Tag: University of Mumbai BMS Notes

Indian equity culture is a notorious concoction of temptation, noise, and information scarcity.

India is indeed a statistical marvel! A country of over a billion people with a $1 trillion plus economy, a middle class population of between 300 million-500 million, around 117 million Smartphone users, and a stock market that boasts capitalization of over a $1 trillion. It’s a country that for some time now has been a data hub to the world owing to its burgeoning BPO, KPO, and IT analytics establishments.

It wouldn’t be an exaggeration then if we call India a land of hopes and promise largely because of her compelling statistics and vast body of data about her economics, consumers, and demographic trends. Ironically, a country washed over by such great proportion of data points has failed brilliantly so far in arming her citizens with actionable information on a wide range of matters. One such class of citizens is the ever vulnerable retail investors and the matter here is about building an equity culture.

The market regulatory bodies SEBI, AMFI have worked hard with the market participants like brokerage and fund houses to push the envelope on investor education since the last two decades. Interestingly, SEBI over the past few years have incentivized the equity culture through a slew of benefits like IPO quotas, price discounts, and tax breaks et al. Nevertheless, the success of these initiatives is highly debatable at best.

Investor Awareness Programs – Temptation or Education?
The brokerage, fund houses, and financial media in India are but dubious stakeholders in the grand project of building equity culture in India. Building an equity culture is an idea and not a trend. Retail investors are often flooded with NFOs and MF schemes when much of the milk has already been skimmed by the fat cats, namely FIIs and HNIs. Recall, not many schemes and NFOs were launched between 2009-2013, when the valuations were cheap and upside price opportunities for long-term retail investors were immense.

Unsurprisingly, during these years Sensex rose over 100% where as retail investors participation grew by just 33%. Come 2014 we have been flooded by a plethora of NFOs and MF schemes when many stocks already have gained, on an average, by well over 30%-60%. Of course, there is immense potential for India’s economy to grow in the next 5 years but isn’t investing supposed to be independent of fads, trends, and upturns?

Building a culture of investing is about being disciplined and regularity. The stakeholders intending to build a robust Indian equity culture must focus on values that are totally independent of market fads and trends. Importantly, investor education is not about tempting gullible investors into overbought and overvalued markets, which has sadly been the only form of education imparted by the equity culture stakeholders.

Financial Media: Noise or News

Indian financial news media (print and TV) has done little in terms helping retail investors understand markets better. Much of what is spoken on business TVs and print media is about events with great importance to the momentum driven portfolios of FIIs than the long-term retail investors. The brilliant case in point is turbulence in Iraq. While oil import risk arising out of the deadly humanitarian crisis in Iraq could potentially affect inflation levels, but the risk to the Indian economy is overblown.

Geopolitical developments are akin to arbitrage opportunities as in they last for a very short duration of time. Investors with flamboyant investment styles are most likely to be affected by such short-term developments than the long-term retail investors. Moreover, not many media or publishing houses aid retail investors by conducting studies on long-term performance of different investment styles, MF schemes (hybrid, capital protection, and arbitrage et al) that could possibly serve as a reference point for small investors for making informed investment decisions.

On the other hand, major data releases like economic indicators, industrial production, Sensex/Nifty movements, and market outlook are expressed in a technical parlance about which much of the retail investors are oblivious. The fact that a major chunk of retail investors make their investment decisions based on tips, advice, and suggestions from a heterogeneous group of brokers, friends, and family members talks a lot about the ineffectiveness of the Indian financial media companies.

As the things stands now the nexus of brokerage, fund houses and financial news companies have succeeded in luring retail investors into yet another Indian bull rally. As I wrap this article the Indian equity culture is a notorious concoction of temptation, noise, and information scarcity!

Broad Constituents in the Indian Capital Markets

Quick summary with stories

Fund Raisers

Fund Raisers are companies that raise funds from domestic and foreign sources, both public and private. The following sources help companies raise funds.

Fund Providers

Fund Providers are the entities that invest in the capital markets. These can be categorized as domestic and foreign investors, institutional and retail investors. The list includes subscribers to primary market issues, investors who buy in the secondary market, traders, speculators, FIIs/ sub-accounts, mutual funds, venture capital funds, NRIs, ADR/GDR investors, etc.

Intermediaries

Intermediaries are service providers in the market, including stock brokers, sub-brokers, financiers, merchant bankers, underwriters, depository participants, registrar and transfer agents, FIIs/ sub-accounts, mutual Funds, venture capital funds, portfolio managers, custodians, etc.

Organizations

Organizations include various entities such as MCX-SX, BSE, NSE, other regional stock exchanges, and the two depositories National Securities Depository Limited (NSDL) and Central Securities Depository Limited (CSDL).

Market Regulators

Market Regulators include the Securities and Exchange Board of India (SEBI), the Reserve Bank of India (RBI), and the Department of Company Affairs (DCA).

Role and Importance Of Capital Market In India

The capital market has a crucial significance to capital formation. For a speedy economic development, the adequate capital formation is necessary. The significance of capital market in economic development is explained below:

Mobilization of Savings And Acceleration Of Capital Formation:

In developing countries like India, the importance of capital market is self-evident. In this market, various types of securities help to mobilize savings from various sectors of the population. The twin features of reasonable return and liquidity in stock exchange are definite incentives to the people to invest in securities. This accelerates the capital formation in the country.

Raising Long-Term Capital

The existence of a stock exchange enables companies to raise permanent capital. The investors cannot commit their funds for a permanent period but companies require funds permanently. The stock exchange resolves this dash of interests by offering an opportunity to investors to buy or sell their securities, while permanent capital with the company remains unaffected.

Promotion Of Industrial Growth

The stock exchange is a central market through which resources are transferred to the industrial sector of the economy. The existence of such an institution encourages people to invest in productive channels. Thus it stimulates industrial growth and economic development of the country by mobilizing funds for investment in the corporate securities.

Ready And Continuous Market

The stock exchange provides a central convenient place where buyers and sellers can easily purchase and sell securities. Easy marketability makes an investment in securities more liquid as compared to other assets.

Technical Assistance

An important shortage faced by entrepreneurs in developing countries is technical assistance. By offering advisory services relating to the preparation of feasibility reports, identifying growth potential and training entrepreneurs in project management, the financial intermediaries in capital market play an important role.

Reliable Guide to Performance

The capital market serves as a reliable guide to the performance and financial position of corporate, and thereby promotes efficiency.

Proper Channelization of Funds

The prevailing market price of a security and relative yield are the guiding factors for the people to channelize their funds in a particular company. This ensures effective utilization of funds in the public interest.

Provision of Variety Of Services:

The financial institutions functioning in the capital market provide a variety of services such as a grant of long-term and medium-term loans to entrepreneurs, provision of underwriting facilities, assistance in the promotion of companies, participation in equity capital, giving expert advice etc.

Development of Backward Areas

Capital Markets provide funds for projects in backward areas. This facilitates economic development of backward areas. Long-term funds are also provided for development projects in backward and rural areas.

Foreign Capital

Capital markets make possible to generate foreign capital. Indian firms are able to generate capital funds from overseas markets by way of bonds and other securities. The government has liberalized Foreign Direct Investment (FDI) in the country. This not only brings in the foreign capital but also foreign technology which is important for economic development of the country.

Easy Liquidity

With the help of secondary market, investors can sell off their holdings and convert them into liquid cash. Commercial banks also allow investors to withdraw their deposits, as and when they are in need of funds.

Divorce between Ownership and Control

Divorce between ownership and control refers to a situation where the owners of a company or corporation (i.e., the shareholders) do not have direct control over the day-to-day operations and decision-making of the company. This can occur when shareholders elect a board of directors to oversee the company’s management and make decisions on their behalf.

The separation of ownership and control is often seen in large corporations where there are numerous shareholders who are not actively involved in the company’s operations. In these cases, the board of directors is responsible for hiring the management team, setting strategic direction, and making decisions on behalf of the shareholders.

While this separation can lead to more efficient decision-making and a greater focus on long-term goals, it can also create conflicts of interest between shareholders and management. For example, managers may prioritize their own interests over those of the shareholders, leading to a misalignment of incentives. Additionally, the board of directors may not always act in the best interests of the shareholders, leading to concerns about corporate governance and accountability.

Ownership and Control of a Business

Ownership and control of a business refer to two different aspects of the management and decision-making of a company. Ownership refers to the legal right to control a business or property and to reap its benefits, usually represented by ownership of shares or equity in the company. Control, on the other hand, refers to the power to manage and direct the day-to-day operations of the business.

In a small business, the owner(s) typically have both ownership and control, making all major decisions and managing the operations of the business. However, in larger companies, ownership and control may be separated. In such cases, the owners of a business are the shareholders, while the management team, led by the CEO or other top executives, exercises control over the company’s operations and decision-making.

The relationship between ownership and control is often a balancing act, as shareholders seek to maximize the value of their investments while the management team aims to grow the business and make decisions that benefit the company as a whole. This can sometimes lead to conflicts of interest, particularly when there is a misalignment of incentives or when shareholders believe that management is not acting in their best interests.

Effective corporate governance mechanisms, such as a board of directors, can help to mitigate these conflicts and ensure that the interests of shareholders and management are aligned. Ultimately, the success of a business depends on finding the right balance between ownership and control and creating a culture of trust and transparency between shareholders and management.

The Principal Agent Problem

The principal-agent problem is a common issue that arises when one person or entity (the principal) hires another person or entity (the agent) to act on their behalf, and the interests of the principal and agent are not perfectly aligned. This problem can occur in various contexts, including corporate governance, public policy, and even personal relationships.

In corporate governance, for example, shareholders (the principals) elect a board of directors to oversee the company’s management and make decisions on their behalf. However, the board of directors (the agents) may not always act in the best interests of the shareholders. Instead, they may prioritize their own interests, such as maintaining their position on the board or pursuing personal gain, over maximizing shareholder value.

The principal-agent problem can also arise in public policy, where elected officials (the principals) hire bureaucrats and other government officials (the agents) to implement policies on their behalf. In this case, the agents may prioritize their own interests or those of special interest groups over the interests of the public.

To mitigate the principal-agent problem, various mechanisms can be put in place, such as performance-based compensation, transparency, and accountability mechanisms. These mechanisms aim to align the interests of the principal and agent and ensure that the agent acts in the best interests of the principal. However, it is often difficult to fully eliminate the principal-agent problem, and it remains an ongoing challenge in many areas of decision-making.

Dealing with the Divorce between Ownership & Control

Dealing with the divorce between ownership and control can be challenging, as it requires finding a way to align the interests of shareholders and management to ensure that the company is being run in the best interests of all stakeholders. Here are some ways that companies can mitigate the issues associated with the separation of ownership and control:

• Strong Corporate Governance: Having a strong board of directors, including independent directors who are not involved in day-to-day operations, can help to ensure that management is held accountable and that decisions are made in the best interests of shareholders.
• Performance-Based Compensation: Tying executive compensation to performance metrics that align with shareholder interests can incentivize management to act in the best interests of shareholders.
• Shareholder Activism: Shareholders can exercise their rights by engaging in proxy contests or shareholder proposals, which can help to influence decision-making by the board and management.
• Transparency and Disclosure: Companies can be transparent about their operations and decision-making, providing regular updates to shareholders about financial performance, strategic direction, and key decisions.
• Social Responsibility: Emphasizing social responsibility and environmental, social, and governance (ESG) considerations can help to align the interests of shareholders and management around long-term sustainability and value creation.

Activist Shareholders

Activist shareholders are individuals or groups of investors who use their ownership stake in a company to advocate for changes that they believe will improve the company’s performance or align it with their values. They typically have a more active approach to investing than passive investors, who simply hold shares of a company without seeking to influence its direction.

Activist shareholders may push for a range of changes, such as board or management changes, strategic shifts, asset sales, share buybacks, or dividend increases. They may also seek to influence a company’s environmental, social, or governance (ESG) practices, such as by advocating for more sustainable or ethical business practices.

Activist shareholders may take a variety of actions to push for change, such as filing shareholder proposals, engaging in public campaigns or media outreach, or even seeking to replace board members through proxy battles. Some activist shareholders may be viewed as aggressive or disruptive by management and other stakeholders, while others may be seen as constructive partners in driving long-term value creation.

Mark Twain once divided the world into two kinds of people:

those who have seen the famous Indian monument, the Taj Mahal, and those who haven’t. The same could be said about investors.

There are two kinds of investors: those who know about the investment opportunities in India and those who don’t. India may look like a small dot to someone in the U.S., but upon closer inspection, you will find the same things you would expect from any promising market. Here we’ll provide an overview of the Indian stock market and how interested investors can gain exposure.

The BSE and NSE

Most of the trading in the Indian stock market takes place on its two stock exchanges: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). The BSE has been in existence since 1875. The NSE, on the other hand, was founded in 1992 and started trading in 1994. However, both exchanges follow the same trading mechanism, trading hours, settlement process, etc. At the last count, the BSE had about 4,700 listed firms, whereas the rival NSE had about 1,200. Out of all the listed firms on the BSE, only about 500 firms constitute more than 90% of its market capitalization; the rest of the crowd consists of highly illiquid shares.

Almost all the significant firms of India are listed on both the exchanges. NSE enjoys a dominant share in spot trading, with about 70% of the market share, as of 2009, and almost a complete monopoly in derivatives trading, with about a 98% share in this market, also as of 2009. Both exchanges compete for the order flow that leads to reduced costs, market efficiency and innovation. The presence of arbitrageurs keeps the prices on the two stock exchanges within a very tight range. 

Trading Mechanism

Trading at both the exchanges takes place through an open electronic limit order book, in which order matching is done by the trading computer. There are no market makers or specialists and the entire process is order-driven, which means that market orders placed by investors are automatically matched with the best limit orders. As a result, buyers and sellers remain anonymous. The advantage of an order driven market is that it brings more transparency, by displaying all buy and sell orders in the trading system. However, in the absence of market makers, there is no guarantee that orders will be executed.

All orders in the trading system need to be placed through brokers, many of which provide online trading facility to retail customers. Institutional investors can also take advantage of the direct market access (DMA) option, in which they use trading terminals provided by brokers for placing orders directly into the stock market trading system.

Settlement Cycle and Trading Hours

Equity spot markets follow a T+2 rolling settlement. This means that any trade taking place on Monday, gets settled by Wednesday. All trading on stock exchanges takes place between 9:55 am and 3:30 pm, Indian Standard Time (+ 5.5 hours GMT), Monday through Friday. Delivery of shares must be made in dematerialized form, and each exchange has its own clearing house, which assumes all settlement risk, by serving as a central counterparty.

Market Indexes

The two prominent Indian market indexes are Sensex and Nifty. Sensex is the oldest market index for equities; it includes shares of 30 firms listed on the BSE, which represent about 45% of the index’s free-float market capitalization. It was created in 1986 and provides time series data from April 1979, onward.

Another index is the S&P CNX Nifty; it includes 50 shares listed on the NSE, which represent about 62% of its free-float market capitalization. It was created in 1996 and provides time series data from July 1990, onward.

Market Regulation

The overall responsibility of development, regulation and supervision of the stock market rests with the Securities & Exchange Board of India (SEBI), which was formed in 1992 as an independent authority. Since then, SEBI has consistently tried to lay down market rules in line with the best market practices. It enjoys vast powers of imposing penalties on market participants, in case of a breach.

Primary and Secondary Market

Primary Market

Primary market is the place where new shares or bonds are issued. Hence primary market is also called as new issue market. In primary market company sells the shares to investors to generate the fund. In primary market the trading is directly between investors and company. Here the price of share is decided by company and is fixed. In primary market investors can only buy shares, they cannot sell them. Shares purchased in primary market are sold in secondary market. In primary market company can raise the fund by three types that is public issue, private placement or right issue.

Secondary Market

Secondary market is also called as After market. Stock exchange is the secondary market. The stock exchange is the medium through which the exchange of shares, Equities takes place between the seller and the buyer. Secondary market is the place where most of the trading takes place. The trading of shares and capital in secondary market takes place between the buyer and the seller, company is not involved in transactions. The price of share is decided by demand and supply of the shares and price keeps on fluctuating. In secondary market no new stocks are issued, only trading of stocks is there.

Equity Shares

Equity shares are the main source of finance of a firm. It is issued to the general public. Equity share­holders do not enjoy any preferential rights with regard to repayment of capital and dividend. They are entitled to residual income of the company, but they enjoy the right to control the affairs of the business and all the shareholders collectively are the owners of the company.

Features of Equity Shares

1. They are permanent in nature.
2. Equity shareholders are the actual owners of the company and they bear the highest risk.
3. Equity shares are transferable, i.e. ownership of equity shares can be transferred with or without consideration to other person.
4. Dividend payable to equity shareholders is an appropriation of profit.
5. Equity shareholders do not get fixed rate of dividend.
6. Equity shareholders have the right to control the affairs of the company.
7. The liability of equity shareholders is limited to the extent of their investment.

Advantages of Equity Shares

Equity shares are amongst the most important sources of capital and have certain advantages which are mentioned below:

1. Advantages from the Shareholders’ Point of View

(a) Equity shares are very liquid and can be easily sold in the capital market.

(b) In case of high profit, they get dividend at higher rate.

(c) Equity shareholders have the right to control the management of the company.

(d) The equity shareholders get benefit in two ways, yearly dividend and appreciation in the value of their investment.

1. Advantages from the Company’s Point of View:

(a) They are a permanent source of capital and as such; do not involve any repayment liability.

(b) They do not have any obligation regarding payment of dividend.

(c) Larger equity capital base increases the creditworthiness of the company among the creditors and investors.

Disadvantages of Equity Shares:

Despite their many advantages, equity shares suffer from certain limitations. These are:

1. Disadvantages from the Shareholders’ Point of View:

(a) Equity shareholders get dividend only if there remains any profit after paying debenture interest, tax and preference dividend. Thus, getting dividend on equity shares is uncertain every year.

(b) Equity shareholders are scattered and unorganized, and hence they are unable to exercise any effective control over the affairs of the company.

(c) Equity shareholders bear the highest degree of risk of the company.

(d) Market price of equity shares fluctuate very widely which, in most occasions, erode the value of investment.

(e) Issue of fresh shares reduces the earnings of existing shareholders.

1. Disadvantage from the Company’s Point of View:

(a) Cost of equity is the highest among all the sources of finance.

(b) Payment of dividend on equity shares is not tax deductible expenditure.

(c) As compared to other sources of finance, issue of equity shares involves higher floatation expenses of brokerage, underwriting commission, etc.

Different Types of Equity Issues:

Equity shares are the main source of long-term finance of a joint stock company. It is issued by the company to the general public. Equity shares may be issued by a company in different ways but in all cases the actual cash inflow may not arise (like bonus issue).

The different types of equity issues have been discussed below:

1. New Issue:

A company issues a prospectus inviting the general public to subscribe its shares. Generally, in case of new issues, money is collected by the company in more than one installment— known as allotment and calls. The prospectus contains details regarding the date of payment and amount of money payable on such allotment and calls. A company can offer to the public up to its authorized capital. Right issue requires the filing of prospectus with the Registrar of Companies and with the Securities and Exchange Board of India (SEBI) through eligible registered merchant bankers.

2. Bonus Issue:

Bonus in the general sense means getting something extra in addition to normal. In business, bonus shares are the shares issued free of cost, by a company to its existing shareholders. As per SEBI guidelines, if a company has sufficient profits/reserves it can issue bonus shares to its existing shareholders in proportion to the number of equity shares held out of accumulated profits/ reserves in order to capitalize the profit/reserves. Bonus shares can be issued only if the Articles of Association of the company permits it to do so.

Advantage of Bonus Issues:

From the company’s point of view, as bonus issues do not involve any outflow of cash, it will not affect the liquidity position of the company. Shareholders, on the other hand, get bonus shares free of cost; their stake in the company increases.

Disadvantages of Bonus Issues:

Issue of bonus shares decreases the existing rate of return and thereby reduces the market price of shares of the company. The issue of bonus shares decreases the earnings per share.

Rights Issue:

According to Section 81 of The Company’s Act, 1956, rights issue is the subsequent issue of shares by an existing company to its existing shareholders in proportion to their holding. Right shares can be issued by a company only if the Articles of Association of the company permits. Rights shares are generally offered to the existing shareholders at a price below the current market price, i.e. at a concessional rate, and they have the options either to exercise the right or to sell the right to another person. Issue of rights shares is governed by the guidelines of SEBI and the central government.

Rights shares provide some monetary benefits to the existing shareholders as they get shares at a concessional rate—this is known as value of right which can be computed as:

Value of right = Cum right market price of a share – Issue price of a new share / Number of old shares + 1

Advantages of Rights Issue:

Rights issues do not affect the controlling power of existing share­holders. Floatation costs, brokerage and commission expenses are not incurred by the company unlike in the public issue. Shareholders get some monetary benefits as shares are issued to them at concessional rates.

Disadvantages of Rights Issue:

If a shareholder fails to exercise his rights within the stipulated time, his wealth will decline. The company loses cash as shares are issued at concessional rate.

Sweat Issue:

According to Section 79A of The Company’s Act, 1956, shares issued by a company to its employees or directors at a discount or for consideration other than cash are known as sweat issue. The purpose of sweat issue is to retain the intellectual property and knowhow of the company. Sweat issue can be made if it is authorized in a general meeting by special resolution. It is also governed by Issue of Sweet Equity Regulations, 2002, of the SEBI.

Advantages of Sweat Issue:

Sweat equity shares cannot be transferred within 3 years from the date of their allotment. It does not involve floatation costs and brokerage.

Disadvantage of Sweat Issue:

As sweat equity shares are issued at concessional rates, the com­pany loses financially.

Regulations are very important for the growth of capital markets all through the world. The development of a market economy is dependent on the growth of the capital market. The regulation of a capital market encompasses the regulation of securities. These rules enable the capital market to function more competently and fairly.

A well regulated market has the prospective to boost additional investors to participate, and contribute in, promoting the development of the economy.

Capital Market Regulatory Authorities Worldwide: The chief capital market regulatory authorities worldwide are as follows:

• Securities and Exchange Board of India
• U.S. Securities and Exchange Commission
• Canadian Securities Administrators, Canada
• Australian Securities and Investments Commission
• Securities and Exchange Commission, Pakistan
• Securities and Exchange Commission, Bangladesh
• Securities and Exchange Surveillance Commission
• Securities and Futures Commission, Hong Kong
• Financial Supervision Authority, Finland
• Financial Supervision Commission, Bulgaria
• Financial Services Authority, UK
• Commission Nacional del Mercado de Valores, Spain
• Authority of Financial Markets

It has been well established that there is a growing network of financial intermediaries that operate in a highly competitive environment while being directed by strict norms. India has one of the most refined new equity issuance markets. Disclosure requirements and the accounting policies followed by listed companies to offer financial information are comparable to the best systems in the world. In Indian scenario, the securities market is regulated by various agencies such as department of economic affairs, department of company affairs, and the reserve bank of India. The capital markets and protection of investor’s interest is now primarily the responsibility of the Securities and Exchange Board of India (SEBI), which is located in Bombay. The activities of these agencies are coordinated by high level committee on capital and financial market. The high level coordinated committee for financial market discusses various policy level issues which require inter regularity coordination between the regulators in financial market such as RBI, SEBI, insurance, regulatory and development authority (IRDA) and pension regulatory and development authority. The committee is chaired by Governor, RBI, secretary minister of finance, chairman SEBI, chairman IRDA, and chairman, PRDA are members of committee.

The capital market is market of equity and debt securities is regulated by Securities and Exchange Board of India (SEBI). Securities and Exchange Board of India (SEBI) has full autonomy and authority to regulate and develop capital market. The government has framed rules under securities controls act, the SEBI act and depositories act.

SEBI’s functions include:

1. Regulating the business in stock exchange and any other securities markets.
2. Registering and regulating the working of collective investment schemes, including mutual funds.
3. Barring fraudulent and unfair trade practices relating to securities markets.
4. Promoting investor’s education and training of intermediaries of securities markets.
5. Prohibiting insider trading in securities, with the imposition of monetary penalties, on erring market intermediaries.
6. Regulating substantial acquisition of shares and takeover of companies.
7. Calling for information from, carrying out inspection, conducting inquiries and audits of the stock exchanges and intermediaries and self-regulatory organizations in the securities market.

To summarize, Capital market is controlled by financial supervisors and their own governance organization. Major grounds of regulation are to keep investors away from scam and deception. Financial regulatory organizations are also charged with decreasing the losing rate of financial, providing licenses to financial service providers, and executing applicable regulations.

Companies all over the world use either fixed pricing or book building as a mechanism to price their shares. Over the period of time, the fixed price mechanism has become obsolete and book building has become the de-facto mechanism used in pricing shares while conducting an initial public offer (IPO). In this article, we will study how book building process works i.e. how are shares priced in an IPO:

Book building is a price discovery mechanism that is used in the stock markets while pricing securities for the first time. When shares are being offered for sale in an IPO, it can either be done at a fixed price. However, if the company is not sure about the exact price at which to market its shares, it can decide a price range instead of an exact figure. This process of discovering the price by providing the investors with a price range and then asking them to bid on it is called the book building process. It is considered to be one of the most efficient mechanisms of pricing securities in the primary market. This is the preferred method which is recommended by all major stock exchanges and as a result is followed in all major developed countries in the world.

Book Building Process

The detailed process of book building is as follows:

1. Appointment of Investment Banker: The first step starts with appointing the lead investment banker. The lead investment banker conducts due diligence. They propose the size of the capital issue that must be conducted by the company. Then they also propose a price band for the shares to be sold. If the management agrees with the propositions of the investment banker, the prospectus is issued with the price range as suggested by the investment banker. The lower end of the price range is known as the floor price whereas the higher end is known as the ceiling price. The final price at which securities are indeed offered for sale after the entire book building process is called the cut-off price.
2. Collecting Bids: Investors in the market are requested to bid to buy the shares. They are requested to bid the number of shares that they are willing to buy at varying price levels. These bids along with the application money are supposed to be submitted to the investment bankers. It must be noted that it is not a single investment banker who is engaged in the collection of bids. Rather, the lead investment banker can appoint sub-agents to tap into their network especially for receiving the bids from a larger group of individuals.
3. Price Discovery: Once all the bids have been aggregated by the lead investment banker, they begin the process of price discovery. The final price chosen in simply the weighted average of all the bids that have been received by the investment banker. This price is declared as the cut-off price. For any issue which has received substantial publicity and which is being anticipated by the public, the ceiling price is usually the cut-off price.
4. Publicizing: In the interest of transparency, stock exchanges all over the world require that companies make public the details of the bids that were received by them. It is the lead investment banker’s duty to run advertisements containing the details of the bids received for the purchase of shares for a given period of time (let’s say a week). The regulators in many markets are also entitled to physically verify the bid applications if they wish to.
5. Settlement: Lastly, the application amount received from the various bidders has to be adjusted and shares have to be allotted. For instance, if a bidder has bid a lower price than the cut-off price then a call letter has to be sent asking for the balance money to be paid. On the other hand, if a bidder has bid a higher price than the cut-off, a refund cheque needs to be processed for them. The settlement process ensures that only the cut-off amount is collected from the investors in lieu of the shares sold to them.

Partial Book Building

Partial book building is another variation of the book building process. In this process, instead of inviting bids from the general population, investment bankers invite bids from certain leading institutions. Based on their bids, a weighted average of the prices is created and cut-off price is decided. This cut-off price is then offered to the retail investors as a fixed price. Therefore, the bidding only happens at an institutional level and not at a retail level.

This is also an efficient mechanism to discover prices. Also the cost and complications involved in conducting a partial book building are substantially low.

First of all, the book building process brings flexibility to the pricing of IPO’s. Prior to the introduction of book building, a lot of IPO’s were either underpriced or overpriced. This created problems because if the issue was underpriced, the company was losing possible capital. On the other hand, if the issue was overpriced it would not be fully subscribed. In fact, if it was subscribed below a given percentage, the issue of securities had to be cancelled and the substantial costs incurred over the issue would simply have to be written off. With the introduction of book building process, such events no longer happen and the primary market functions more efficiently.

Stock Exchange (also called Stock Market or Share Market) is one important constituent of capital market. Stock Exchange is an organized market for the purchase and sale of industrial and financial security. It is convenient place where trading in securities is conducted in systematic manner i.e. as per certain rules and regulations.

It performs various functions and offers useful services to investors and borrowing companies. It is an investment intermediary and facilitates economic and industrial development of a country.

Stock exchange is an organized market for buying and selling corporate and other securities. Here, securities are purchased and sold out as per certain well-defined rules and regulations. It provides a convenient and secured mechanism or platform for transactions in different securities. Such securities include shares and debentures issued by public companies which are duly listed at the stock exchange, and bonds and debentures issued by government, public corporations and municipal and port trust bodies.

Stock exchanges are indispensable for the smooth and orderly functioning of corporate sector in a free market economy. A stock exchange need not be treated as a place for speculation or a gambling den. It should act as a place for safe and profitable investment, for this, effective control on the working of stock exchange is necessary. This will avoid misuse of this platform for excessive speculation, scams and other undesirable and anti-social activities.

London stock exchange (LSE) is the oldest stock exchange in the world. While Bombay stock exchange (BSE) is the oldest in India. Similar Stock exchanges exist and operate in large majority of countries of the world.

Characteristics or features of stock exchange are:

1. Market for securities: Stock exchange is a market, where securities of corporate bodies, government and semi-government bodies are bought and sold.
2. Deals in second hand securities: It deals with shares, debentures bonds and such securities already issued by the companies. In short it deals with existing or second hand securities and hence it is called secondary market.
3. Regulates trade in securities: Stock exchange does not buy or sell any securities on its own account. It merely provides the necessary infrastructure and facilities for trade in securities to its members and brokers who trade in securities. It regulates the trade activities so as to ensure free and fair trade
4. Allows dealings only in listed securities: In fact, stock exchanges maintain an official list of securities that could be purchased and sold on its floor. Securities which do not figure in the official list of stock exchange are called unlisted securities. Such unlisted securities cannot be traded in the stock exchange.
5. Transactions effected only through members: All the transactions in securities at the stock exchange are affected only through its authorised brokers and members. Outsiders or direct investors are not allowed to enter in the trading circles of the stock exchange. Investors have to buy or sell the securities at the stock exchange through the authorised brokers only.
6. Association of persons: A stock exchange is an association of persons or body of individuals which may be registered or unregistered.
7. Recognition from Central Government: Stock exchange is an organised market. It requires recognition from the Central Government.
8. Working as per rules: Buying and selling transactions in securities at the stock exchange are governed by the rules and regulations of stock exchange as well as SEBI Guidelines. No deviation from the rules and guidelines is allowed in any case.
9. Specific location: Stock exchange is a particular market place where authorised brokers come together daily (i.e. on working days) on the floor of market called trading circles and conduct trading activities. The prices of different securities traded are shown on electronic boards. After the working hours market is closed. All the working of stock exchanges is conducted and controlled through computers and electronic system.
10. Financial Barometers: Stock exchanges are the financial barometers and development indicators of national economy of the country. Industrial growth and stability is reflected in the index of stock exchange.

The earliest stock exchange was set up in Amsterdam in 1602 and it was involved in buying and selling of shares for Dutch East India Company. Prior to this, brokers existed in France dealing with government securities. It must be noted that the first real stock exchange started in Philadelphia in the United States during the late 18th century. Later, the New York Stock Exchange became popular and Wall Street became the hotspot of brokerage activities. Earlier stockbrokers were largely unorganised, but later most of them joined hands to form institutions and organisations.

Security Trading in India goes back to the 18th century when East India Company began trading in loan securities.

Derivatives market have been functioning in India in some form or the other for a long time. Corporate shares with the stock of Bank and Cotton presses started being traded in the 1830s in Mumbai with Bombay Cotton Trade Association being the first to start future trading in 1875 in the arena of commodities trading and by the early 1900s, India had one of the world’s largest futures industry. Going back to 1850s the roots of stock exchanges in India sprouting when 22 stockbrokers began trading opposite the Town Hall of Bombay under a banyan tree. The tree is still present in the area and is known as Horniman Circle.

This trading continued till a shift to banyan trees at the Meadows Street Junction, which is now known as Mahatma Gandhi Road, a decade later. The shift was an ongoing one and number of brokers gradually increased finally settling in 1874 at what is known as Dalal Street. The group of 318 people came together to form “Native Shares and Stock Brokers Association” and the membership fee was Re 1. This association is now known as Bombay Stock Exchange (BSE) and in 1965 it was given permanent recognition by the Government of India under the Securities Contracts (Regulation) Act (SCRA), 1956. BSE is also the oldest stock exchange in Asia and it is been 144 years since it has been formed. Following its formation, Ahmedabad stock exchange came into operation in 1894 trading in shares of textile mills. Another development in the history of stock exchanges began with the Calcutta stock exchange opening up in 1908 and began trading shares of plantations and jute mills. It was followed by Madras Stock Exchange starting in 1920.

Post-independence Era and Reforms in the market

There were a series of reforms in the stock market between 1993 and 1996 which further lead to the development of exchange-traded equity derivatives markets in India.

There was a certain element of the trading system called “Badla” involving some elements of forwards trading which had been in existence for decades. This practice led to the growth of undesirable market practices and to check this development it was prohibited off and on till it was banned in 2001. In the 1980s stockbroking services were restricted only to the wealthy class who could afford them. With the spread of the Internet, stockbroking became accessible.

In the 1990s stock market witnessed a steady increase in stock market crises. An aspect of these crises was market manipulation on the secondary market. Following are the incidents which prompted the development of the stock market:

1. 1992: Harshad Mehta: The first “stock market scam” was one which involved both the GOI bond and equity markets in India. Thereafter, manipulation was based on inefficiencies in the settlement system in GOI bond market transactions. Inflation came about in the equity markets and the market index went up by 143% between September 1991 and April 1992 and the amount involved in the crises was Rs 54 billion.
2. 1994: MS Shoes: Here the dominant shareholder of the firm, took large leveraged positions through brokers at both Delhi and Bombay stock exchanges, to manipulate share prices prior to the rights issue. After the share prices crashed, broker defaulted and BSE shut down for three days in a consequence.
3. 1995: Sesa Goa: Another episode of market crises for the BSE, was the case of price manipulation of the shares of Sesa Goa. This was perpetrated by two brokers, who later failed on their margin payments on leveraged positions in the shares and the exposure was around 4.5 million.
4. 1995: Bad deliveries of physical certificates: When anonymous trading and the nationwide settlement became the norm by the end of 1995, there was an increased incidence of fraudulent shares being delivered into the market. It has been the expected cost of encountering fake certificates in equity settlement in India at the time was as high as 1%.
5. 1997: CRB. C.R. Bhansali created a group of companies, called the CRB group, which was a conglomerate of finance and non-finance companies. Market manipulation was an important focus of group activities. The non-finance companies routed funds to finance companies for price manipulations. The non-finance companies were tasked with sourcing funds from external sources, using manipulated performance numbers. The CRB episode was particularly important in the way it exposed extreme failures of supervision on part of RBI and SEBI. The amount involved in the episode was Rs 7 billion.
6. 1998: BPL, Videocon and Sterlite: This is an episode of market manipulation involving the broker that engineered the stock market bubble of 1992, Harshad Mehta. He seems to have worked on manipulating the share prices of these three companies, in collusion.
7. 2001: Ketan Parekh. This was triggered by a fall in the prices of IT stocks globally. Ketan Parekh was seen to be a leader of the episode, with leveraged positions onset of stocks called the “K10 stocks”. There are allegations of fraud in this crisis with respect to an illegal “Badla” market at the Calcutta Stock Exchange and banking fraud.

The above instances have had a disruptive effect on the market that is(i) pricing efficiency (ii) intermediation between households investing in shares and firms financing projects by issuing shares which were resolved by reform measures by the government.

In the post-independence era, the BSE dominated the volume of trading. However, the low level of transparency and undependable clearing and settlement systems, apart from other macro factors, increased the need for a financial market regulator, and the SEBI was born in 1988 as a non-statutory body. Later it was made a statutory body in 1992.

Thereafter, in 1952 cash settlement and options trading were prohibited by the government and derivatives trading shifted to informal forwards market. At present, the government allows for markets based pricing mechanism and shows less scepticism towards derivatives trading. The prohibition on futures trading of many commodities was lifted starting in the early 2000s and national electronic exchanges were created. In the 1980s stockbroking services were used only by a wealthy class who could afford them. With the rise of the Internet, stockbroking services became accessible to even the common man. Major organisations became involved in stockbroking activities. 

Although in the wake of Harshad Mehta scam in 1992, there was a pressing need for another stock exchange large enough to compete with BSE and bring transparency to the stock market. It leads to the development of the National Stock Exchange (NSE). It was incorporated in 1992, became recognised as a stock exchange in 1993, and trading began on it in 1994. It was the first stock exchange on which trading was conducted electronically. In response to this competition, BSE also introduced an electronic trading system known as BSE Online Trading (BOLT) in 1995.

Thereafter, BSE launched its own sensitivity index, the Sensex, known at present as the S&P BSE Sensex, in 1986 with 1978-79 as the base year. This is an index of 30 companies and is a benchmark stock index, measuring the overall performance of the exchange. Equity derivatives were introduced by the exchange in 2000. Index options launched in June 2001, stock options in July 2001, and stock futures in November 2001. India’s first free-float index, BSE Teck, was launched in July 2001.

Its competitor, NSE launched its benchmark exchange, the CNX Nifty, now known as Nifty 50, in 1996. It comprises of 50 stocks and functions as a performance measure of the exchange. In terms of electronic screen-based trading and derivatives, it has left behind its competitor BSE by introducing first of its kind products and services.

Stock exchanges at present

After incorporation of BSE and NSE, 23 stock exchanges were added not including the BSE. At present, there are 23 approved stock exchanges in India out of which 6 are functional:-

1. BSE Ltd
2. Calcutta Stock Exchange
3. India International Exchange (India INX)
4. Metropolitan Stock Exchange
5. NSE 
6. NSE IFSC Ltd

Thus, from the times when buyers and sellers had to assemble at stock exchanges for trading till the present times when the dawn of IT has made the operations at stock exchanges electronic hence making stock markets paperless. Trading facilities can be accessed from home or office on phone or Internet. Therefore, with new products and services, rampant growth in stock trading can be foreseen.

Initial public offering is the process by which a private company can go public by sale of its stocks to general public. It could be a new, young company or an old company which decides to be listed on an exchange and hence goes public.

Companies can raise equity capital with the help of an IPO by issuing new shares to the public or the existing shareholders can sell their shares to the public without raising any fresh capital.

A company offering its shares to the public is not obliged to repay the capital to public investors.

The company which offers its shares, known as an ‘issuer’, does so with the help of investment banks. After IPO, the company’s shares are traded in an open market. Those shares can be further sold by investors through secondary market trading.

An IPO (initial public offering) is referred to a flotation, which an issuer or a company proposes to the public in the form of ordinary stock or shares. It is defined as the first sale of stock by a private company to the public. They are generally offered by new and medium-sized firms that are looking for funds to grow and expand their business.

 It is also referred to as “public offering”

 Basics of private and public:

• Private
• Public

A privately held company has fewer shareholders and its owners don’t have to disclose much information about the company. Most small businesses are privately held, with no exceptions that large companies can be private too, like Domino’s Pizza and Hallmark Cards being privately held. Shares of private companies can be reached through the owners only and that also at their discretion. On the other hand, public companies have sold at least a portion of their business to the public and thereby trade on a stock exchange. This is why doing an IPO is referred to going public.

The main reason for going public is to raise the good amount of cash through the various financial avenues that are offered. Besides, the other factors include:

• Public companies usually get better rates when they issue debt due to increased scrutiny.
• As long as there is market demand, a public company can always issue more stock.
• Trading in the open markets means liquidity.
• Being Public makes it possible to implement things like employee stock ownership plans, which help to attract top talent of the industry.

Factors to be considered before applying for an IPO:

There are certain factors which need to be taken into consideration before applying for Initial Public Offerings in India:

• The historical record of the firm providing the Initial Public Offerings
• Promoters, their reliability, and past records
• Products offered by the firm and their potential going forward
• Whether the firm has entered into a collaboration with the technological firm
• Project value and various techniques of sponsoring the plan
• Productivity estimates of the project
• Risk aspects engaged in the execution of the plan

General Terms involved in IPO:

Primary market: It is the market in which investors have the first opportunity to buy a newly issued security as in an IPO.

Prospectus: A formal legal document describing the details of the company is created for a proposed IPO, also making the investors aware of the risks of an investment. It is also known as the offer document.

Book building: It is the process by which an attempt is made to determine the price at which the securities are to be offered based on the demand from investors.

Over-Subscription: A situation in which the demand for shares offered in an IPO exceeds the number of shares issued.

Green shoe option: It is referred to as an over-allotment option. It is a provision contained in an underwriting agreement whereby the underwriter gets the right to sell investors more shares than originally planned by the issuer in case the demand for a security issue proves higher than expected.

Price band: Price band refers to the band within which the investors can bid. The spread between the floor and the cap of the price band is not more than 20% i.e. the cap should not be more than 120% of the floor price. This is decided by the company and its merchant bankers. There is no cap or regulatory approval needed for determining the price of an IPO.

Listing: Shares offered in IPOs are required to be listed on stock exchanges for the purpose of trading. Listing means that the shares have been listed on the stock exchange and are available for trading in the secondary market.

Flipping: Flipping is reselling a hot IPO stock in the first few days to earn a quick profit. The reason behind this is that companies want long-term investors who hold their stock, not traders.

1. Growth in Financial Intermediation:

The Indian capital market has grown due to innovation of the mechanism of indirect financing.

This innovation has enhanced the efficiency of flow of funds from ultimate savers to ultimate users through newly established financial intermediaries like UTI, LIC and GIC. The LIC has been mobilising the savings of households to build a ‘life fund’.

It has been deploying a part of ‘life fund’ to purchase the shares and debentures of the companies. Until 1991 UTI was amongst the top ten shareholders in one out of every three companies listed in the Stock Exchange in which it had a shareholding. Likewise, UTI has been mobilising savings of households through the sale of ‘units’ to invest in securities of ‘blue-chip’ companies.

In short, financial intermediaries like LIC, UTI and GIC have activated the growth process of Indian capital market. It is evident from the rising intermediation ratio. The intermediation ratio is a ratio of the volume of financial instruments issued by the financial institutions, i.e., secondary securities to the volume of primary securities issued by non-financial corporate firms rose from 0.27 during 1951-56 to 0.37 during 1979-80 to 1981-82.

2. Growth in Underwriting of Securities:

The New Issue Market as a segment of capital market can be activated through institutional arrangements for the underwriting of new issues of securities. During the pre-independence period, the volume of securities underwritten was quite minimal due to lack of an adequate institutional arrangement for the provision of underwriting. Stock brokers and banks used to perform this function.

In recent years, the volume and amount of securities underwritten have tremendously increased owing to increasing participation of specialized financial institutions like LIC and UTI and the developed banks like 1FC1,1CICI and IDBI in underwriting activities. It is evident from the fact that the amount of securities underwritten was only 55 per cent in 1960-61, whereas at present it is about 99 per cent.

3. Growth in Response to the Offer of Public Issues of Shares and Bonds:

Traditionally investors in India being risk-investors had been reluctant to invest in shares of public limited companies. Hence, industrial securities as a form of investment were not popular in India before 1951. However, since 1991 public response to corporate securities has been improving. But equity-cult has yet to be developed in rural areas.

It is important to point out that the public response to new issues of shares and bonds depends upon number of factors such as rates of return on industrial securities relative to rates of return on non-marketable financial assets and real assets, government’s monetary policy and fiscal policy and above all legal protection to investors in recent years.

All the above mentioned factors have contributed to the growth of public response to new issue of corporate securities. In short, growing response to public issues has strengthened the Indian capital market. It is evident from the fact that the number of shareholders rose from 60 lakh in 1985 to 160 lakh in 1994.

4. Growth of Merchant Banking:

The role of merchant banking in India’s capital market can be traced back to 1969 when Grind lays Bank established a special cell called the ‘Merchant Banking’. Since then all the commercial banks have set up the ‘Merchant Banking Division’ to play an important role in the capital market.

The merchant banking division of commercial banks advises the companies about economic viability, financial viability and technical feasibility of the project. They conduct the initial ‘spade work’ to find out the investment climate to advise the company whether the public issue floated would be fully subscribed or under-subscribed.

The merchant banks in India act as the underwriter as well as the manager of new issues of securities. The Securities and Exchange Board of India (SEBI) regulates all merchant banks as far as their operations relating to issue activity are concerned. To sum up, the emergence of merchant banking has strengthened the institutional base of Indian capital market.

5. Growth of Credit Rating Agencies:

Of late, credit rating agencies have emerged in the financial sectors. This is an important development for the growth of Indian capital market. Investment Information and Credit Rating Agency of India (ICRA) rates bonds, debentures, preference shares, CDs (Corporate Debentures) and CPs (Commercial Papers).

As Credit Rating Information Services of India Ltd. (CRISIL) is a pioneer in credit rating, it rates debt instruments of banks, financial institutions and corporate firms. The credit assessment of companies issuing securities helps in the growth of New Issue Market segment of the capital market.

6. Growth of Mutual Funds:

Mutual funds companies are investment trust companies. Mutual funds schemes are designed to mobilise funds from individuals and institutional investors, who in exchange get units which Can be redeemed after a certain lock-in period, at their Net Asset Value (NAV). The mutual fund schemes provide tax benefits and buy back facility.

The Unit Trust of India (UTI) can be regarded as pioneer in the setting up of mutual funds in India. Of late, commercial banks have also launched in India mutual funds schemes. Can-stock scheme of the Canara bank and LIC’s scheme, such as Dhanashree, Dhanaraksha and Dhanariddhi are mutual funds schemes.

Since mutual funds schemes help to mobilise small savings of the relatively smaller savers to invest in industrial securities, so these schemes contribute to the growth of capital market. The total assets of mutual funds companies increased from Rs. 66,272 crore in 1993-94 to Rs. 99,248 crore in 2005 and to Rs. 4,13,365 crore in 2008. The investment of mutual funds in the secondary market influences the share prices in the stock exchange.

7. Stock Exchange Regulation Act:

The growth of capital market would not have been possible had the Government of India not legislated suitable laws to protect the investors and regulate the Stock Exchanges. Under this Act, only recognized stock exchanges are allowed to function. This Act has empowered the Government of India to enquire into the affairs of a Stock Exchange and regulate it’s working.

The Government of India established the Securities and Exchange Board of India (SEBI) on April 12, 1988 through an extra ordinary notification in the Gazette of India. In April 1992, SEBI was granted statutory recognition by passing an Act. Since 1991, SEBI has been evolving and implementing various measures and practices to infuse greater transparency in the capital market in the interest of investing public and orderly development of the securities market.

8. Liberalisation Measures:

Foreign Institutional Investors (FII) have been allowed access to Indian capital market. Investment norms for NRIs have been liberalized, so that NRIs and Overseas Corporate Bodies can buy shares and debentures, without prior permission of RBI. This was expected to internationalize Indian capital market.

To sum up, the Indian capital market has registered an impressive growth since 1951. However, it is only since the mid-1980s that new institutions, new financial instruments and new regularity measures have led to speedy growth of the capital market. The liberalisation measures under New Economic Policy (NEP) gave a further boost to the growth of Indian capital market.