels prices would stagnant. Security prices went into a free fall. While prices fell, the entire market was of the view that prices should fall; hence, no difference of opinion existed, and therefore no buyers existed. Buyers surfaced only after a large fall. At these levels, potential buyers were convinced they were once again getting value for their money; hence, they became counterparties to sale transactions, and that is when transactions started happening. Such conditions of market stress directly impact liquidity.

Liquidity is the ease at which you can trade a particular asset. When traders demand liquidity, they expect their transactions to be executed immediately. Liquidity is also determined by market width, which is the cost of executing the transaction of a specified size, and by market depth, which is how much quantity can be executed at a given cost. In markets where securities are relatively illiquid, possibilities exist that the market is willing to bet on only one side; that is, either the players are willing only to buy or only to sell. Even when two-way quotes exist, the depth could be small. This means not enough orders could be in the system to match a large order. This will make traders go through an agonizing wait if not enough takers exist for their orders. This is a condition most traders/investors abhor. In fact, large investors are known to avoid stocks that are illiquid. Traders go long on a stock they think will go up in price. Such traders are called bullish on the stock. Similarly, traders go short on stocks they think will decline in price. Such traders are called bearish on the stock. At any given time, a trader could be bullish on one stock while being bearish on another. Or, even for a particular stock, the trader could be bullish at a particular price and bearish at another price. To see the price at which a security is trading, traders need to refer to a quote. A quote could be a purchase price or a sale price. It could also be a two-way quote. A two-way quote comprises a bid price (the purchase price) and an offer price (the sale price). The bid price is the price a counterparty is willing to pay you in case you want to sell your securities to that party. The offer price is the price the party is asking for in case you want to buy securities from that party.

The offer price will logically be higher than the bid price. When you ask for a quote, for example, you will get a figure such as $54.10/$54.15 (see Figure 1-2).

In a two-way quote, the first price is the bid price. In other words, $54.10 is the price you will get if you want to sell your securities; the condition is called hitting the bid. If you want to buy, the trader will sell that security to you for $54.15. This is called taking the offer. The difference between the bid price and offer price is called the spread. The spread is the profit the trader makes by providing a two-way quote and doing a round-turn transaction (both buy and sell) at that quote. In this example, the spread is $0.05. Spread is thus a profit for the quote-providing trader and a cost for the investor.

Some traders also do arbitrage. Arbitrage is buying a stock (or any asset) from a market where its quote is cheaper and selling it in a different market simultaneously where its quote is at a higher rate. Though it sounds simple, arbitrage has its own nuances and risks. We will discuss the arbitrage business in more detail in Chapter 8.

Understanding Entities in the Equities Market

Generally, you can divide an entire market into a buy side and a sell side (see Figure 1-3).

The buy side includes fund managers, institutions, individual investors, corporations, and governments that are looking for investment avenues and solutions to issues they face. For example, corporations could be looking to issue fresh equity and thus be looking for investors. Corporations could also be hedging their existing exposure. This means they would be buying or selling some assets to cut risk they are already facing. Fund managers could be looking for avenues to park their funds to provide returns to their unit holders. Portfolio managers play a similar role and could be looking for opportunities to sell and make profits.

The sell side includes entities that provide liquidity services and solutions to the buy side. Examples of sell-side entities include stock exchanges, clearing corporations, and depositories. Fund managers and portfolio managers could trade on an exchange and settle their transactions through clearing corporations. Corporations could access the market's issuance mechanism to raise money. In short, the sell side comes forward to provide services to the buy side.

The equity market comprises a lot of entities, including stock exchanges, clearing corporations, clearing members, members of the exchange, depositories, banks, and so on. In the subsequent sections, we will describe the roles played by individual entities in the equities market.