Stock Market and how it works:
Basically
the stock market is a place where you can buy and sell shares in a company.
When a company makes shares available for the public to buy they are called
stocks and this is what you are trading. In most cases what you get when you
buy a stock is a very small piece of the company. You are an owner of that
company and as it grows the company should become more valuable which means
that your stocks should become more valuable as well. At least that is the
theory but in practice there are other things that affect the stock price as
well.
Like
anything that is being bought and sold stocks are subject to the law of supply
and demand, since the number of shares is limited when the number of people who
want to buy them increases the price will go up. On the other hand when the
number of buyers declines, or the number of people who want to sell increases
then the price will go down. In theory the demand is based on how profitable
the company is but in practice it is based mainly on expectations of what the
company will do in the future.
Since the
goal of investors is to get the maximum return on their investment the goal is
to buy the stock before the price goes up and then to sell it before it goes
back down. This means that you have to pay attention to what the value of the
company you are buying stock in will be in the future. This is why you often
see the price of the stock go up before an earnings announcement and then
decline even if the earnings were higher than expected. People bought the stock
in the expectation of good earnings which drove the price up and then sold when
the good earnings were announced since it was likely that the stocks value had
peaked, at least temporarily.
Bombay Stock Exchange:
Bombay Stock
Exchange is a corporatized and demutualised entity, with a broad
shareholder-base which includes two leading global exchanges, Deutsche Bourse
and Singapore Exchange as strategic partners. BSE provides an efficient and
transparent market for trading in equity, debt instruments, derivatives, mutual
funds. It also has a platform for trading in equities of small-and-medium
enterprises (SME). More than 5000 companies are listed on BSE making it world's
No. 1 exchange in terms of listed members. The companies listed on BSE Ltd
command a total market capitalization of USD Trillion 1.32 as of January 2013.
BSE Ltd is world's fifth most active exchange in terms of number of
transactions handled through its electronic trading system. It is also one of
the world’s leading exchanges (3rd largest in December 2012) for Index options
trading (Source: World Federation of Exchanges).
BSE also
provides a host of other services to capital market participants including risk
management, clearing, settlement, market data services and education. It has a
global reach with customers around the world and a nation-wide presence. BSE
systems and processes are designed to safeguard market integrity, drive the
growth of the Indian capital market and stimulate innovation and competition
across all market segments. BSE is the first exchange in India and second in
the world to obtain an ISO 9001:2000 certification. It is also the first
Exchange in the country and second in the world to receive Information Security
Management System Standard BS 7799-2-2002 certification for its On-Line trading
System (BOLT).
National Stock Exchnage:
NSE has a
market capitalisation of more than US$0.989 trillion and 1,635 companies listed
as of July 2013. Though a number of other exchanges exist, NSE and the Bombay
Stock Exchange are the two most significant stock exchanges in India, and
between them are responsible for the vast majority of share transactions. NSE's
flagship index, the CNX NIFTY 50, is used extensively by investors in India and
around the world to take exposure to the Indian equities market.
NSE was
started by a clutch of leading Indian financial institutions. It offers trading,
clearing and settlement services in equity, debt and equity derivatives. It is
India's largest exchange, globally in cash market trades, in currency trading
and index options. NSE has diversified shareholding. There are many domestic
and global institutions and companies that hold stake in the exchange. Some of
the domestic investors include LIC, GIC, State Bank of India and IDFC Ltd.
Foreign investors include MS Strategic (Mauritius) Limited, Citigroup Strategic
Holdings Mauritius Limited, Tiger Global Five Holdings and Norwest Venture
Partners X FII-Mauritius, who have a stake in NSE. As of June 2013, NSE has
1673 VSAT terminals and 2720 leaselines, spread over more than 2000 cities
across India.
Reforms:
Equity
trading in India was dominated by floor–based trading on India’s oldest
exchange, the Bombay Stock Exchange (BSE) up to late 1994. This process had
several problems. The floor was non– transparent and illiquid. The non–
transparency of the floor led to rampant abuse such as investors being charged
higher prices for purchases as compared with the prices actually traded on the
floor. It was not possible for investors to crosscheck these prices. Investors
were forced to pay high brokerage fees to
undercapitalized individual brokers, who had primitive order processing
systems.
According
to critics some of the key challenges were
a) Indian
stock market is highly speculative,
b) Indian
investors are dissatisfied with the services provided to them by the brokers,
c) margins
levied by the stock exchanges are inadequate and
d)
liquidity in a large number of stocks in Indian markets is very low.
This
situation was transformed by the arrival of the new National Stock Exchange
(NSE) in 1994. A consortium of government–owned financial institutions, owned
NSE. NSE built an electronic order–matching system, where computers matched
orders without human intervention. It used satellite communications to make
this trading system accessible from locations all over the country. Trading in
equities commenced at NSE in November
1994. The removal of License Raj especially in areas related to private sector
financing options, led to a direct increase in market based financing of
industrial investments through an expansion in three broad channels, FDI,
Global depository receipts (GDR’s) in the international market and the last
being the Capital market which consists of the secondary market and the new
issue market. One important factor that led to the growth of the new issue
market was the growing significance of financial assets, with increase in the
saving rate and monetization of the economy. Further, the government and SEBI have initiated a number
of healthy measures to develop the capital market.
The
efficiency of a capital market which can be defined in terms of its ability to
reflect the impact of all relevant information in the prices of the securities
and the large number of profit driven individuals who act dependently on one
another grew tremendously in the Indian context. The number of issues enlisted
before and after 1991 has been exponential in nature. Some of the major reasons
for their growth are advent of SEBI and abolishment of Capital Issues Control
Act, new regulations for protection of
investors, online trading, depositories and credit rating system etc.
To enable
the capital market to mobilize and allocate the resources efficiently, it must
be appropriately broadened and deepened. This calls for establishing an
institutional framework capable of attracting domestic savings and channelizing
them into productive investments. The efficient allocation of savings flow
entail s development of appropriate mechanism of pricing ,intermediation and
settlement of financial transactions.
A wide
spectrum of instruments designed to meet various risk reward levels and
liquidity preferences are needed to meet the requirements of issuers and investors. An enabling legal and regulatory framework coupled with necessary enforcement is
necessary for the market to function in
a fair and transparent manner.
The
capital market reforms have been at the forefront reform agenda of various Governments since
1991. As greater faith was placed on the allocative efficiency of the markets,
they progressively liberalized
controls that had created severe
distractions and impeded the market f functioning in the past.
The capital
market is the barometer of any country’s economy and provides a mechanism for
capital formation. Across the world there was a transformation in the financial
intermediation from a credit based financial system to a capital market based
system which was partly due to a shift in financial policies from financial
repression (credit controls and other modes of primary sector promotion) to
financial liberalization. This led to an increasing significance of capital
markets in the allocation of financial resources. The Indian capital market
also went through a major transformation after 1992 and the sensex is hovering
around the 18000 mark by the 2012, which
seemed a dream just a decade back. Since
then the market has been growing in leaps and bounds and has aroused the
interests of the investors. The reason for such a development was an increasing
uncertainty caused due to liberalization and standardization of the prudential
requirements of the banking sector for global integration of the Indian
financial system. Further, rise in their non-performing assets led to a
decrease in credit from banks to the commercial sector.
The major
reform in the capital market was the abolition of capital issues control and
the introduction of free pricing of equity issues in 1992. Simultaneously the
Securities and Exchange Board of India (SEBI) was set up as the apex regulator
of the Indian capital markets. In the last five years, SEBI has framed
regulations on a number of matters relating to capital markets. Some of the
measures taken in the primary market include:
• Entry norms for capital issues were tightened
• Disclosure requirements were improved
• Regulations were framed and code of conduct
laid down for merchant bankers, underwriters, mutual funds, bankers to the
issue and other intermediaries
• In relation to the secondary market too,
several changes were introduced:
• Capital adequacy and prudential regulations
were introduced for brokers, sub-brokers and other intermediaries
• Dematerialization of scrips was initiated
with the creation of a legislative framework and the setting up of the first
depository
• On-line trading was introduced at all stock
exchanges. Margining system was rigorously enforced.
• Settlement period was reduced to one week;
carry forward trading was banned and then reintroduced in restricted form; and
tentative moves were made towards a rolling settlement system.
• In the area of corporate governance
• Regulations were framed for insider trading
• Regulatory framework for take-overs was
revamped
• Grant of legal status to SEBI for protecting
investor’s interest and regulating the market.
• Pricing of issues was left free.
• Permission to FII’s (foreign institutional
investors) to enter the primary and secondary market.
• Equity issue in foreign markets by Indian
companies through ADR’s and GDR’s.
• Dematerialization of shares.
• Compulsory credit rating.
• Promotion of the concept of corporate
governance.
• Permission for buy back of shares.
• Participation of foreign partners with equity
in all industries.
• Reduction in interest rates.
Liberalization
and opening of the gates led to an expansion of three broad channels of
financing the private sector namely, a) Domestic capital market b)
International capital market (American depository receipts and Global
depository receipts) and c) Foreign direct investment.
SEBI has been
going through a protracted learning phase since its inception. The apparent
urgency of immediate short term problems in the capital market has often seemed
to distract SEBI from the more critical task of formulating and implementing a
strategic vision for the development and regulation of the capital markets.
KEY REFORMS
Now let us
discuss some of the key reforms
- Disintermediation
- Institutionalization
- Globalization
- Modernization
Disintermediation
The major
fallout of the reform is the increasing
disintermediation in the capital markets. There has been a marked shift
form staid and conventional source of funding
to bold initiatives in the capital markets. The corporate sector
directly accesses the market rather than rely excessively on institutional and
bank borrowings. The abolition of controller to capital issues has given a big
boost to this process.
The
institutionalization of the market has had a positive impact on the quality of
intermediation services
and
disclosure standards. The institutional investors have become an important
source of pressure on companies they invest into improve the quality of their
corporate governance.
Institutionalization
Another most visible trend is the instituti0onalsisation
of the market The market is being
increasingly pervaded by the institutional entities. The dominant players in
the market are mutual funds, FII’s, financial institutions, Venture capital
funds, private equity funds, debt funds, banks etc. intermediaries such as
brokers and merchant bankers are in the
process of becoming corporate entities.
The system of
Book
building and proportionate allotment has
strengthened the market. According to experts the proposed entry of pension
funds and provident funds into the market will further accelerate the process.
Globalization
Another
notable feature is the integration of Indian market with the global market. The
process started with the opening of our markets to foreign portfolio
investment. Initial conditions and the ceilings for investments were
progressively liberalized. The ceilings for investment by non-Resident Indians
(NRIs) and Overseas Corporate Bodies (OCBs) have also increased. The government
also permitted the Indian corporate to tap the international markets for
raising capital. This measure enabled listing of Indian paper on the
international stock exchanges. The government has also allowed the Indian
mutual funds to invest in the foreign markets as a part of global
diversification of their portfolios.
MODERNSIATION
The impact
of reforms is more pronounced in the areas of modernization of the market .The
main drawback of the Indian capital markets was the prevalence of the obsolete
systems and practices.Modernisation involved replacing them with the new
systems which are line with those existing in the advanced capital markets.
Technology has played a vital role in the whole process.
The changes
are aimed at establishing transparent trading system, efficient clearing and settlement system, reducing
transaction costs, introducing of risk management products, eliminating paper
by setting up depository.
MAJOR
CHANGES IN THE PRIMARY MARKET
The major
changes include
• Free pricing
• Entry norms
• Disclosures
• Book building
• Streamlining
the Procedures
• Registration of Intermediaries
• Free pricing
The
abolition of capital of the controller of capital issues resulted in the
emergence of the new era in the primary markets. All controls on the pricing,
designing, tenure of the instruments were abolished. A wide variety of
instruments were designed to meet the specific requirements of the issuers and
investors. The issuers were also given the freedom to price the instruments. It
was left to the market forces to decide the appropriateness of the pricing.
Entry norms
Hitherto
there were no restriction for the companies to tap the capital markets. This
resulted in the massive surge of small cap issues. Many of the companies were
promoted by spurious persons with dubious credentials. Most of these shares
were not even traded in the secondary markets after listing. Several investors
have lost heavily by investing in these shares. The need for transparent entry
barriers were felt. SEBI introduced eligibility norms in the form of dividend
track record for existing companies and compulsory appraisal of projects for
new companies.
Disclosures
The quality
of disclosures in the offer documents were extremely poor. Several vital pieces
of adverse information was not disclosed in the offer documents. SEBI has
introduced stringent disclosure norms. The Malegam committee was appointed to
suggest measures to increase the level of disclosures by Indian issuers. Most
of the recommendation of the committee have been implemented. The attempt is to
make Indian disclosure norms to confirm to global standards.
Book
building
Book
building is the process of price discovery.
One of the drawback of the free pricing
was the pricing mechanism. The issue price has to be decided around
60-70 days before the opening of the issue. Further the issuer has no clear
idea about the market perception of the
price determined. Introduction of book
building helps in overcoming the limitation and results in market driven
pricing of securities.
Streamlining the Procedures
All the
procedural formalities were streamlined. Many of the operational aspects were
hitherto unregulated and different practices were being followed.SEBI has
issued guidelines to ensure uniform procedures.
Registration
of Intermediaries
SEBI started the process of registration of
some of the intermediaries associated with the process of issue management.
This is done to ensure the professionalize of the intermediaries and to
curb the malpractices indulged buy some of the intermediaries. Registration
has become mandatory for the following
primary market intermediaries:
• Merchant banker
• Registrars and share transfer agents
• Brokers to the issue
• Bankers to the issue
• Debenture trustees.
MAJOR
CHANGES IN THE SECONDARY MARKET
The major
changes in the secondary markets include
• Trading systems
• Depository
• Clearing mechanism
• Settlement system
• Carry forward system
• Trading systems
For a long
time the trading on the stock exchanges were carried out by “ public outcry” in
the trading ring. This system lacked transparency. The introduction of
information technology in the working of the stock exchanges is a landmark in
the history of capital markets. Some of the major changes include
Introduction
of screen based trading systems in all the exchanges namely
a) The Over The Counter Exchange of India
(OTCEI)
b) NATIONAL STOCK EXCHANGE (NSE)
c) The Bombay Stock Exchange (BSE)
Depository
One of the
major drawback was/is that the securities were/are held in the form of
certificates. This led to the problem in physical storage and transfer of
certificates. The transaction costs were also higher due to physical movement
of paper and the incidence of stamp duty. National Security Depository Ltd
(NSDL) was set up in 1996 as India’s first depository. A depository is an
entity which holds the securities in
electronic form on behalf of the investor. This is done through the
dematrialsisaion of the holdings at the request of the investor.
Dematerialization is the process by which physical certificates of the investor
are destroyed and an equalent number of securities are created to the amount of
investor. This also enables the transfer of securituties by book entries. The
risk of bad deliveries are also eliminated. The transaction costs are also
reduced due to less flow of paper and transfer of security through depository
does not attract stamp duty. Further the depository also handles all the corporate actions like exercising for rights,
collection of dividends, credit for bonus, exercising of warrants, conversion
of option etc, on behalf of the investor.
Clearing
mechanism
The
clearing houses attached to the stock exchanges functioned only as conduits to
delivery of securities and money. The NSE was the first stock exchange to set
up a clearing corporation. The National
Securities Clearing Corporation ( NSCC)assumes the counterparty risk in all
trading deals made on the exchange.NSCC acts as a counterparty for all the
trades and the default risk in the deal
is borne by it .NSE has created a special Trade Guarantee fund for this purpose
and loss due to defaults will be met by
drawing from its corpus.
Settlement
system
Trading in
securities is internationally done on rolling settlement basis. one of the key
areas of change was the change in the settlement time duration in the stock
exchange transactions. The settlement
duration was reduced to T+2 system (i.e.
the trade will be settled on the 2nd day from the date of execution of the
transaction).
Carry
forward system
The Indian
stock exchanges have been an amalgam of cash market and forward market. the
prices of the steps on the exchange did
not reflect their ‘true’ price in the underlying cash market. Further there was
indiscriminate and rampant speculation in the market. Defaults were common and
other members were forced to “accommodate” the defaulting member. Often, the
defaults had a snowballing effect and
the entire market would be in the throes of a major payment crisis. This frequently resulted in the closure of the exchanges for a few days. In order to
curb the prevailing malpractices,SEBI banned carry forward transactions on all
stock exchanges.
Progress since
reforms
The market
capitalization of the Bombay Stock Exchange (which represents about 90% of the
total market capitalization of the country) has quadrupled from Rs 1.1 trillion
at the end of 1990-91 to Rs 4.3 trillion at the end of 1996-97. As a percentage
of GDP, market capitalization has been more erratic, but on the whole this
ratio has also been rising. Total trading volume at the Bombay Stock Exchange
and the National Stock Exchange (which together account for well over half of
the total stock market trading in the country) has risen more than ten-fold
from Rs 0.4 trillion in 1990-91 to Rs 4.1 trillion in 1996-97. The stock market
index has shown a significant increase during the period despite several ups
and downs, after reached its peak in 1994-95, the stock market index has been
languishing at lower levels apart from a brief burst of euphoria that followed
an investor friendly budget in 1997. For the primary equity market too, 1994-95
was the best year with total equity issues (public, rights and private
placement) of Rs 355 billion. The market has been undergoing many low and up
swings since the 2008 subprime crisis. There has been as surge of equity issues
by the public sector and by banks.
New capital
raised from the market by public limited companies
S.L. No. Period Capital raised (Rs. Crore) Yearly average Growth rate (Per Cent)
1 1951-60 285 28.5 155.4
2 1961-70 728 72.8 36.3
3 1971-80 992 99.2 2254.5
4 1981-90 23,357 2,335.70 457.2
5 1991-99 1,06,799 13,349.80
Source :
based on data in the The Report on Currency and Finance, RBI, India, various
years
Number of
investors
S.L. No. Yearly No. of Investors (in lakh)
1 1990 90-100
2 1993 140-150
3 1997 200
4 1999 128
Source: The
Report on Currency and Finance, RBI, India, 1990 to 1999
STOCKS AND
SCAMS
Controller
of Capital Issues Act in 1992, enabled issuers to freely access the market and
enabled a flurry of activities in the primary market which attracted a large
number of households to invest in equity issues, but there were also a plethora
of poor quality public issues both at par and at premium. These issues saw a
rapid decline in valuations on the stock market when trading commenced and
there was a substantial loss of wealth of the households who had invested in
them. In some cases there were companies who vanished completely after gobbling
people’s hard earned money. Such
companies were termed as fly by night operators. By 1995- 96 there was
worrisome erosion of investor confidence and investors turned away from direct
investment in equity shares to safer fixed income instruments and bank
deposits. Primary market activity diminished significantly and the market
remained dull till about the third quarter of 1999. The high interest rates
prevailing since 1995-96 further encouraged this trend. In order to gain
investor confidence a lot of initiatives was taken and the SEBI was bestowed
with more power. Some of the major crises, which occurred in the equity market
during the period were:
• In 1995,
the BSE closed for three days in the context of payment problems on M.S.Shoes.
• In 1997
there was a scandal where CRB mutual fund defrauded its investors, which cast
doubts upon the supervisory and enforcement capacity of SEBI and RBI.
• In summer
1998 there was an episode of market manipulation involving three stocks (BPL,
Sterlite and Videocon). In this case a variety of questionable methods were
employed at the BSE to avoid a failure of settlements. The actions partly led
to the dismissal of the BSE President by SEBI.
• crisis,
in march 2001, led to the second dismissal of a BSE President, the dismissal of
all elected directors on the BSE and the Calcutta stock exchange(CSE), and
payment failures on the CSE (Thomas 2001).
Some of the
biggest stock market scams include
- The scam involving stock broker Harshad Metha
- Scam involving stock broker Ketan Parikh
Volatility
in the Indian stock markets- theory and experience
A number of
times in the past, it has been observed that investments by FIIs and the
movements of Sensex are quite closely correlated in India and FIIs wield
significant influence on the movement of Sensex. But it could be a classic case
of bullish market psychology snapping back after being stretched to extreme.
It is to be
noted that in India, almost all previous experiences with high phases of stock
market volatility have been associated with some form of irregularities and
corruption. Generally there is a belief that stock markets movements actually
reflect real economic performance. But studies have shown that it may not be
completely true. Stock market indices
are indicators of the expectations of finance capital, and they can move up and
down for a variety of reasons, may not be related even to the current
profitability of productive enterprises. Theoretically, the major determinants
of stock prices are corporate earnings and interest rates. But, they are prone
to irrational bubbles and sudden collapses that reflect all sorts of factors,
ranging from international forces to domestic political changes, and may have
very little relation to economic processes within the economy. The movements of
stock markets and Sensex may not necessarily imply any fundamental changes in
the economy as these movements affect a very small minority of the country’s
population. Stock prices are more variable than prices of most other assets,
which mean that the returns can change dramatically from year to year.
Even though
trends across the world have shown that, the stock market almost always falls
before recession, it is also prone to giving false alarms. These false alarms
appears to have increased in the post war period. Shifts in sentiment and
psychology can sometimes cause substantial changes in the market.
It is
important to note that the prices of securities react very quickly to new
information about their value. Efficient capital markets are commonly thought
as markets in which security prices fully reflect all relevant information that
is available about the fundamental value of securities. Because the security is
a claim on future cash flows, this fundamental value is the present value of
the future cash flows that the owner of the security is expected to receive.
The study of capital market efficiency examines how much, how fast, and how
accurately available information is incorporated into security prices.
Financial
economists often classify efficiency of capital markets into three category
based on what is meant as available information- the weak, semi strong, and
strong forms. Weak form efficiency exists if security prices reflect
information contained in the history of past prices and returns. Some public
information about fundamentals may not yet be reflected in the prices. Here
investors can earn excess profits from trading rules based on past prices and
returns. Under semi strong security prices fully reflect all public
information. Thus traders with access to nonpublic information can earn excess
profits. Finally, under strong form efficiency all information even apparent
company secrets- is incorporated in security prices; thus, no investor can earn
excess profit trading on public or nonpublic information.
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