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Chapter 1 Securities Markets 1

2 Part I Investment Management

INVESTMENTMANAGEMENT

Dr. V. A. AVADHANIM.A. Ph.D., (USA), M.A., LLB., CAIIB.

(Retired Adviser in RBI & FormerDirector of Training Institute in Bombay Stock Exchange,

Former Advisor to HSE.)

EIGHTH REVISED EDITION : 2011

MUMBAI NEW DELHI NAGPUR BENGALURU HYDERABAD CHENNAI PUNE LUCKNOW AHMEDABAD ERNAKULAM BHUBANESWAR INDORE KOLKATA GUWAHATI


© AuthorNo part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or any means, electronic,mechanical, photocopying, recording and/or otherwise without the prior written permission of the publisher.

First Edition : 1996Reprint : 1996Second Revised Edition : 1997Third Revised Edition : 1999Fourth Revised Edition : 2000Fifth Revised Edition : 2002Sixth Revised Edition : 2006Seventh Revised Edition : 2008Reprint : 2009Eighth Revised Edition : 2011

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PREFACE TO THE EIGHTH REVISED EDITION

The theory and principles of Investment Management remain unaltered but the backdrop of the operations ofinvestment and the practices and procedures of invesment management change from time to time.The financial markets in which most of the operations take place are a reflection of the economy and its performance.The economic and financial reforms in India are a continuing process and these affect the operations in the financialmarkets. The changes are to be incorporated in any revision of a book of this nature, which is being used by students offinance whether in MBA or M.com. or any other professional course. This is the rationale of the present revision, whichhopefully helps the student update the information relevant to the area.

During the recent past and in the present decade from 1999 to 2009, the GDP growth was at a rate of about 8%higher than ever before, with the latest year 2006-7 showing a growth of 9.2%. Nearly 60% of this growth is due toservices sector which includes the financial services like banking, insurance, stock broking etc. The financial structureand institutional framework is being stengthened and banking and e-commerce are the highlights of the recent past. Stockand capital markets are booming reflecting the strong economic fundaments and good corporate performance. Foreignfunds inflow is increasing particularly during the period 2004 to 2008 when the BSE Sensex has reached a peak of 21,207in January 2008 and after a low of 7,697 in October 2008, firmed up again to a high of 18,048 in April 2010 and is around17,000 in May 2010. Globalization trends are perceptible in all spheres of the economy and particulary in the financialmarkets. These trends along with privatization of the enterprise gave a new boost to the economy and financial markets.The global recession 2008-09 had its impact along with the financial turmoil in Euro-markets due to debt crisis in Greeceon the Indian markets.

The strong points in the economy are the good monsoons and rapid growth of the manufacturing sector, control ofinflation and larger inflow foreign direct and portfolio investments and good buffer of forex reserves. Although theinflation rate reached a level of 10% at one stage, it is being controlled through monetary and fiscal measures. Whileequity market is bullish, the corporate debt market is being developed by the SEBI and the Goverment Debt market by theRBI. FDI inflows are being encouraged through the policy changes reducing the red tapism, and Govt. regulations,increase in limits for Foreign investments in selected sectors and rise in the ECB limits.

The Eleventh Plan aims at accelerating the growth of agriculture to 4% and increasing the GDP growth rate to 10%for which all necessary inputs are being planned. In the fiscal field, the fiscal deficit is being kept low; subsidies are beingrationalized and fiscal prudence is being observed. In the monetary and credit field, flexibility in interest rate policy andfrequent use of repo rate and CRR has curbed the growth of money supply beyond the required level. CRR was raisedmany times from 4.5% in 2003 to 7.75% in Jan. 2008 but it stood at 6% in April 2010. Greater autonomy is given to banksin their risk management, credit policy and interest rate policy. The RBI has been curbing the excess liquidity due toforeign inflow and foreign investment and credit creation by the banks through plastic money etc.

The call money rates are around the repo and reverse repo rates. Due to the recession in our economy, following theglobal recession 2009-10, The Reverse Repo was raised to 3.75% and Repo rate to 5.25%. The monetary policy wasantiinflationary. While the Rupee is getting strengthened against dollar in the forex market, the RBI. is thinking of allowingthe currency futures in the markets. Derivative markets in stock index and a equities are having a larger turnover than inthe cash market, reflecting the larger operations of foreign FIs and MFs etc. The RBI is also allowing the rupee to find itsown level but is keeping watch on the inflationary expectations.

It is in this context that the present book is revised to bring out the impact of these changes and to update thefigures and data used in the text. In this task, I acknowledge with thanks the suggestions of the teaching colleages and theco-operation of the Himalaya Publishing House.

— DR. V. A. AVADHANI


PREFACE TO THE FIRST EDITION

This book on Investment Management is intended as a textbook for the students of M.Com. and M.B.A. Coursesin Finance. Admittedly, there are many books on Finance Management and Investment Management, but what made mewrite this book is that it covers the syllabus of many Universities for M.Com. and M.B.A. courses, specially designed tohelp the students with simple presentation, practical illustrations and in the Indian background. With my experience of 32years in the Reserve Bank of India in economic and financial research, and nearly six years of research and trainingexperience in the Bombay Stock Exchange and Hyderabad Stock Exchange, and teaching the subjects of Finance andInvestment in many management institutes, including I.I.M. Calcutta, my background is down to earth practical and myapproach is teaching for job orientation. I have trained many sub-brokers to become brokers and hundreds of investorsto become wise investors, which all helped me to make theory useful for practical applications.

Many professors whom I know have encouraged me to venture into this useful service to the studentsby presenting the subjects in a practical manner and with an Indian background. In particular, I kept thesyllabus for M.Com. and M.B.A. courses of the Osmania University, Andhra University, Kakatiya University and MadrasUniversity, among others, before me when I wrote the book. Shri D.P. Pandey of the Himalaya Publishing House has beenconstantly helping me and giving all encouragement during the course of mywriting this book. Any suggestions for improvement may be sent to him and I shall incorporate such suggestions, in thenext edition.

This book is structured in a manner to be very comprehensive and sweepingly wide so as to accommodate thesyllabus of almost all universities, to the extent possible. This book has the mission of serving the student community, inthe areas of Commerce, Finance and Management.

This book is meant to be highly practical with Indian bias but incorporates the theoretical inputs necessary to satisfythe components of the syllabus of M.Com. and M.B.A., and the practical needs for job orientation of students, in IndianFinance and Investment Companies, Mutual Funds, Merchant Banks, Stock Broker Firms etc.

The scheme of the book is divided into six parts: Part I presents the Investment setting and include chapters suchas Securities Markets, Savings and Investment Avenues, Tax Planning, Growth Process of the Economy and FinancialSystem in India. Part II deals with Financial Markets and Institutions setting out the details of the New Issues Market,Stock Market, Money Market and Regulations, Trading and Operations in them. Part III sets out the Process of InvestmentDecision Making. It contains the sources of Information, Inflation, Security Market Analysis, Financial Analysis,Fundamental and Technical Analysis. Part IV discusses the Risk: Return Concepts, including Financial Arithmetic, CreditRating, Market Indicators, Interest Rate Theories and Structure. Part V sets out the Valuation of Stocks and Bonds,Security Pricing, Valuation of Bonds, Stock Valuation Theorems, Valuation of Contingent Claims, Valuation of Optionsetc. Part VI deals with the Portfolio Management, Diversification, Risk and Return Analysis, Modern Portfolio Theory,Portfolio Construction, Revision, Monitoring and Evaluation and ends up with a brief treatment of the Mutual Funds andtheir Schemes.

I will be failing in my duty if I do not acknowledge the help of Shri D. P. Pandey in writing this book. I also owe adeep sense of gratitude to my parents who instilled in me the spirit of service to the community, in the faculty that Godhas given me.

— Dr. V. A. AVADHANI


CONTENTS

PART – I

INVESTMENT SETTING

1. SECURITIES MARKETS 3 - 14Introduction — What is Securities Market? — What are Securities? — Mobilisation of Savings for Investment— IOUs as Securities — Characteristics of Securities — Primary Issues and Derivative Securities — SchematicPresentation of Emergence of Market — Legal Framework for Securities Markets — Companies Act —Acceptance of Fixed Deposits — Compulsory Repayment of Deposits which have Matured for Repayment —Procedure for Making Application to Company Law Board — Cases in Respect of which Applications to theCompany Law Board will not Lie — Factsabout Company Deposits — Care to be Exercised while Investing in Fixed Deposits — Problems in SecuritiesMarkets.

2. SAVINGS AND INVESTMENT 15 - 18How do Savings Emerge? — Why do People Save? — Impact of Inflation — Investment Activity — What isInvestment Activity? — Savings and Investments — Objectives of Investors — Investment for Consumptionand Business — Investment and Speculation — Investment Opportunities — Financial Investments vs. PhysicalInvestment — Bank Deposits.

3. Macro aspects of savings and investments 19 - 25Structure of the Economy — What is Growth Process? — Role of Savings — Other Factors in Development— Financial Intermediation — Links of Real Economic System and Financial System — Savings Rate —Gross and Net Savings — Household Savings — Shifts within Industrial Sector — Lead and Lag Industries —Public Sector Enterprises — Paradox of High Savings and Low Growth — Role of Private Corporate Sector— Conclusions.

4. Financial System —Intermediation 26- 35Financial Intermediation — Ratios of Financial Intermediation — Some Financial Indicators — What ConstitutesFinancial Activity? — RBI and the Financial System — Money Market —Characteristics — Discount andFinance House — Operations of DFHI — Stock Market — Financial Institutions — Savings and Investment —Interest Rate Structure — Capital Market — Unorganised Financial System — Bullion Market.

5. Investment avenues 36 - 41Introduction — Financial Position — Classification of Investments — What is Investment — Macro HouseholdSavings and Investment — Modes of Investment — Cash Management — Tax Provision — SpecialisedKnowledge.

6. Features of investment avenues 42 - 52Objectives of Investor — Characteristics of Investment — Risk-Return Relationships — Tax Benefits —Marketability and Liquidity — Safety vs. Riskiness — Need for Tradability — Classes of Instruments —Investment Profile of Average Household — Analysis of Household Sector Savings — Non-Corporate Investments— Corporate Investments — Deposits with Banks — Instruments of Post Offices — Public Provident Fund —


7. Tax Planning for Investment 53 - 61Taxation of Dividend and Interest Income — Brokerage Income and Business Profits — Tax Treatment onInvestments — Interest and Dividend: Section 80 L — Tax Rebate under Section 88 — Scheme Elegible forRebate u.s. 88 — Income Tax and Corporation Taxes — Capital Gains Taxation —Postal Investments —Wealth Tax — Gift Tax — Taxation of NRIs — Taxation of Investment Business in India — Taxation of FFIsin India — Latest Trend — Transaction Costs —Introduction — Objectives — Elements of Costing — Costsin Investment Activity — Transaction Costs — Real and Nominal Costs — Tax and Govt. Charges and Fees —Recent Changes.

PART – II

MONEY AND CAPITAL MARKETS AND INSTITUTIONS

8. Overview of capital market 65 - 71What is Capital Market? — Structure of the Market — Players in the Market — Stock Market Intermediaries —Instruments of Issue/Trading — New Instruments — SEBI Guidelines — Indian Capital Market — Landmarksand Developments During a Decade — Recent Trends in Capital Markets — A New Order — Genesis of NewOrder — National Market System — Need for Larger Financial Base — SEBI Reforms of the SecondaryMarkets.

9. Institutional structure in capital market 72 - 83Development and Investment Institutions — UTI & Its Objectives —Activities of UTI — Investment Pattern— Schemes Offered by the UTI — IDBI — Schemes of IDBI Assistance — Sources of Funds — ICICI —IFCI — Functions — I.R.B.I. — Functions — IIBI — Insurance Companies — Life Insurance Corporation(LIC) — General Insurance Corporation (GIC) — Public Sector Mutual Funds — SFCs/SIDCs — SHCIL(Stock Holding Corporation of India Ltd.) — Organisational Structure — Functions — Clearing Services —Depository Services — Support Services — Management Information System — Developmental Services —CRISIL (Credit Rating and Information Services of India Ltd.) — CRISIL Rating and Investor Protection —ICRA — Factors Considered — Ratings — Advantages — CARE — DPCR — FIR.

10. Capital market reforms 84 - 98Introduction — Narasimham Committee — Free Entry to Capital Market — Liberalisation Measures — NewInstruments — SEBI Guidelines — Strengthening of SEBI Powers — Stock Invest — Changes in ListingGuidelines — Guidelines for Takeovers — Relaxation of Some Restrictions — Details for Investor Protection— More Recent Changes in New Issue Market — Changes in Companies Act — Institutional Strengthening —Electronic Trading — Stock Exchange Reforms — Market Makers — BOLT System — Badla Trading —SEBI’s Insider Trading Regulations — Central Depository System — Corporate Membership — PendingReforms — SEBI norms for Book Building — SEBI Reforms on Stock Exchanges — Take over Code —Record of Take Overs — Critique of Bhagwati Committee’s Report — Pending Reforms in Banking Sector —Second Generation Reforms (Budget 2000-01) — Some Recent Reforms — Banking and Financial Reforms

11. New issues market and problems 99 - 110Definition — Functions — Methods of Floatation — Offer Through Prospectus — Offer of Sale — PrivatePlacement — Right Issue — Debt versus Equity — Rights of Conversion of Debt into Equity — PreferenceShares — Bonus Shares — Cost of Floatation — Underwriting Activity — Abuses in the New Issue Market —Problems of the New Issue Market — Primary Market — Problems — Public Response — Timing of NewIssues — Cost of Capital Issues — Wasteful Procedures on Public Issue — Group on Primary Market


12. Money market and its instruments 111 - 121Developed and Underdeveloped Markets — Integration and Specialisation — Advantages of Mature MoneyMarket — Sub-Markets — Bill Market in India — Institutional Structure — Characteristics — Discount andFinance House of India (DFHI) — New Money Market Instruments — Classification of Money MarketInstruments — Money Market Rates — Commercial Paper (C.P.) — Certificate of Deposits (C.D.) — ParticipationCertificates — Repos Transactions — Management in Money Market — Securities Trading Corporation ofIndia Ltd. (STCI).

13. The securities and exchange board of india (sebi) 122 - 134Introduction — Objectives — SEBI Guidelines — Reforms in the New Issues Market — Details of SEBIGuidelines — For Capital Market —SEBI Reforms on Stock Exchanges — Complaints against Members —Grievances Cell — Complaints against Companies — Customers’ Protection Fund — Investors Beware —Specific Goals — Pre-requisites of Investor — Preparing to Invest — Balance Sheet Study — Choice of aBroker — Protection in the New Issues Market — Protection for Fixed Deposits — Guidelines to Investors —Legislative Protection to Investors — CRISIL Rating and Investor Protection.

PART – III

SECONDARY MARKETS IN INDIA

14. Securities Trading Regulations 137 - 140Objectives — Coverage — Recognised Stock Exchanges — Options in Contracts — Regulation of Trading —Restrictions on Transferability.

15. Instruments Of Issue And Trading 141 - 153Issues of Securities — Government Securities — Corporate Securities — Corporate Debentures — Other Securities— Company Deposits — Commercial Paper — Legal Provisions — Despatch of Share Certificates — DebentureCertificates — Fixed Deposits — Law regarding Dividends — New Companies Bill 1993 — SEBI Guidelines —Equity Shares — Dividend Distribution — Dividend Policy — Other Instruments — Bonus Shares — RightsShares — Preference Shares — CCP — Government and Semi-Government Bonds — Equity Shares — PublicIssue — Cost of Issue Guidelines — New Instruments — Recent Liberalisation of Policy — ADR and GDRProceeds — Latest Foreign Investment Policy Measures — Relaxation in ECB Norms — Instruments of ForeignBorrowing.

16. Stock Markets In India 154 - 164History of Stock Exchanges — What is a Stock Exchange? — Byelaws — Regulation of Stock Exchanges —Recognition by Government — Licensed Dealers — Securities Contracts (Regulation) Rules, 1957 — PresentRecognised Stock Exchanges — Qualifications for Membership — Organisation — Demutualisation of StockExchanges — Advantages of Demutualisation — Disadvantages — Governing Body — Functions of StockExchanges — Listed Paid-up Capital — Who Owns the Securities? — Bombay: Stock Exchange — PatelCommittee — Regulations on Trading — Investor Protection — Measures to Promote Healthy Stock Markets— Other Reforms — Rolling Settlement System CDSL: Central Depository Services Limited — Globalisation


17. Otcei, nse and icse 165 - 182Securities Exchanges — Structured Markets — OTC Defined — Investor Interests — Practices Abroad —OTC and New Issues Market — OTC and Stock Exchange — Advantages of OTC — Structural Weaknessesin India — Role of OTC — Over-the-Counter Exchange of India (OTCEI) — Objectives of OTCEI —Establishment of OTC — Listing on OTCEI — Investors Benefitted — Market Players — Listing Procedure —Trading on the OTCEI — Conclusion — Problems — OTCEI and Dave Committee Report — DAVE CommitteeRecommendations — Annexure — National Stock Exchange — National Market System — Characteristics —NSE Operations — Automated Lending and Borrowing Mechanism (ALBM) — Central Depository System —Listing of Securities — Settlement System — The National Securities Depository Limited (NSDL) — What isa Depository? — Rematerialisation — Advantages of the Depository — About the Depository Participants —NSDL’s First Participants — Legal Aspects — Interconnected Stock Exchange — Objective — ComputerSystem — Trader Work Stations — Advantages of ISE.

18. Stock Market Operations And Functions 183 - 191Introduction — Specified and Non-Specified Groups — Customer’s Orders — Trading Ring — Block Book(or the Sauda Book) — Contract Note — Drawing Up and Bills — Cum and Ex-dividend — Settlement inSpecified List — Badla Charges — Factors Influencing Badla Rates — Carry Forward Facilities — Example 1— Example 2 — Book Closure Badla Financing (BCBF) — Settlement in Non-Specified Shares — After theBadla Day — Kinds of Delivery — Hand Delivery — Spot Delivery — Special Delivery — Delivery for Clearing— Present Position of BADLA — J.S. Varma Committee (July 1997) — Dhanuka Committee Report — RecentReforms of Stock Exchanges.

19. Trading In The Stock Market 192 - 203Pattern of Trading — ‘Z’ Group in Bombay Stock Exchange — Trading and Settlement — Speculative Tradersvs. Genuine Investors — Types of Speculators — Activities of Brokers — Brokers’ Charges — Delivery/Payment — Settlement Procedure — Auctions — Clearing Procedure — Regulation — National Market System— Characteristics — Objectives — Study Group Recommendations — Experience in Foreign Countries —National Clearance and Depository System — Present Settlement and Clearance System — National TradeComparison and Reporting System — Internet Broking — Order Routing System (ORs) — e-Broking —SEBI’s Role — Dynamics of Net Trading in Stocks — Emerging Role of Stock Exchanges.

PART – IV

SECURITY ANALYSIS

20. Sources of investment information 207 - 211Types of Information — Need for Information — Uses of these Data — Conclusion.

21. Inflation and investments 212 - 218What is Inflation? — Traditional Explanation of Inflation — Demand Pull and Cost Push Inflation — StructuralFactors — Inflationary Tendencies — Inflation Indicators — Causes of Inflation — Effects of Inflation —Inflation — A Fallout of Reforms — RBI’s Responsibility — Inflation as a Monetary Phenomenon — Mid-termAppraisal of the VIII Plan — Impact of Govt. Measures — Role of RBI — Credit Control by RBI — Responsibility


22. Security market analysis 219 - 228What is Security Analysis? — Origin of Markets — Information Flows — Savings or Money Flows — FactorsInfluencing the Market Behaviour — Trading — Instruments — Players — Intermediaries — What is MarketAnalysis? — Valuation — Theoretical Framework — Schematic Presentation of Theory — Investment andTime Value of Money — Present Value Method — D.C.F. (Discounted Cash Flows).

23. Investment decision making 229 - 234Investment Management Involves Correct Decision Making — What is Investment Management? — Criteriafor Investment Decision — Risk and Investment — What is Fundamental Analysis? — Investment Objectives— Cost-Benefit Analysis — Environmental Considerations — Chit Funds and Nidhis — Tax Planning in InvestmentManagement — Execution of Investment Decisions.

24. Financial analysis and interpretation 235 - 239What is Financial Management? — Components of Financial Statements — Comparison of the FinancialStatements — Ratio Analysis — Usefulness of Ratio Analysis — Fund Flow Analysis — Trend Analysis.

25. Balance sheet analysis and blue chips 240 - 249Annual Reports — Market Price and Corporate Performance — Ana-lysis of Financial Position — Types ofShares in the Market — Growth Shares — Cyclical Shares — Defensive Shares — Discount Shares — NetFinancial Results and Profitability — Corporate Performance — How to Locate Emerging Blue Chips? —Established Blue Chips.

26. fundamental analysis 250 - 263Influence of the Economy — Economy vs. Industry and Company — Industry Analysis— Example of anIndustry Analysis — Petro-Chemicals — Company Analysis — Need for Forecast — Guidelines for Investment— Example of Company Analysis — How to Pick Up Growth Shares? — Pharma Industry — Profile ofPharma Industry — Future Outlook — Conclusions.

27. Technical analysis of the market 264 - 275Importance of Timing in Investment — Basic Tenets of Technical Analysis — Tools of Technical Analysis —Dow Theory — Major Trends — Chartist Method — Breadth of the Market — Volume of Trading — Tripodof Technical Analysis — Principles of Technical Analysis — Charts and Trend Lines — Moving Averages —Advantages of Moving Averages — Criticism of Dow Theory — Charts — Head and Shoulders — Breaking theNeckline — Resistance and Support Lines — Speculative Trading and Technical Analysis — Elliot WaveTheory — Operation of Wave Theory — Oscillators (Rate of Change or ROC).

28. Efficient market theory 276 - 281Assumptions — Random Walk Theory — Assumptions of Random Walk Theory — Random Walk and EfficientMarket Theory — Empirical Tests — Filter Tests — Serial Correlation Tests — Run Tests — Other Tests —Mutual Fund Peformance — Efficient Market Hypothesis — Semi Strong Form — Strong Form of EMH —


PART – V

RISK AND RETURN CONCEPTS AND MEASUREMENT

29. Risk and credit rating 285 - 295Introduction — Risk and Uncertainty — What Causes the Risks? — Systematic and Unsystematic Risks —Risks are Classified into Major Categories — Examples of Systematic Risks — Examples of UnsystematicRisks — Other Risks — Risks and Returns — Purchasing Power Risk — Problem — Standard Deviation andVariance — Investment Decision-Making — Risk Measurement — Range of Variation — Why Credit Rating?— Rating in USA — What is Credit Rating? — How to Understand Ratings and Rating System? — WhatInstruments are Rated? — Limitations to Ratings — Key Factors Considered — Risk and Credit Rating —Confidentility of Information — CRISIL — ICRA — CARE —Duff and Phelps — Fitch India Pvt. Ltd.

30. Security market indicators 296 - 307Introduction — Functions and Activity — Segments of the Markets — Segment of Government Securities —Yield Curve — Indicators — Corporate Securities Section — Main Indicators — Security Price Indices — RBIIndex of Industrial Security Prices — BSE Sensitive Index — Scrip Selection — Methods of Compilation —Weightage — Other Adjustments — BSE Sensex Composition — BSE National Index — BSE 200 and Dollex— Daily Current Market Data — Other Indicators — Other Indices — Indexes for other Segments.

31. Interest rates — theory and structure 308 - 321Introduction — Role of Interest Income — Relative Share of Interest Income — Role of Interest Rates —Theories of Interest Rate — Structure of Interest Rates — Factors Influencing Interest Rates — Interest Rates inIndia — Bank Rate and Refinance Rates — Money Market Rates — Rates in Gilt-edged Market — Private andGovernment Bond Rates — Rates of Borrowings and Lendings by Commercial Banks — Interest Rates on SmallSavings — Interest Rates on Non-resident Accounts — Export Credit — Level and Structure of Rates — Level ofInterest Rates — Structure of Interest Rates — Reforms — Recent Deregulation Measures — The Yield —Current Yield — Redemption Yield — Holding Period Yield (HPY) — Real Yield — Net Yield — Maturity and Yields— Yield Curve.

PART – VI

VALUATION OF STOCKS AND BONDS

32. Financial arithmetics 325 - 339Introduction — Calculation of Returns (Yields) — Yields on Bonds/Fixed Interest Securities — Simple Yield orInterest Calculation — Yields on Equity — Time Value of Money and Securities — Time Preference for Money— Applications — Features of a Bond — Equity Valuation — Fundamentals of Valuation of Securities —Discounting — Bond Prices — Factors Influencing — Formulae — Valuation of Convertible Bonds/Debentures— Why Convertible Financing? — Valuation of Convertibles — Conversion Ratio — Conversion Premium —Valuation of ‘Rights’ — Example of Rights Pricing — Callable Bonds — Detachable and Non-Detachable


33. Security pricing 340 - 352Factors Influencing Valuation — Security Valuation — Constant Growth Model — Book Value — Liquidating Value(Breakdown Value) — Replacement Value — Instrinsic Value vs. Market Price — Equity Valuation — Single-PeriodValuation Models — Example — Multi-Period Share Valuation Model — Example — Dividend Capitalisation —Earnings Capitalisation — Use of P/E Ratio — Security Pricing Models — Other Models — Graham’s Approach toValuation of Equity — Valuation of Securities in India — Example — Free Market Pricing — SEBI Guidelines —Theory of Pricing — Share Valuation Models — Granger Causality Test.

34. Investment analysis and theory 353 - 368Introduction — Flow of Funds Theory — Price Formation — Capital Assets Pricing Model — Risk and Portfolio— Efficient Market Theory — Random Walk Theory — Trend Walk Theory — Capital Asset Pricing (CAP) Theory— Modern Portfolio Theory — Concept of Beta — Fundamental School — Intrinsic Value and Market Value —Evaluation of Shares — Gordon’s Hypothesis — Gordan Dividend Model — M.M. Hypothesis — Walter’s Formula— Walter Model — Problems — Graham Dodd Model — Discount Model — Malkiel and Cragg Regression Model— Cootner’s Price Value Interaction Model — Random Walk Theory — Random Walk Theory Assumptions —Martingale Models — Capital Market Theory — Security Market Line — CAPM — Tobin “Q” Theory.

35. Valuation of bonds — bond market 369 - 412Introduction — Bond Market In India — Special Features of Bonds — Interest Rate Structure — Properties ofBonds and Bond Value — Measures of Bond Returns — Calculation of Yield to Maturity (YTM) — Valuation ofBonds — Solved Problems — Accrued Interest — Calculation of Accrued Interest and Value — Discrete Models —Bond Price Theorems — Malkiel Bond Theorems — Risk Premium on Bonds — Yield Curves — Term Structure —Types of Bond Management — Active Strategies — Yield Curve Study — Objectives of Raising Incremental Return— Need for Tax Planning — Sequence of Steps for Bond Issues — Steps in Management of the Issue — GeneralBenchmarks in Making Issues — Valuation of Bonds — Price Risk — Riding the Yield Curve — Duration Measure— Risks to be Covered — Duration and Immunisation — What is Duration? — Use of Duration as a Concept —Macaulay’s Duration (MD) — Duration (Example) — Theorems Emerging from MD — Advantages of M.D. —Uses of Duration — Interest Rate Elasticity and Risk — Modified Duration (by Hicks) — Short Cut Formula forDuration — Immunisation — What is Immunisation? — Immunisation Process — Immunisation Operations —How Immunisation is Effected? — Problems of Immunisation — Bond Holding Strategies — Immunisation —CashMatching (Dedicated Portfolio) — Price Elasticity — Illustration — Volatility of Bond Prices — Immunisation —Immunisation — (A) Present Value of Bonds: (Total PV = 62.05) — (B) Face Value of Bonds: (Yield is 11%) —Macauly’ Duration — Problems in Bonds.

36. Valuation Of contingent claims and options 413 - 434Introduction — What is Contingent Claim? — Pricing of Such Claims — Free Market Pricing — What is aConvertible Security? — Valuation of Rights Shares — Preference Shares — CCP — Legal Provisions — Normsfor N.C.D. of Non-Convertible Portion of P.C.D. — Conversion Value — Conversion Premium — Pricing ofConvertibles — Valuation of Convertibles — Graphical Presentation — Role of Interest Rate — Graphical Depiction— Brigham’s Model on Convertible Bonds — Valuation of Options — Factors Affecting the Option Value — Calland Put Options — Hedge Ratio (Black-Scholes Model) — Hedge Ratio Data — Black-Scholes Formula — What isBlack-Scholes Formula? — Implications — Solved Problem (B/S Model)


PART – VII

PORTFOLIO THEORY AND MANAGEMENT

37. Risk and return in portfolio management 437 - 442What is the Objective? — What is Risk? — How to Minimise the Risks? — What is Beta? — Risk ReturnAnalysis — Degree of Risk and Risk Free Return — Capital Market Instruments — Money Market Instruments— What is a Portfolio? — Definition of Portfolio? — Speculative Instinct — Precautions for Investment —Decomposition of Return.

38. Capital asset pricing model (capm) 443 - 468CAPM-Assumptions — CML — Security Market Line (SML) —CAPM Analysis — Market Model — Uses andLimitations — Capital Asset Pricing Model — Limitation of CAPM — SML Security Market Line — CAPM —Diversification — Why Diversification — Example on Measurement of Risk — Calculation of Standard Deviation—Example Escorts — Example of Simple Diversification — Markowitz Diversification — CML — SML —CAPM — Asset Pricing Implication of SML — Equilibrium price: (SLM) — Problem on CAPM — Problem onSML.

39. Portfolio analysis 469 - 480Return on Portfolio — Risk on a Portfolio — Example of Standard Deviation — Regression Equation — Alpha— Beta — Rho or Correlation Coefficient (covariance) — An Example for Covariance and Correlation —Expected Returns — Calculation of Beta — Calculation of Alpha — Calculation of Residual Variance — Calculationof Residual Variance — Method of Calculation of (r) — Variance of IBM — Variance of BSE Index —Covariance of Returns — Correlation Coefficient.

40. Diversification And Techniques of Risk Reduction 481 - 489What is Diversification?— Principles — Random Diversification — International Diversification — WhyInternational Diversification? — Risks in Foreign Investments — FFI’s Investment in India — NRI Investmentin India — A. Personal Investments Scheme — B. Direct Investment Scheme — (C) Portfolio InvestmentScheme — Passive International Investment Strategy — Active International Investment Strategy — ReturnForecasts — International Investing — Problem — Advantages of Diversification — Naive Diversification —Evans & Archers’ Study.

41. Markowitz model 490 - 508Assumptions of Markowitz Theory — Markowitz Diversification — Parameters of Markowitz Diversification— Criteria of Dominance — Markowitz Model — Measurement of Risk (Example) — Portfolio Risk —Equation for Portfolio Return — Equation for Portfolio Variance — Arbitrage Pricing Theory — Introduction— Asset Selection in the Above Model — Components of Expected Returns — Empirical Testing of APTModel — Arbitrage Pricing Theory — Problem — Sharpe Model — Optimal Portfolio of Sharpe — Basis forCut-off Rate — Distribution of Investments.

42. Basics Of Portfolio Management In India 509 - 514Some Aspects of Portfolio Management — Investment Strategy — Objectives of Investors — Risk and Beta —Modern Portfolio Theory (MPT) — Time Value of Money — Compounding — Discounting — Perpetuity —


43. Modern portfolio theory 515 - 521What is Modern Portfolio Theory (MPT) — Basis of Modern Portfolio Theory — B. Cap Theory and Conceptof Dominance (Capital assets pricing model) — Dominance Concept — C. Role of Beta — Portfolio InvestmentStrategy — Asset Allocation — Risk Management Strategy — Duration — Beta — Target Return — Borrowingfor Investment — Problems — Portfolio Return Equation is — Portfolio Risk = Standard Deviation of Portfolio.

44. Portfolio management: construction, revision and evaluation 522 - 548Fact Sheet — Clients’ Data Base — Objectives of Investors — Motives for Investment — Tax Provisions —Capital Gains — Portfolio Construction — Risk-Return Analysis — Time Horizon of Strategy — Types of Risk— Efficient Portfolio — Market Efficiency Theorem — Diversification — Portfolio Management — Elementsof Portfolio Management — Execution of Strategy — Monitoring — Building of the Portfolio — PortfolioRevision — Security Pricing and Portfolio Management — Markowitz Model of Portfolio Theory — RiskAnalysis — Evaluation of Portfolio Performance — Criteria for Evaluation of Portfolio — Example of Sharpe’sMeasure — Treynor’s Measure Evaluation Problem — Comparison — Jensen’s Measure — Jensen’s Model— Evaluation Criteria for Portfolios — Portfolio Performance Evaluation — Jensen’s Performance Measure:(JP) — Returns and Performance Evaluation — Problems — Take Home Problems.

45. Mutual funds and their schemes 549 - 572Introduction — Definition — Types of Funds — Unit Trust of India — UTI Schemes for Resident Indians —Off shore Funds — SBI Mutual Fund — India Magnum Fund N.V. — Other Funds — Overall Progress in India— Investment Policy — Steps to Popularise Mutual Funds — Response of NRIs — For All MFs CommonRules — Advantages of Mutual Funds — Progress in Nineties — Regulation of Mutual Funds — Authorisationof Existing Mutual Funds — Money Market Mutual Funds (MMFs) — MMMF’s Regulation — Authorisationof New Mutual Funds — Mutual Funds Present Status — Taxation and M.Fs — Wealth Tax — Gift Tax —Tax Benefit under 1999-2000 — Saga of Fortunes of MFs — Stocklending by Mutual Funds — Latest Trends— Annexure I - RBI Guidelines on Mutual Funds — Annexure II -SEBI.

46. Disinvestment management 573 - 590Introduction — What is Disinvestment? — Why Disinvestment? — Role of Disinvestment — DisinvestmentUnder Adverse Conditions — Disinvestment Motivated by Market Conditions — Types of Disinvestment —Factors Influencing Disinvestment — Role of Fundamental Factors — How to Make Disinvestment Decision?— Objectives — Investment Avenues — Stock Market Disinvestment — Fundamental Analysis — FIIs and theArt of Contrariness — FII Investments in India — Role of Technical Factors — Timing of Disinvestment(Through Technical Analysis) — R.S.I (Relative Strength Index) — Moving Average Convergence and Divergence(MACD) — Disinvestment by Government Sector — Problems of PSU Disinvestment — NAVARATNAS —Central Public Sector Undertakings — Divestment Methods of Government — Open Bidding Process ofDivestment — A Proposal on Mutual Fund Route — Banks’ Divestment Scheme

47. Securities Market Report (BSE) 591 - 607Introduction — Global Comparison — Overview of BSE Market Report — Globalisation Trend — DailyReport Analysis — Sensex Shows 5% Fall on FII Selling — Price Index Snapshots of the Market — TradeTurnover — Advance/Decline Line — Role of Institutional Agencies — Trading Cycle — Record Dates andBook Closure — Circuit Band Hitters — Speculative Positions — Surveillance System — Index Details — BSEStock Tables — Main Indicators — Face Value — Market Macro Indicators — Badla Statistics — DerivativesTrading.


Chapter 1: Securities Markets

Chapter 2: Savings and Investment

Chapter 3: Macro Aspects of Savings and Investments

Chapter 4: Financial System – Intermediation

Chapter 5: Investment Avenues

Chapter 6: Features of Investment Avenues

Chapter 7: Tax Planning for Investment

PART — IInvestment Setting


IntroductionThe issue of securities by corporate units in India is as old as the introduction of joint-stock enterprises by the

British Government. The 18th and 19th centuries saw the emergence of cotton and jute textiles, tea and other plantationindustries in India. Many companies were set up as joint-stock enterprises with liability limited by shares. A vast numberof businessmen in major cities purchased these shares and trading started in them early in the 19th century, thanks to theirenterprising spirit. In those days, although many of these companies were financed by the issue of shares to the public,they mainly depended on the joint-stock British banks in India and borrowals from abroad. British enterprise and theBritish Government have thus helped the emergence of the securities markets in India. The corporate securities havecome to have a market first. So far as the Government securities are concerned, the British India Government borrowedmostly in London by issue of Sterling consols. Only later in the 19th century the Government issued treasury bills andGovernment securities in rupees. This led to the emergence of the Government securities market also in India.

What is Securities Market?Securities markets are markets in financial assets or instruments and these are represented as I.O.Us (I owe you) in

financial form. These are issued by business organisations, corporate units and the Governments, Central or State. Publicsector undertakings also issue these securities. These securities are used to finance their investment and current expenditure.These are thus sources of funds to the issuers.

There are different types of business organisations in India, namely, partnership firms, co-operative societies,private and public limited companies and joint and public sector organisations etc. The more frequently organised methodis the company, registered under the Indian Companies Act 1956. Under this Act, there are three types of companies:(a) companies limited by guarantee; (b) companies which are private limited companies — limited by shares paid up; and(c) companies which are public limited companies — limited by shares paid up and companies limited by guaranteecannot enter the market. The private limited companies can have 50 members and their shares are not transferable freely.These companies reserve the right to refuse any transfer of shares and as such trading in them is restricted. Due to theseinhibitive features, private limited companies do not have easy access to the securities markets. Only public limitedcompanies are largely popular as they can raise funds from the public through the issue of shares. The methods of raisingfunds used by the corporate sector are to issue securities, either ownership instruments or debt instruments.

What are Securities?Securities are claims on money and are like promissory notes or I.O.U. Securities are a source of funds for

companies, Governments and Semi-Government bodies. There are two types of sources of funds namely internal andexternal and securities emerge when funds are raised from external sources.

Securities MarketsCHAPTER 1CHAPTER 1


The external sources of funds of the companies are as follows:

(A) Long-term Funds

(i) Ownership Capital — equity and preference capital, and Non-voting Shares.

(ii) Debt Capital — debentures and long-term borrowings in the form of deposits from public or credit limitsor term loans or advances from banks and financial institutions, etc.

(B) Short-term Funds

(i) Borrowings from banks, and other corporates.

(ii) Trade credits and suppliers’ credits, etc.

Of the above sources, the most popular are those which are tradable and transferable. They have a market and theirliquidity is ensured, as in the case of equity shares, preference shares, debentures and bonds. Of these the ownershipinstruments, particularly the equity shares, are generally the most liquid as they are not only tradable in the securitiesmarkets but also enjoy the prospects of capital appreciation, in addition to dividends. The market for these has thusgrown much faster than for others.

Mobilisation of Savings for InvestmentThe issue of securities can be looked at from various angles. These may be set out as follows:

(i) From the point of view of issuers, these are the sources of finance for long-term capital investment and forworking capital. They can thus invest more than their resources;

(ii) From the point of view of investors, these are IOUs or promissory notes, giving an income or a return to theirinvestment. They provide a channel to their savings and cater to the asset preferences of the public withvarying characteristics of risk, income, maturity, etc.;

(iii) From the point of view of the nation, these issues mobilise the savings for investment and capital formation inthe country. They promote the growth of output and income by a multiplier leading to a rise in the output by amultiple of the original investment over a period of time;

(iv) From the point of view of the financial intermediaries like banks, financial institutions, etc., these issues are asource of income to them for the management of these issues placing them with the public, providing liquidityand marketability to them and by activating idle funds.

Thus, the securities markets comprise all the above players, namely, issuers, savers, investors, intermediaries, etc.and the major activity is the moblisation of funds from saving and their channelisation into investment.

IOUs as SecuritiesIn the securities markets, the securities dealt with are equity shares, preference shares, debentures and bonds.

These securities being financial claims are issued as I.O.U.s or Promissory Notes. In the primary market, the issues aremade to the primary or original savers. The other forms of holding debt or borrowings such as public deposits or bankowned IOUs are not securitised and hence not tradable. In certain cases like the P.O. Certificates, bank deposits, LICpolicy certificates etc., they are not transferable by endorsement, but they have a primary market as these primary issuesare I.O.U.s, used to mobilise the savings of the public. The market for such primary securities is limited to one stage andthere is no secondary market for them. The UTI units and the instruments of many mutual funds in India belong to ahybrid category, as these are not securities according to the strict definition of the term under the Indian Companies Act.But as they can be sold back to the issuing institution or sold in the market if they are quoted on the Stock Exchange, theyenjoy liquidity. Thus UTI units under the 1964 scheme for example can be repurchased by the UTI, which providesliquidity to these instruments. The master shares of UTI and the stocks of some mutual funds can also be traded as theyare quoted on the Stock Exchanges and they are close ended schemes.


The securities markets emerge out of the two characteristics of financial instruments: (a) mobilising primarysavings from the public to serve as sources of funds for the issuing authority; and (b) providing liquidity to theseinstruments through regular quotations in the financial markets and thus traded. The primary markets exist only if the firstcondition is satisfied. The secondary market also operates if both the conditions are satisfied.

The pattern of corporate financing and the extent of their dependence on the external sources of funds, as opposedto the internally generated cash flows, would thus determine the creation of new securities. The retained earnings are theinternally generated funds which have an opportunity cost but whose issue costs are zero. These can be converted intosecurities by issue of bonus shares to existing share holders. There are, however, issue costs for equity and preferenceshares, convertible and non-convertible debentures etc. The capital market and stock market do provide the facilities fornew issues and conversion of issues into money and vice versa, so that investors are assured of liquidity for theirinvestments so as to induce them to enter these markets.

Characteristics of SecuritiesThe major characteristics of securities are their transferability and marketability. These help the process of trading

and investment in them.

Under the Indian Companies Act, Sections 82 and 111 deal with the transfer of shares. In the case of public limitedcompanies, the objective of the Companies Act as also of the Listing Agreement with the Stock Exchanges is to ensurefree and unfettered transfer of shares. Under Section 82 of the Companies Act, shares are treated as any movableproperty. As any right to property, these are freely transferable. By one amendment in 1985, Section 22(A) of theSecurities Contracts (Regulation) Act has denied the right to refuse to transfer shares by a public limited company excepton technical grounds. The other grounds on which the transfer can be refused are specifically laid down under the Actand the company has to specify the reasons for such refusal to transfer and reference has to be made to the CompanyLaw Board whose decision to refuse or not to refuse the transfer of shares will be final. Thus the essential characteristicof transferability of shares is well preserved which gives them the market which in turn extends liquidity to these shares.This has led to the emergence of securities markets in India.

Primary Issues and Derivative SecuritiesPrimary issues are those issued to the public by the companies, Governments and financial institutions. Derivative

issues are those which are based on the original primary issues. There are a number of derivative instruments which areused to generate a market for the primary issues. Thus in many developed markets abroad, there are warrants, options,futures, index linked instruments etc. which have well-established markets and they are based on some primary instruments.In India, options are now permitted and some form of futures trading exists in Group A securities on the stock exchangesas they are permitted to be carried forward from settlement to settlement without taking delivery of shares. Since January1995, options and futures have been permitted by change in law by the Government and they are now developing understrict control of SEBI, since 2000.

More recently, new instruments have been developed in India, namely, warrants, Zero coupon bonds, conversionoptions, rights options etc. But in many cases these are not well developed and secondary markets for these instrumentsare under developed and trading does not take place as in the case of listed shares and particularly those on the specifiedgroup (Group A) of stock exchanges.

Reference is made in the subsequent chapters to many new instruments which are introduced both in the capitalmarket and the money market in India. Besides, the RBI has also recently permitted the securitisation of book debts ofbanks and financial institutions in the sense that the debit balances on companies’ accounts can be transferred to otherbanks and financial institutions which are willing to discount them or purchase them at a price but the market in manynew instruments is yet to be developed in India.


Derivatives Markets in IndiaIn India, options and futures were allowed as securities to be traded in stock exchanges by necessary changes in the

S. C. (R) Act 1956, in the year 1996-97. But actual trading in them did not take place until 2000-2001, due to the need forpreparing the members for this new system and for setting up the necessary architecture and infrastructure for trading inderivatives.

In June 2000, Index futures and in November 2001, stock futures were started, on NSE and BSE. But the indexoptions were initiated in June 2001 and stock options in July 2001. More importantly interest rate futures were introducedonly in June 2003 on the NSE. But the process in interest rate futures and currency futures are yet to take off.

The volume of turnover has grown faster on the NSE than on BSE. Secondly, turnover in derivative markets hasgrown faster than in the cash markets, although the former were started only a decade ago.

Schematic Presentation of Emergence of MarketA schematic presentation of the emergence of markets through the flow of cash, credit and savings of the public is

made in Charts 1.1 to 1.5. It will be seen from Chart 1.1 that money flows lead to claims on financial assets and physicalassets and financial assets in turn when issued as securities result in trading in markets. The money and capital marketsare shown separately as short-term and long-term wings of the markets. The components of capital market are shown asprimary and secondary markets whose details are explained in terms of instruments traded, institutions involved andoperations undertaken in Charts 1.3 and 1.4 respectively. Chart 1.2 explains the savings flows of the household sectorinto financial assets invested by the household sector, namely, currency, deposits of banks, etc. Chart 1.5 presents theinter-relations of the various institutions and markets, namely, the stock exchange, brokers, banks, financial institutions,etc. Finally, the investor clients and corporate clients and the various services rendered to them by these markets arebriefly depicted in this chart as constituting the totality of the markets. The further details of these charts are explained inlater chapters.


Chart 1.1

Broad Contoursof Money Flows

BROAD CONTOURS OF MONEY FLOWS

MONEYCASH + CREDIT

CREATED BY CREATED BY INCOME MINUSR.B.I. CASH BANKS CREDIT EXPENDITURE =

SAVINGS

INVESTMENTS FUTURE CLAIMS PHYSICALON MONEY ASSETS

FINANCIAL ASSETS — INSTRUMENTS

A. SHORT-TERM —DDs, MTs, CHEQUES ETC.CALL MONEY, T.Bs, C.Ps, ETC

B. LONG-TERM — SECURITIES SHARES, DEBENTURES(CAPITAL MARKET) — DEPOSITS, BORROWINGS, ETC.

SECONDARY MARKETPRIMARY MARKET OR STOCK MARKET

TRADING IN OLD SHARESOR SECURITIES

INSTRUMENTS ASSETS TRADED

NEW ISSUES,ALLOTMENT LETTERS, GOVT. SECURITIES,RIGHTS-BONDS, CORPORATE SHARES,VOUCHERS, DEBENTURES,RENUNCIATIONS ETC. UNITS, ETC.


Chart 1.2

Saving Profileof Macro

Household

Percentage of GrossFinancial Assets

Form of Assets 2004-05 2003-04 2006-07 2007-08 2008-09

1. Currency 9.2 10.5 8.6 11.4 12.42. Deposits of Banks 37.1 36.7 55.6 50.4 54.93. Deposits of Non-Bank Companies 0.4 4.9 0.1 1.8 3.64. LIC, Insurance, PF and Pension Funds 26.4 27.6 24.2 20.0 29.65. Claims on Govt. (Postal Savings, 24.0 20.2 5.2 –4.0 –3.1

Govt. Securities etc.)6. Shares and Debentures & MFs 1.1 0.1 6.3 12.4 2.6

7. Others 1.8 Nil

Total 100 100 100 100 100

SAVINGS FLOWS

2008-09

TOTAL SAVINGS ESTIMATES(HOUSEHOLD SECTOR)

FINANCIAL ASSETS PHYSICAL ASSETS48% 52%

STRUCTURE OF FINANCIAL ASSETS(GROSS SAVINGS IN FINANCAL FORM)

Source: Latest RBI Annual Reports


Chart 1.3

Primary Market

INSTRUMENTS — PRIMARY MARKET

CORPORATE SHARES, DEBENTURES, RIGHTS, ETC., ARE THE INSTRUMENTS

BASIS:

1. ENABLING LEGISLATION, PRACTICES, PROCEDURES

2. PATTERN OF CORPORATE FINANCING - STRUCTURE

A. INTERNAL FINANCE, RETAINED INCOME

B. EXTERNAL SOURCES — METHODS

EQUITY, DEBT DEBENTURES FOREIGN PUBLIC INTER-ORDINARY, BORROWINGS CONVERTIBLE SOURCES, DEPOSITS CORPO-PREFERE- FROM BANKS NON-CON- EQUITY OF RATENCE, and FIs VERTIBLE DEBT VARIOUS INVEST-ETC. MATURI- MENT

TIES

FIs -NABARD - IFCI - SIDBI - LIC - GIC - etc.

UNDERWRITING PLANNINGSAGENCY WORK CONSULTANCY,LEAD MANAGING AGENCY,MERCHANT BANKING, etc. BROKING etc.

3. PRIMARY MARKET OPERATIONS

PROJECT PLANNING, FINANCE PLANNING, CONSULTANCY,FINANCIAL MANAGEMENT, TAX PLANNING, GOVT. REGULATIONS,DEALINGS IN THE PRIMARY MARKET-ISSUES TO THE HOUSEHOLDS, etc.PROSPECTUS, ALLOTMENT, LISTING, etc.


Chart 1.4

SecondaryMarket

STOCK EXCHANGES

SEBI SECURITIES APPELLATE AUTHORITY

GOVT. STOCK EXCHANGESCOMPANIES P.S.Us.

BROKER DEPTSJOBBER FUNCTIONS

OWN BUSINESS (WHOLESALE) — JOBBERCLIENT BUSINESS (RETAIL) — BROKERS

CUSTOMERS

INDIVIDUALS, COMPANIES, FIs, MUTUAL FUNDS etc.

TRADING BID OFFER/PURCHASE & SALE PRICES

SPECIFIED SHARES RAISING OF ENABLINGNON-SPECIFIED CONTRACTS & NOTESSHARES/BONDS, etc.

CLEARING HOUSESETTLEMENT

O.T.C. OPTIONS DELIVERY PAYMENT etc.& FUTURES

GOVT. SECTOR FINANCING — CENTRAL — STATELOCAL BODIES AND SEMI-GOVT. ORGANISATIONS

GILT-EDGED MARKET, RBI, UNDERWRITERS, PRIMARYDEALERS, BANKS, PF, FIs — BROKERS etc.

CORPORATE SECTOR FINANCING —EQUITIES, PREFERENCE SHARES, DEBENTURES, BONDS etc.

REGISTRATION, CONSOLIDATION, SUB-DIVISIONFLOW OF INFORMATION ON COMPANY AFFAIRS etc.


LEGAL FRAMEWORK FOR SECURITIES MARKETS

New Issues Market and Stock Exchange are a part of the Capital Market where the shares, debentures, bonds andother securities of companies and Government are traded. The Stock Exchange provides facilities for exchange of sharesinto money and vice versa. New Issues Market is the Primary market where the issuers can sell securities, but cannotbuy. Stock Exchange is defined as an Association of Member Brokers who assist, facilitate and regulate trading insecurities. One can buy and sell in the Stock Exchange or Secondary market.

These securities are issued by the Companies under the Companies Act and by the Government under the IndianPublic Debt Act, since replaced by the Government Securities Act in 1999. Since the public are not interested in GovernmentSecurities due to lower level of interest rates on them, the public awareness of this market is little or negligible. Thismarket is mainly confined to banks, financial institutions etc.

The capital market comprises of two components, namely, New Issues Market where companies issue directlysecurities to the public and the Stock Market or the Secondary Market where the existing securities are bought and sold.

Chart 1.5

Inter-relationsINTER - RELATIONS

GOVT. INVESTOR PROTECTION —SEBI ENCOURAGEMENT TO FLOW OF

SAVINGS + INVESTMENT —FAIR TRADING PRACTICESGRIEVANCES REDRESSAL etc.

F.Is, GIC, LIC FINANCIAL SUPPORT TO BOTHMUTUAL PRIMARY AND SECONDARYFUNDS, MARKETS — INSURANCEBANKS, COVERAGE — INVESTMENT —CHIT FUNDS PORTFOLIO MANAGEMENT —COMPANIES CONSULTANCY — BROKINGetc. BUSINESS, UNDERWRITING etc.

BANKERS INDIVIDUALS CORPORATEFINANCE AND AS CLIENTS UNITS AS CLIENTSDEALINGIN GILT-EDGED

INVESTMENTS MERCHANTADVICE & BANKINGCONSULTANCY NEW ISSUESPORTFOLIO PLANNING PROJECTMANAGEMENT REPORT FINANCIALTAX PLANNING MANAGEMENT

ACCOUNTACY& AUDIT

CORPORATE FINANCE STUDY —

RATIO ANALYSIS BALANCE SHEET —

INCOME-EXPENDITURE ANALYSIS etc.

BR

OK

ER

S/D

EA

LER

S

EX

CH

AN

GE

AU

TH

OR

ITY


Trading in old securities is governed by the Securities Contract (Regulation) Act of 1956 and the Securities Contract(Regulation) Rules of 1957. The Act has provided for recognition to the Stock Exchanges and gave wide ranging powersto the Government to control and regulate the Stock Exchanges. It has laid down the types of contracts in securitieswhich can be traded or purchased and sold and for listing of securities of public limited companies, whose shares arebeing traded. The Act and the Rules made thereunder have provided for qualifications for members, contracts to betraded, trading period, permitted deals, settlement periods, clearance and delivery of shares etc. The actual Rules andBye-laws of each Stock Exchange have enshrined these rules. The Act is applicable to Public Limited Companies, whichare listed on Stock Exchanges and ensure transferability of shares and laid down the conditions under which transferabilitycan be denied to investors.

Companies ActThe Companies Act which regulates the activities of the companies from birth to death has provided for the sources

of finance for companies and the methods of marketing the public issues which are marketable. These are in the form ofownership category, namely, Equities and Preference shares and Debt capital in the form of convertible and non-convertibledebentures, fixed deposits etc. Under the Companies Act, Sections 55 to 68 provided for issue of prospectus, its contents,Registration of Prospectus, civil and criminal liabilities of the Directors for any mis-statements in prospectus etc.

The Act has laid down the methods of raising new issues, namely, through prospectus, letter of offer or statementin lieu of prospectus, Rights and Bonus. Section 58 A and B deal with the conditions for acceptance of deposits, repaymentsof deposits, etc., while companies (acceptance of deposits) Rules of 1975 laid down the period of maturity, interest ratesand other conditions. The company deposits are an avenue of investment, but are not tradeable. The details regardingthem are dealt with briefly later.

Sections 69 to 73 deal with the allotment of new issues to applicants, delivery of certificates and their listing onStock Exchanges. The allotment is also governed by the guidelines given by the Stock Exchanges as per the listingagreement in the case of listed companies.

The basic framework for trading is provided by the Companies Act in the form of:

(1) Marketing the shares as movable property under Section 82.

(2) Ensuring transferability of shares in respect of public limited companies under Sections108 - 112.

(3) The transfer deed through which share certificates are to be transferred is provided for under Section 108which was amended to legalise the demat form of transfer since 1999.

(4) The validity of the transfer deed under Section 111 is 12 months in the case of listed companies and 24 monthsin the case of non-listed companies.

(5) Section 114 provides for issue of share warrants.

So far as investors are concerned, it is desirable that they know the main provisions of the Companies Act, becausethe issue of prospectus, the contents of it, allotment of new issues, despatch of certificates, transferability etc., are all laiddown in it. The rights of shareholders and debentureholders, and different categories of creditors and debtors of companiesare set out. The book closure for accounts, presentation of Balance Sheet and Income-Expenditure accounts, paymentsof dividends etc., are all provided for in this Act. In Particular, Section 82 provides for transferability of shares andSection 73 lays down the conditions for listing of Public Limited Companies. While these sections ensure the marketabilityof shares of listed public limited companies, trading in them is made possible by the Securities Contracts Regulation Actand the Rules made thereunder.

In view of the fact that purchase and sale of shares through recognised Stock Exchanges and through licensedStock Brokers are only legal, and those are governed by the SC(R) Act, the investors have to be familiar with this Act andthe Rules made thereunder. The relations between the Brokers and Investors and in particular, the disputes if any, betweenthem are governed by the Rules and Bye-laws of the Stock Exchanges which are formulated under this Act.


Acceptance of Fixed DepositsA company cannot accept deposits in excess of 35% of the paid up capital and free reserves. Of this, 25% deposits

can be accepted from the public and the rest 10% from shareholders of the company. The minimum period of acceptanceof deposits is one year and the maximum period is limited to 3 years. The company is under an obligation to maintain anamount not less than 15% of the company’s deposit liability maturing during the course of the year, in liquid investmentssuch as Government securities, units, deposits with banks etc. The maximum rate of interest that can be offered ondeposits is fixed at 11% to 14%. A ceiling on brokerage payable on deposits has been fixed at 1%. The interest earned onfixed deposits of companies does not enjoy any exemption from income tax. Neither does the amount of deposit qualifyfor any exemption under wealth tax. Under the existing provisions of the Income Tax Act, tax on interest paid/payable isdeducted at source if the interest payment exceeds Rs. 2,500 in a financial year unless suitable declaration is furnished bythe depositor in regard to the total income of the depositor not exceeding the minimum liable to tax in a financial year.(Form 15(H) under I.T. Act)

The acceptance of deposits by non-bank non-financial companies is governed by the Companies (acceptance ofdeposits) Rules 1975 as amended from time to time. Along with the prescribed application form the terms and conditionsof acceptance of deposits are required to be furnished by companies, to the RBI in the case of non-bank financecompanies and a copy in case of non-bank non-finance companies.

A careful study of either the financial data in the advertisement or the prescribed particulars as available within theapplication form would generally reveal the working results and the financial position of the company.

Compulsory Repayment of Deposits which have Matured for RepaymentThe Companies Act, 1956 has been amended by the Companies (Amendement) Act, 1988 with effect from 1.9.1989

so as to provide for compulsory repayment of deposits which have matured for repayment (Section 58(9)]. Under theamended provisions, the Company Law Board has been empowered to take cognizance of non-repayment of any depositon maturity and to direct repayment of such deposits on such conditions as may be specified by the Company Law Boardin its Order. This will help and ensure repayment of public deposits and will create confidence amongst the public.

Procedure for Making Application to Company Law BoardThe person holding a matured fixed deposit which he has not renewed and which the company has failed to repay,

has to make an application in triplicate in Form No.11. The application has to be accompanied by a fee payable by way ofbank draft in favour of the Pay & Accounts Officer, Dept. of Company Affairs, New Delhi/Mumbai/Kolkata/Chennai.

The Company Law Board has four Regional Benches. The aggrieved depositors may make an application to theBench of the Company Law Board having jurisdiction according to the Registered Office of the company. The CompanyLaw Board would, after giving a reasonable opportunity of hearing to the company and other persons interested in thematter, make suitable orders for repayment of such deposits. Non-compliance of the order of the Company Law Boardis a punishable offence attracting penalty by way of imprisonment upto 3 years and fine of not less than Rs. 50 for everyday till such non-compliance continues.

Where the deposit which has fallen due for payment remains unpaid the depositor can seek remedy in a civil court,or can file an application for winding up of the company to the court after serving on the company written demandrequiring the company to repay the deposit (Section 433, 434 and 439 of the Companies Act may be referred to for thepurpose). The SEBI is not permitting such companies to make public issues.

Cases in Respect of which Applications to the Company Law Board will not LieIt is essential to know that under Section 58A of the Companies Act, the power to order repayment of matured

deposits can be exercised by the CLB only in respect of deposits accepted Under the Companies (Acceptance of Deposit)Rules 1975 as amended from time to time. In other words, an application to the Company Law Board of repayment ofmatured deposits shall not lie in the following cases:

(i) Deposits made for booking purchases of scooter, car etc.


(ii) Deposits accepted by financial companies like, hire-purchase finance company, a housing finance company, aninvestment company, a loan/mutual benefit financial company, a chit fund company, which are governed by therules made by the RBI.

(iii) Deposits accepted by companies which have been notified as ‘relief undertakings’ under special laws enactedby various State Governments. Court rulings point to the fact that the monetary liabilities of relief undertakingsduring the notified period stand suspended and any proceedings including the proceedings for compulsoryrepayment of deposits under Section 58A(9) shall accordingly remain stayed.

(iv) Deposits accepted by a sick industrial company covered by the Sick Industrial Companies (Special Provisions)Act, 1985 in respect of which, the Board for Industrial and Financial Reconstruction has specifically, by ordersuspended the operations of any contract, agreement, settlement, etc. under Section 22(3) of the Act.

Facts about Company DepositsThe deposits accepted by a company are not repayable before the date of maturity. It is left to the discretion of a

company to allow premature repayment of a deposit. If and when the deposits are prematurely repaid the depositors areentitled to a lower rate of interest than the contracted rate. Most importantly, the company deposits are unsecured andrank pari passu with other unsecured liabilities. Hence, the investor has no recourse to any asset of the company in caseof default by a company to repay the deposit on maturity.

Care to be Exercised while Investing in Fixed DepositsInvitation to deposits from public for various schemes of deposits is invariably published in newspapers in the form

of a statutory advertisement giving the following details:

(i) Terms of acceptance of deposits, rate of interest on different maturities, minimum amount of deposits, cumulativeor non-cumulative nature of the deposit, etc.

(ii) Brief details of the name of the company, date of its incorporation, business carried on by it, places where thecompany has offices and names and address of directors.

(iii) Details of profits and dividends for the last three years.

(iv) Summarised financial position to the company (i.e., assets and liabilities) as appearing in the two latest auditedbalance sheets, alongwith details of contingent liabilities not provided for.

(v) Details regarding maximum amount of deposits which a company can accept.

(vi) A specific declaration that deposits accepted are unsecured and would rank pari passu with other unsecuredliabilities.

(vii) A statement of deposits remaining unpaid.

Problems in Securities MarketsSecurities markets are highly sensitive to any socio-economic and political factors. As such, the stock market is

said to be the window of the economy. A large element of speculation is rampant in these markets and a right dose ofregulation is a necessary evil. The sensitivity of external factors has increased after 1992 economic and financial reforms,when liberalisation and globalisation trends began to be perceptible.

Lack of professionalisation and broker-banks nexus has led to a number of scams. Even big banks got involved inScams, in 1991-92 and 2000-01. Corruption and malpractices including mismanagement led to many bank failures,involving the U.T.I. as well. The trust and confidence reposed in the markets by investors were rudely shaken by thefailure of U.S. 64 Scheme of UTI, urban corporative banks’ failures and non-refund of deposits by many financial andnon-financial companies. The laxity in regulation and in supervision by C.L.B., SEBI and RBI is one obvious reason forincreased malpractices in the financial system, shaking the confidence of savers and investors. The failure of global TrustBank, and scam of Satyam Computers are examples of laxity in supervision.

chapter 1 securities markets 1 - himpub.com delhi : “pooja ... write this book is that it covers...

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