Organization and functioning of securities market : Organization and functioning of securities market Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
What is security market? : What is security market? Market is a place where persons of opposite needs join together and transact with each other to fulfill their requirements. For example to buy/sell commodities, to borrow/lend money, to seek/give employment etc.
Securities are transferable instruments, issued by organizations to procure fund. For example shares, bonds, treasury bills etc.
Security market is a place where securities are bought/sold. It can be divided into two parts:
Primary Market: IPO & FPO
Secondary Market: Security exchanges, OTC deals etc. Prepared by: CA Tarun Mahajan
Characteristics of a well functioning Security Market : Characteristics of a well functioning Security Market Timely and accurate information on the price and volume of past transactions and on current supply and demand conditions.
Liquidity which requires price continuity.
Internal efficiency refers to low transaction costs.
Informational (external) efficiency, which means that prices rapidly adjust to new information so that the prevailing market price reflects all available information regarding the value of the asset. Prepared by: CA Tarun Mahajan
Primary Market : Primary Market Primary capital markets refer to the sale of new issues of securities.
Most issues are distributed with the aid of an underwriter. The underwriter provides three services to the issuer:
Origination, which involves the design, planning, and registration of the issue.
Risk bearing, which means the underwriter insures or guarantees the price by purchasing the securities.
Distribution, which is the sale of the issue Prepared by: CA Tarun Mahajan
Secondary Market : Secondary Market Place where securities are traded after initial offer.
Provides liquidity to the investors.
May be divided as follows:
National Exchanges (NSE, BSE)
Regional Exchanges (DSE, CSE, MPSE)
Over the Counter Exchanges (OTCEI): It is negotiated market in which investors negotiate directly with dealers.
It can also be classified as:
Call Market: trades only on specific time. First all the bids and asks are declared and then one negotiated price is set to settle the trades. Used in smaller markets.
Continuous Market: Trade occurs at any time the market is open. Used in major market. Prepared by: CA Tarun Mahajan
Third & Fourth Markets : Third & Fourth Markets Third Market: Securities listed on registered exchange may also be traded in the Over the Counter Market. This part of OTC market is termed as third market.
Fourth Market: Direct exchange of securities between investors without the service of any intermediary. Prepared by: CA Tarun Mahajan
Structure of Secondary Market : Structure of Secondary Market Price Driven or Quote Driven: It is a market in which the dealer is a market maker. Means the dealer maintains the inventory of the stock and provide both bid and ask price. It is preferable for low liquidity markets.
Order Driven: Here traders directly deal with each other without dealer as intermediary. A buyer has many seller and a seller has many buyers to deal with. Identity of counterparty is not known. It is preferable where there are many buyers and sellers. Prepared by: CA Tarun Mahajan
Membership categories at U.S. exchanges : Membership categories at U.S. exchanges specialist controls the limit order books. (Clearing Corporation in India)
commission broker trades for a brokerage firm. (Clearing Members)
Floor brokers act as freelance brokers for other commission brokers. (Trading Members)
Registered traders trade for their own accounts. (Investors) Prepared by: CA Tarun Mahajan
Types of Orders : Types of Orders Market orders are orders to buy or sell at the best price available.
Limit orders are orders to buy or sell at your own price rather than current market price. Limit orders must be timed: instantaneous, 1 day, 1 week, 1 month or good till canceled.
Stop loss orders are used to prevent losses or to protect profits. Suppose you own a stock currently selling for $40. You are afraid that it may drop in price, and if it does, you want to sell it, thereby limiting your losses. You would place a stop loss sell order at a specific price (e.g., $34) and also set a trigger price (say $ 35) equal to or more than the limit price; if the stock price drops to trigger level, your order will move from stop loss book to the main order book. Prepared by: CA Tarun Mahajan
Short Sell : Short Sell Selling the security which you do not have.
Short sell is made when the seller thinks that current price is too high and it will come down.
Need to borrow security & provide collateral to the lender.
To close the position, buy the security and give it to the security lender.
Meanwhile, if any dividend is declared borrower need to compensate the same to the lender.
(uptick rule: One can short the security only at a price higher than the price of previous trade) Prepared by: CA Tarun Mahajan
Margin Buying : Margin Buying Buying security with borrowed money. Still need to pay initial margin.
Brokers can lend money and keep the security as collateral.
Leverage Advantage: Earn same dollar return by putting less money initially. But risk also increases. Prepared by: CA Tarun Mahajan
Margin Call : Margin Call Initial Margin: Amount to be paid by investor (Say 40%) at the inception of margin buying or short sell. We can also call it investor’s equity.
Maintenance Margin: Minimum level of investor’s equity (say 25%) if the investor’s balance fall below this level he is required to bring it back to the maintenance level.
Example: Po = $1000, Initial margin 40%, Maintenance Margin 25%. Prepared by: CA Tarun Mahajan
Margin Call: Margin Buying : Margin Call: Margin Buying It means that in case of margin buying the investor must put up $400 (40%) initially as his own equity and if the price falls below $1000 his equity should not be below 25%.
Say if the price falls to $900 than the investor’s equity will fall to $300 (400-100). Which is 33.33% (300/900) more than maintenance level.
Now the question is that at what price margin will be called? We can calculate it using the following formula: Prepared by: CA Tarun Mahajan
Margin Call: Short Selling : Margin Call: Short Selling Here if the price rises to say $1100 level. Margin account will fall to $300 (400-100), which is 27.27%.
Now the question is that at what price margin call will be made? We can use the following formula:
Note: you can mug up the formula as follows: short sell results in loss if the price rises hence + sign in the formula. Margin call results in loss if the price falls hence – sign in the formula. Prepared by: CA Tarun Mahajan
Security Market Indicators : Security Market Indicators Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Formation of Index : Formation of Index An Index is number calculated taking current data in numerator and historical (Base year) data in denominator.
Data used to calculate index is usually a weighted average of a sample data. For example Sensex is an index, based on price of shares of thirty Indian companies.
This sample is drawn in such a manner, so that it can represent the entire population, e.g., Sensex represents position of entire capital market of india.
Example: Price of gold Prepared by: CA Tarun Mahajan
Uses of Index : Uses of Index Barometer of economy
Benchmark for investors’ portfolio
Passive Fund Management
Calculation of beta. Prepared by: CA Tarun Mahajan
Weighting Schemes : Weighting Schemes Price Weighted: add together market price of each stock and divide by number of stocks.
Market Value Weighted: total current value is divided by total base year value. (Here Value = price per share x No. of shares.)
Un-weighted (equally weighted): It assumes equal dollar investment in each stock hence equal weight is given to the returns of all the stocks. For taking average of % return geometric returns are preferable over arithmetic returns. Prepared by: CA Tarun Mahajan
Example : Example Price Weighted: (25.5/20) -1 = 27.5%
Value Weighted: (18600/13000) -1 = 43.08%
Un-weighted: (1.50 x 1.20)1/2 – 1 = 34.17% Prepared by: CA Tarun Mahajan
Biases in Weighting Schemes : Biases in Weighting Schemes Price Weight:
Stocks having high price per share will dominate
Denominator is adjusted downward after stock split. Large growing companies tend to split their stock more often, hence these companies will loose weight in the Index.
Value Weight:
Firms having greater market capitalization will dominate.
Un-weighted:
Geometric mean causes downward bias. Prepared by: CA Tarun Mahajan
Efficient Market : Efficient Market Prepared by: CA Tarun Mahajan Prepared by: CA Tarun Mahajan
Efficient Capital Market : Efficient Capital Market where the current price of a security fully reflects all the information currently available about that security, including risk. Market efficiency assumes:
A large number of participants are analyzing and valuing securities independent of each other.
New information comes to the market in a random fashion, and that the timing of news announcements is independent of each other.
Investors adjust their estimate of security prices rapidly to reflect their interpretation of the new information received.
The expected returns implicitly include risk in the price of the security. Prepared by: CA Tarun Mahajan
Three forms of EMH : Three forms of EMH The weak form EMH states that current stock prices fully reflect all publically available security market information, and as such an investor cannot achieve excess returns using technical analysis.
The semi-strong form EMH states that security prices adjust rapidly to the release of all public market & non market information, and as such an investor cannot achieve abnormal returns using fundamental analysis.
The strong form EMH asserts that stock prices fully reflect all information from public and private sources (inside information), and as such no group of investors should be able to consistently achieve abnormal returns. Prepared by: CA Tarun Mahajan
Market Anomalies & EMH : Market Anomalies & EMH Earnings surprises to predict returns: Earnings surprises can be used to identify individual stocks that will produce abnormal returns.
Calendar studies. The January Anomaly and the weekend effect have been known to allow investors to earn abnormal returns.
Price-earnings ratio (P/E) tests indicate that low P/E ratio stocks experienced superior results relative to the market, while high P/E ratio stocks have significantly inferior results.
The small firm effect indicates that small firms consistently experienced significantly larger risk-adjusted returns than larger firms.
The neglected firms effect shows that firms with only a small number of analysts following them have abnormally high returns.
Greater book value/market value ratios have been associated with abnormal returns. Prepared by: CA Tarun Mahajan
Overall conclusion about EMH : Overall conclusion about EMH Most, but not all, evidence generated by testing the weak form of the EMH indicates support of the weak form of the EMH.
The results are mixed for the semi-strong form of the EMH.
Aside from the results on corporate insiders and specialists, the tests support the strong form of the EMH. Prepared by: CA Tarun Mahajan
Behavioral Finance : Behavioral Finance It is Study of investors psychological which leads to less efficient market:
Overconfidence bias: overemphasize the impact of good news and to underestimate the negative value implications of bad news.
Confirmation bias. seek out supporting information after making a decision and to avoid or ignore new information that would call the decision into question.
Escalation bias. Tendency to commit more funds to a position that has gone down, escalating the size of their positions. Prepared by: CA Tarun Mahajan
Why Mispricing may persist? : Why Mispricing may persist? Transactions Costs. The trades necessary to exploit any apparent mispricing may not be profitable because the costs of the trades are greater than the potential abnormal returns.
Small Profit Opportunities. The total profit to be gained by exploiting a mispricing may be small enough that it does not represent a significant profit opportunity to large funds.
Trading Restrictions. Restrictions on short selling make some strategies impossible for some period of time. Note that when a stock is first offered to the public, it typically cannot be shorted immediately after the IPO since shares cannot be borrowed.
Irrational Behavior. Investor tendencies of perception and analysis that run counter to rational trading and investing may lead to persistent mispricing that are not rapidly exploited by arbitrageurs. Prepared by: CA Tarun Mahajan
Why Mispricing may persist? : Why Mispricing may persist? Risk Measurement and Abnormal Returns. The model used to estimate normal returns may be flawed. For example, it may fail to adequately capture the entire spectrum of risks.
Arbitrageurs do not have unlimited funds. Given the limitations on the funds that investors make available for exploiting mispricing, only the more significant mispricing may be exploited while others are allowed to persist. Prepared by: CA Tarun Mahajan