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-- Stock Exchange - A Serious Business

-- Equity Investments – Your Share of Ownership
-- Stock Index - A Barometer for the Stock Market
-- IPOs and Public Issues - What you Need to Know
-- Bonds and Debentures – If you Dislike Risk
-- Trading in Stock Exchanges – The Great Gizmo
-- Speculation in Stock Exchanges – Hardly Gambling in a Den!
-- Mutual Funds - A Product or Service?
-- Dematerialization - Share Vanishing Trick!
-- Bonus, Rights and Share Splits – How much are they worth?
-- ADRs and GDRs – More or Less the Same as Shares.
-- This, That and the Other
-- Pricing of Shares – Here is How
-- A Portfolio Perspective - Spread your Wager
-- The CAPM – A Persuasive Theory


1. What are stock exchanges all about?

Stock exchanges are perhaps the most crucial agents and facilitators of
enterpreneurial progress among modern service institutions. Since the industrial
revolution, business enterprises have grown such that proprietors or even
partnership firms can no longer raise the colossal amounts of money required for
large entrepreneurial ventures. Such massive capital can only be raised through the
participation of a large number of investors – the number running into hundreds,
thousands and even millions, depending on the size of the business venture.

In general, small time proprietors ()or partners of a proprietary or partnership firm)

find it difficult to get out of their business when they wish to do so. This is
because it is difficult to find buyers for an entire business, or even part of a
business just when one wishes to sell it. Similarly, it is not easy for a person with
savings, especially with small savings, to readily find an appropriate investment
opportunity. These problems become more magnified with larger proprietorships
and partnerships. Firstly, one would prefer not to invest in such partnerships since
savings once invested, are very difficult to convert into cash and people do have
many reasons, such as better investment opportunity, marriage, education, death,
health etc. for wanting to convert their savings into cash. Clearly then, big
enterprises can raise capital from the public at large, only if there is some
mechanism which enables investors to purchase or sell their share of the business
as and when they wish to do so. This implies that ownership in business has to be
“broken up” into a large number of units, so that each unit may be independently
and easily bought or sold without hampering the regular business activity. Such a
breaking up of the ownership of the business would also help mobilize small
savings in the economy into entrepreneurial ventures.

In a modern business, this objective is achieved through the mechanism of shares.

A share represents the smallest recognized fraction of ownership in a publicly held
business and is represented in the form of a certificate, known as the share
certificate. The breaking up of the total ownership of a business into small
fragments, each represented by a share certificate, enables these to be easily bought
and sold.

The institution where this buying and selling of shares essentially takes place is
the stock exchange. In the absence of stock exchanges i.e. institutions where small
parts of business could be traded, there would be no modern business in the form
of publicly held companies. Today stock exchanges enable one to be an owner or
a part owner in an electronics company without being an electronics wizard. They
enable part ownership of one company today and another tomorrow; part
ownership of several companies at the same time or of a company hundreds or
thousands of miles away. In addition, they facilitate conversion of one‟s entire
ownership stake into cash, at short notice. Thus, by enabling the convertibility of
ownership in the product market into financial assets, namely shares, stock
exchanges bring together buyers and sellers (or their representatives) of fractional
ownership of companies. For this reason, activities relating to stock exchanges
(and its variations, as we shall see later) are also appropriately enough, known as
the Stock Market or the Security Market. Like a vegetable market, a stock
exchange too is distinguished by its own specific locality and characteristics. In
fact, according to H.T. Parikh, the earliest location of the Bombay Stock Exchange,
which for a long period was known as “The Native Share and Stock Brokers‟
Association”, was probably under a tree, sometime in1870!.

2. How old are stock exchanges as institutions?

The world‟s oldest stock exchange probably dates back to 1460 in Antwerp,
Belgium. Although trading in financial instruments existed much earlier, it was
probably the first time that a magnificent monument of gothic architecture had
been built for the trading of stocks. It was simply known as a “bourse” derived
from the Latin word “burse”, meaning purse. In fact, the gothic structure was so
magnificent that Queen Elizabeth –I had it copied, when the Royal Exchange of
London was built. In the later part of the fifteenth century, however, Antwerp‟s
role as a leading stock trading center declined for various reasons and Amsterdam
emerged as the new hub for financial securities trading.

In fact many consider the Amsterdam stock exchange, established in 1602, as the
oldest in the world because of its uninterrupted continuity. The Dutch East India
Company established this exchange for dealings in their own stocks and bonds. In
due course, bonds and shares issued by other companies also started trading at this
stock exchange.

3. What are the broad characteristics of stock exchanges in India?

Traditionally, an Indian stock exchange was an association of individual members

called, member brokers (or simply members or brokers), formed for the express
purposes of self-regulating and facilitating the buying and selling of securities by
the public and institutions at large. These member brokers were essentially
middlemen, who carried out the desired transactions in securities either on behalf
of the b public (for a commission) or on their own behalf.

There are currently 23 recognized stock exchanges in India of which 4 are national
and 19 are regional exchanges. The four national level exchanges are – Bombay
Stock Exchange (BSE) renamed The Stock Exchange, Mumbai, National Stock
Exchange (NSE), OTC Exchange of India (OTCE) with OTC Standing for “Over
The Counter” and Inter-connected Stock Exchange of India (ISE). All these
exchanges operate with due recognition from the Government under Securities
and Contracts (Regulations) Act, 1956. The overall development and regulation
of the securities market was entrusted to the Securities and Exchange Board of
India (SEBI) by an act of Parliament in 1992 .

BSE dominated the Indian stock market for well over a century, until the NSE took
the lead in the early 90s. Today, with the availability of the Internet and
broadband communication, most of the securities trading is conducted at NSE and
BSE through trading terminals available all over India.

The Inter-connected Stock Exchange of India Limited (ISE) was promoted by the
14 regional stock exchanges, with a view to provide trading connectivity to all
members of the participating exchanges, in a cost-effective manner. This, like all
other national exchanges, provides trading, clearing, settlement, risk management
and surveillance support to its dealers and traders, in order to address the needs of
smaller companies and retain investors in smaller towns.

OTCEI was promoted in 1990 as a profit making company, along the lines of
NASDAQ in the USA. Its main objective was to help enterprising promoters in
raising finance for new projects in a cost effective manner and to provide investors
with a transparent and efficient code of trading. OTCEI introduced many novel
concepts to the Indian capital markets. It was the first to offer screen-based
nationwide trading, sponsorship of companies, market making and scripless
trading. It primarily targeted technology related growth companies for listing.
Notwithstanding its excellent start, the exchange did not take off in a big way over
the years.

In India, in the pre-NSE days, typically a board consisting of directors, largely

elected by the member brokers and a few who were nominated by the Government,
governed the stock exchanges. Government nominees included representatives of
Ministry of Finance, as well as some public representatives, who were expected to
safeguard the public interest in the functioning of the exchanges. A President,
usually nominated by the Government from the elected members headed the board.
The Executive Director, usually appointed by the stock exchange with Government
approval, was the operational chief of the stock exchange. The Executive
Director‟s duty was to ensure that the day-to-day operations of the stock
exchange were carried out in accordance with the various rules and regulations that
governed its functioning.

But such a structure, where the brokers were also the governors of the stock
exchanges often raised issues of good governance. Since brokers generally
governed the stock exchanges themselves, they operated more for their own benefit
rather than that of the investors. There were many instances where brokers had
manipulated the stock market to their advantage. Being governing members
themselves, they did not, could not or would not intervene with sufficient vigor to
check the malpractice. In other words, the structure was not effective enough to
provide an arms-length model of governance to check malfeasance among brokers.
Clearly, an alternative structure to the bourses was called for and the answer came
in the form of de-mutualization or corporatization of stock exchanges in the
avatar of NSE.

4. What is demutualization or corporatization of stock exchanges and how is NSE

structured differently from BSE :

As said earlier, the old structure of stock exchanges did not provide for a good
governance model. Hence it was essential that ownership, management and
membership of the stock exchanges be made independent of each other. This
segregation of the three arms of the stock exchanges, by giving them a corporate
model is referred to as demutualization (Ah! The world of jargons!). Following
the High Powered Study Group on Establishment of New Stock Exchange of the
Government of India, financial institutions (FIs) promoted the NSE in 1992, as a
tax paying company to provide equal access to investors from all over the country.

NSE started operations in the wholesale debt market segment and the equities
segment in 1994 and in the derivatives segment in 2000.. In order to correct the
ills of the traditional broker-driven stock exchanges, NSE ensured that its
management and brokers were separated or “de-mutualized” so that no broker
member could become an office bearer of the stock exchange. In the de-
mutualized model NSE members merely enjoy the privilege of trading but do not
manage or govern the exchange. More specifically, they do not participate in the
administration of the stock exchange. Presently, BSE as well as other regional
stock exchanges are in the process of being demutualized.

Today NSE towers all other bourses as the biggest and the leading stock exchange
in India with a market capitalization(the total market value of all the securities
listed on the exchange) of around Rs. 10,000,000 million, which probably accounts
for well over 90% of the total market capitalization of the Indian capital market!
The formation of NSE heralded a new chapter in the Indian securities market and
revolutionized the security trading system by computerizing the whole process
through a screen-based trading system. NSE started the electronic order book
system where the computer matched different orders without any human
intervention, when BSE was still on the open outcry system. However, in keeping
with the competition, BSE too followed suit with computerized order matching

5. What is the Inter-connected Stock Exchange of India (ISE) and what is its role?

With the advent of technology, regional stock exchanges lost their relevance.
Technological develo0ments, such as online screen based trading, improved
connectivity through leased lines. VSATs etc. made it possible for investors to
trade directly in NSE and BSE. Consequently, trading activities shifted to these
major stock exchanges. It is also led to a significant decline in trading activity in
regional stock exchanges as a result of which some of them closed down their
trading platforms. As many small companies were only listed in regional
exchanges, non-availability of a trading platform made these investments illiquid
as there was no exit route. The cost of membership at NSE and BSE also made it
difficult for broker members of regional stock exchanges to trade directly at these
exchanges, leading to loss of income for them. In short, the regional stock
exchanges were beginning to lose their relevance.

To address these issues, 14 regional stock exchanges jointly promoted ISE in

February 1999. The ISE was conceptualized in line with EURONEXT following
the merger of stock exchanges in three different countries, bringing together the
Paris, Amsterdam and Brussels stock exchanges. The ISE was started as a national
level stock exchange and provides trading linkage/connectivity to all members of
participating exchanges. One of the most important objectives of ISE is to widen
the market for the securities listed on the regional exchanges, by providing an
exposure to a larger investor base across the country. ISE also focuses on listing
and trading of small capitalization stocks. ISE‟s subsidiary, ISE Securities &
Services Limited (ISS) is also a corporate member of NSE and BSE. This assists
ISE traders and dealers to undertake trading of shares listed not only at ISE but
also in NSE and BSE.

6. What are the obligations of the companies vis-à-vis the stock exchanges?

Many stock exchanges are the backbone of the capital market. They not only
provide the necessary infrastructure for secondary trading of securities issued by
various companies to the public at large, but also ensure that companies abide by
the rules and regulations set forth by the exchanges and other regulatory bodies,
like SEBI.

In general, different stock exchanges may have different listing criteria. Once a
company lists its securities in a stock exchange, it has certain obligations towards
that exchange. For instance, it is required to provide the stock exchange quarterly
and annual financial statements and details of the company board meeting agenda,
prior to the meeting and also to inform them of the decisions taken immediately
after the board meeting. Companies must also inform the stock exchange about
the dates of their Annual General Meetings (AGMs), decisions regarding
dividends, right issues, bonus issues, mergers, details of changes in the board of
directors, change of auditors, changes in the shareholding pattern etc. This
requirement of the disclosure of information ensures that all price-sensitive
information is communicated to the bourses first, who in turn make it available to
the public, so that everybody is privy to this information at the same point of time.
This minimizes the probability of someone obtaining such information ahead of
others and profiting from it unfairly vis-à-vis the investing public. Stock
exchanges also require companies to deposit an annual listing fee. In turn the stock
exchanges are responsible for ensuring that the listed companies abide by the
statutory and listing requirements by imposing strict penalties for non-adherence
and thus bring about a degree of fair play in the capital market.

7. What is a securities market?

Securities market is the market in which securities are bought and sold. However,
this is not related to a physical location. The term, securities market loosely stands
for the entire system in which financial securities eor financial instruments are
traded, including the people and institutions involved in these transactions, the
organizations issuing or intending to issue the securities and the systems that
enable the trading processes. In short, it implies the entire infrastructure required
for transacting in securities, including the set of regulatory bodies to ensure that
the transactions are carried out in a fair and transparent manner.

At the center of the securities market lies the word “security”. One definition of
security stands for an investment instrument issued by a Government of a
company including the evidence of either ownership (shares) or creditorship
(bonds, debentures). The most important feature of a security is that it can be
traded so that its ownership can be transferred from one party to another. Thus,
if the ownership cannot be transferred, it will not qualify as a security. A life
insurance policy for example, or a bank loan taken by an individual would not
qualify as a security. The definition of securities also extends to other forms of
financial instruments, such as futures, options etc.. Questions on the various kinds
of securities available for investment and trading are answered later in the book.

Although a securities market cannot be identified with a physical location it can

logically be divided into two categories, capital market and money market,
depending upon whether the instruments being traded are long-term or short-term
in nature. Capital market refers to a market for long-term financial instruments of
ownerships (such as shares) and creditorship (such as bonds and debentures). The
money market on the other hand, deals with short-term financial instruments,
typically those having a maturity of less than one year.

8. What is capital market?

Every company needs a long-term as well as short-term capital. Long-term capital
is required essentially for investment in fixed assets such as land, buildings, plant
and machinery, vehicles etc.. It also includes core working capital and certain
kinds of R&D, pre-operating expenses and preliminary expenses incidental to
setting up a business, which are required to be deployed or incurred for the
production or rendering of goods and services. Short-term capital or working
capital on the other hand, is required essentially for financing the requirements of
the day-to-day operations of the business, such as raw materials, work-in-progress,
finished goods, trade debtors etc.. Capital market is thus a broad term, which
includes primary markets, secondary markets, term lending institutions, long-term
bonds and debenture markets, banks, investors and almost anybody who is engaged
in providing long-term capital (whether equity or debt capital) to the industrial

9. What is the money market?

As stated, every company needs long-term as well as short-term capital. While

long-term funds are accessed in the capital market, the short-term funds are
accessed from the money market. Money market includes all the agencies
providing short-term capital (or working capital), as opposed to long-term capital,
to the industry at large. Like the capital market, the money market also has its own
primary and secondary markets. Banks, under the control of the Reserve Bank of
India (RBI) play a major role in the working of money markets. However, in the
money market, the biggest player is the Government of India – the issuer of
Treasury Bills or T-Bills. T-Bills are securities issued by Government for its own
borrowings while money market instruments are short-term (less than one year)
instruments, the money market itself rivals the capital market in size.

10. What are primary and secondary (capital) markets?

A company cannot easily find investors for its securities (shares or debentures)
from the public if they cannot subsequently trade these shares and debentures at
will. In other words, a security cannot have a good primary market unless it has an
active secondary market.
The primary market comprises companies who make the security issues and the
general public who subscribe to them. The primary market is where a company in
search of capital makes its first contact with the general public. Therefore, if one is
wondering whether or not to invest in the new issue of a company, one is basically
contemplating whether or not to participate in the primary market.

The secondary market comprises buyers and sellers of shares and debentures
subsequent to the original issue. For example, having subscribed to the share or
debenture of a company, if one then wishes to sell this, it will be done in the
secondary market. Similarly, one can also buy the share or debentures of a
company from the secondary market (if the company is listed in the stock
exchange), without having to wait for that company to come out with a new public
issue. Thus, by their very role, stock exchanges are an important constituent of
the capital market.

The two markets mentioned above are not two physically segregated institutions.
Often the same parties may be involved in both the markets. Primary market
merely alludes to the first purchase of a new share or debenture by the public
directly from the issuing company, whereas secondary market refers to the
subsequent trading in those shares and debentures. A stock exchange is the single
most important institution in the secondary market for securities.

A conversation on investments in capital markets

(with due apologies to (w.a.t) Lewis Carroll in Alice”s Adventures in


“ You are old, Father William‟, the young man said.

“ And your hair has become very white;
And yet you incessantly INVEST IN MARKET.
Do you think at your age, it is right?
“In my youth”, Father William replied to his son,
„ I feared it might injure the brain;
But, now that I am perfectly sure I have none,
Why, I do it again and again‟.

11. What is the nature of Securities and Exchange Board of India (SEBI) and what
is the regulatory role in the capital market?

Securities and Exchange Board of India or SEBI is the national regulatory body
for the securities market – the Big Daddy. It was set up under the Securities and
Exchange Board of India Act, 1992 to “protect the interests of investors in
securities and to promote the development of and to regulate the securities market
and for matters connected therewith or incidental to”. However, that is a board
canvas and the picture is for more complex than the description suggests.

SEBI has its head office in Mumbai and has regional offices in the metropolitan
cities of Kolkata, Chennai and Delhi. The board of SEBI comprises of Chairman,
two members from the central Government representing the Ministries of Finance
and Law, one member from the Reserve Bank of India and two other members
appointed by the central Government.

According to the SEBI Act, 1992, the powers and functions of the board
encompass the regulation of stock exchanges and other securities markets,
registration and regulation of the working of stock brokers, sub-brokers, bankers
to an issue (public offer of capital), trustees of trust deeds, registrar to an issue,
merchant bankers, underwriters, portfolio managers, investment advisors and other
intermediaries who may be associated with the stock market in any way. It also
includes registration and regulation of mutual funds, promotion and regulation of
self-regulatory organizations, prohibiting fraudulent and unfair trade practices and
insider trading in securities markets, regulating substantial acquisition of shares
and takeover of companies, calling for information, undertaking inspection,
conducting inquiries and audits of stock exchanges, intermediaries and self-
regulatory organizations of the securities market. In addition, it is responsible for
performing the functions and exercising the powers contained in the provisions of
the Capital Issues (Control) Act, 1947 and the Securities Contracts (Regulation)
Act, 1956. Levying various fees and other charges, conducting necessary research
for the above purposes and performing such other functions as may be prescribed
from time to time.
SEBI also has an „investor education programme‟ aimed at educating investors
about their rights and responsibilities with respect to different kinds of
investments. It also has a grievances redressal cell where various issues can be
reported directly to SEBI for necessary action.

Alice on Regulator
(w.a.t. Lewis Carroll In Alice‟s Adventures in Wonderland)
I‟ll be judge, I‟ll be jury, said cunning old fury; I‟ll try the whole cause,
and condemn you to death.


12. What are stocks and securities?

Stocks or securities are generic terms for instruments of ownership such as shares,
and for instruments of lending like bonds and debentures, which are issued
publicly. Just as a share represents the smallest unit of ownership, a debenture or a
bond represents the smallest unit of lending. Shares and debentures may be of
many different kinds.

13. What are ordinary shares?

An ordinary share represents the form of fractional ownership in which a

shareholder (one who holds ordinary shares), as a fractional owner, undertakes the
usual entrepreneurial risk associated with a business venture. This risk has several
dimensions. In a business, an ordinary shareholder generally receives dividends
out of operating surplus. This surplus is the residual from the revenue, after
subtracting all operating expenses, the interest charges on all borrowings, various
taxes and dividends, due to non-ordinary shareholders. Various economic factors,
government policies, market conditions, the labour situation, management
efficiency etc. may affect revenues, expenses, interest, taxesetc. In such a way that
in any given period, there may or may not be adequate surplus left for ordinary
shareholders. Even when a business is on the verge of closing, all other
stakeholders such as employees, creditors, lenders, government, preference
shareholders, etc. . must be paid their claims and only the residual can be shared
by the ordinary shareholders. For various reasons this may or may not be enough
for the ordinary shareholders to get back their investment. Thus, during the life as
well as closure of a business, the ordinary shareholders are the last to receive their
claims. In this sense from among all the stakeholders in a business, ordinary
shareholders are exposed to the highest risk. If they are favoured with luck and
good times a big residual surplus may accrue to them but if not, they may suffer a
loss. It is this possibility of variation in their earnings, which constitutes the
entrepreneurial risk and since they undertake this risk, they expect to be reasonably
compensated for it in the long run through higher earnings.

In addition, the entrepreneurial risk entitles them to a voting right in proportion to

the number of shares held by them. They may exercise this right to suitably shape
the affairs of the company. The vote is usually exercised on resolutions placed
before the company, at the Annual General Meetings (AGMs) or Extraordinary
General Meetings (EGMs).

14. What are preference shares?

Preference shares differ from ordinary shares in some significant ways. In the
payment of dividends during the life of the business as well as in sharing the
residual dividend upon the event of a company‟s termination, a preference
shareholder gets preference over the ordinary shareholder and receives his dues
first. Thus, the preference shareholders assumed a lower risk and it is therefore,
reasonable that in the long run they should normally expect to earn less than
ordinary shareholders.

Usually, a the rate of dividend for preference shares is fixed at the time of issue.
Alternatively, a preference shareholder may be guaranteed a minimum fixed
dividend on the share with an additional variable component depending upon the
extent of profits made in a given year. Preference shares that entitle the holders to
receive this additional variable component, are called participative while those
that do not are known as non-participative preference shares. In addition,
preference shares may be cumulative or non-cumulative. In the case of
cumulative preference shares, if the dividend is not paid in a particular year due to
insufficient profit, it is cumulatively made good in the following year or years, thus
providing the shareholders an extra assurance on their dividend earnings. A non-
cumulative preference share on the other hand does not provide for any such
assurance and is, therefore, riskier. Again, a preference share may or may not
have voting rights. Furthermore, it may be irredeemable or redeemable which
means that the preference share capital may either be permanent like the ordinary
shares or that the company may repurchase them by paying back the capital.
However, in India, preference shares are not very popular and are generally not
used. Occasionally, an investor may also encounter shares called :convertible
preference shares”. These are preference shares that can be converted into
ordinary shares at a future date on terms and conditions that are specified in
advance. Many companies have also issued cumulative convertible preference
shares. These are often known as CCPs. As the name implies, these are
cumulative convertible preference shares that are converted to equity shares in due
course of time at a suitable conversion price.

15. What are non-voting shares?

Saavings shares or non-voting shares are like ordinary shares, except that they
have no voting rights. In many countries such shares co-exist with ordinary shares,
and usually earn higher dividends as compensation for the loss of voting right.
Similarly, there are other kinds of savings shares, which may have more than one
voting right each. In Sweden for example, there are shares with 1000 voting rights
each – also known as golden shares – which enable the promoters to wield control
over their companies with relatively smaller financial stakes. Savings shares are
not very popular in India, though the Department of Company Affairs has
permitted profit making companies to issue non-voting shares.
Ideally of course all promoters have non-voting shares at the hands of others for
obvious reasons! But for that very reason, usually non-voting shares have a few

In India, there are examples of implicit non-voting shares. For example, even
though foreign direct investors are allowed to invest up to 74% in Indian banks,
their voting rights are restricted to only 10%. Thus, for any foreign direct investor,
the shares are effectively non-voting or rather they have restricted voting rights.
And yet, for an Indian investor the same shares may remain ordinary shares!

16. What is the difference between shares issued at par and shares issued at a

Par value is the notional face value of a share that a company issues to its
investors. In India, until recently, par value was typically fixed at either Rs. 10/- or
Rs. 100/- through a Government circular issued in 1983. In 1999, SEBI dispensed
with the system of a fixed par value of Rs. 10/- or Rs. 100/- by withdrawing the
1983 circular. Under the new system, companies are free to decide on any par
value as long as the value is an integer. In other words, a share cannot be issued at
a fractional par value of, for example Rs. 1.50. Thus, the minimum par value is
Re. 1. At present, most companies have shares outstanding at five different par
values, namely Re. 1, Rs. 2, Rs.5, Rs. 10 and Rs. 100. However, there are a few
companies whose shares are issued at par values of Rs. 8, Rs. 20 and Rs. 50.
When the par value of a share is not Rs. 10, financial newspapers generally
identify them separately.

Par valaue also implies the value at which a share is originally recorded in the
balance sheet as equity capital or ordinary share capital.

A company may issue shares above the par value i.e. at a premium over the par
value, if it meets certain profitability criteria laid down by SEBI. However, it
should be noted that when a company does this, it is able to raise the required
amount of capital from the public by issuing a fewer number of shares. It can be
readily seen that the higher the premium the fewer will be the number of shares a
company ahas to service in terms of payment of dividends etc..
For example, a new company promoted by first time entrepreneurs intending to
raise around Rs. 10 million may offer 1 million ordinary shares at Rs. 10 each (at
par). An ongoing company, however, may raise the same amount by offering only
2.5 million shares at a price of Rs. 40 each (which is perhaps closer to the market
value of its shares.), even though the par value of their shares is Rs. 10. When this
is done, a company is said to have issued its shares at a subscription price or issue
price of Rs. 40 i.e. at a premium of Rs. 30 over the par value. In such a situation,
under Indian accounting norms, the company‟s books of accounts will show Rs.
10 towards the share capital account and Rs. 30 towards the share premium

In India, no company is allowed to issue shares at a discount i..e. at a price below

par, although the par value itself could be any integer value. A company also
cannot raise equity capital in excess of the limit authorized in its Memorandum of
Association ( a document dealing the terms and conditions under which a
company is incorporated under the company law) at any time, without undergoing
certain legal formalities. This limit is known as authorized capital. At no point in
time, can the subscribed capital (capital issued by the company until then) exceed
the authorized share capital. However, authorized capital may be increased
through a resolution in the annual general meeting.

Although the share capital is more or less a permanent source of capital for a
company, it may buyback or redeem its own share. Prior to 1999, Indian
companies were not permitted such buybacks. However, the Companies
(Amendment) Act, 1999 permitted companies to buy back their shares under
certain conditions. Once a company buys back a certain proportion of its shares
from existing investors, there is a reduction in the subscribed capital and number
of outstanding shares etc..

17. What are the implications of different par values to an investor?

Linked to the concept of the face value is the important matter relating to
dividends. For some obscure reason, Company Law in India requires companies to
declare dividends on the face value of their share, even if the share is issued at a
premium or its market price is considerably above the par value. For example,
consider a company that has issued shares at a par value of Rs. 10
at a premium of Rs.30, quoting at around Rs. 500 in the market. Let us assume
that the company has declared a dividend per share of Rs. 5 . In India, the
company is said to have paid a dividend of 50% (dividend of Rs. 5 on the par value
of Rs. 10), while in the US the company is said to have paid a dividend per share
(DPS) of Rs. 5, which means that the dividend yield (dividend per share as a
percentage of the current market value of the share) is just 1%.

This link between face value and the dividend declared becomes important
particularly when different companies have shares with different par values.

18. How does one read daily stock quotations in a financial daily? The columns
are so numerous and confusing?

Most financial dailies publish stock prices along with other connected details.
True, this format can be a little intimidating but that is only when someone is not
familiar with these pages! Here is a typical row from the share quotation published
in the Economic Times. The row (split in two for reasons of space constraint)
captures the price and related information for the company, Wipro Ltd., on a
certain day.

1 2 3 4 5 6 7
Company Previous Open High Low Close
Wipro 1544.45 1555 1584 1530 1552.45 142397

8 9 10 11 12 13
Value Trades P/E M-Cap 52W H/L Dividend

220540.99 6504 39.5 36172.1 1861/1791 1045%(04)

A quick review of the contents of each of the 13 columns reveals the following:
Column 1 (Company:
Is just the name of the company - a no brainer.
Column-2: (Previous Close):
Is the closing price at the end of the previous trading day. For example, on
Tuesday, the closing price of the previous day i.e. Monday is given and on any
Monday the closing price shown is that of the previous Friday, as there is no
trading in the stock exchanges on Saturdays and Sundays.

Column-3 (Open):
Indicates the price at which the first r trading occurred on that day. This is called
the opening price.
Column-4 (High):
Indicates the highest price at which an order was executed on that day.

As you would have guessed, is the lowest price at which an order was executed on
that date.

Column-6: (Close):
Gives the closing price of the trading day. Counter intuitive as it may seem, it is
not the same as the last traded price at which is in fact the price at which the last
order executed before the stock exchange closes at 3.30 p.m.. Closing price is the
weighted average of the prices of all the trades that were transacted during a
specific period of time before the closure of the exchange. This may vary from
exchange to exchange. For example, the closing price at BSE is the weighted
average price of all the trades transacted in the last 15 minutes of the day‟s trading
session, while the closing price at NSE is the weighted average price of all trades
in the last 30 minutes of the trading session.

Stock exchanges take special case to calculate the closing price as it has important
implications. For example, the calculation of a stock market index involves the
use of closing prices of the companies that make up the index. Similarly, it is used
in margin trading, as the maintenance margin calculations are also based on the
closing prices of shares. The stock exchanges ensure that closing prices are
determined in such a way that no market players can manipulate them.

Column-7: (Volume)
Indicates the total volume or the total number of shares that were traded on that

Column-8: (Value):
Indicates the total rupee value of shares traded on that day. It is sum of the value
of individual trades that were transacted. For example, even though column 7
indicates a volume of 142,397 shares, these shares may have been traded at
different prices ranging from a daily low to daily high. For example, assuming that
142,397 shares have been traded at three different prices the value is simply the
cumulative sum of the number of shares traded, multiplied by the price at which
these shares were traded.

Indicates the total number of times orders have been executed for trading the
volume shown in column 7.

Column-10: (P/E):
Is the P/E multiple (Price-Earning multiple) of Wipro‟s share (more details on P/E
Question 140). In other words, this column indicates that Wipro‟s share is quoting
at 39.5 times its earnings per share (EPS). EPS is simply the total profit of the
company divided by the total number of shares that it has issued to all its
shareholders. The Economic Times reports the EPS as the last one year‟s net profit
(being the sum of the net profits of the latest available four quarterly results)
divided by the total number of outstanding shares.

Is the market capitalization, that is, the total number of shares issued by the
company as on date, multiplied by the day‟s closing price as given in column-6.

Column-12 (52-Wk-H/L):
Represents the 52 week high and low price for Wipro‟s share. For example, it
indicates that Rs. 1861 was the highest and Rs. 791 was the lowest price during
the preceding 52 weeks and highlights the range of the price movement of Wipro
during this period.

Column-13 – (Dividend %(Yr))

Indicates that the dividend declared by the company during the previous financial
year was 1045%. In other words, the dividend was Rs. 20.9 against the par value
of Rs. 2. Representing dividends as percentage to the par value rather than, as
dividend per share, is an age-old misleading convention. Close scrutiny reveals
that a dividend of Rs. 20.9 on an average market price of Rs. 1326 (average of high
and low of Rs. 1861 and Rs. 791) was merely a yield of 1.6%.


19. What are stock indices and how are they calculated?
The most visible and tracked parameter of any stock market is the movement of the
stock index. This is just a number that helps to measure the movement of the
market against a benchmark index, taken as 100, on a base year. Most stock
indices attempt to be proxies for the market they exist in . Each stock exchange
has flagship index like the Sensex at BSE or the Nifty of NSE.

An index is calculated daily by tracking the share prices of its constituent member
companies. For example, the Sensex is an index comprising 30 component stocks
representing a sample of large, well established and leading companies while the
Nifty consists of 50 company stocks. Sensex and Nifty are calculated using
market capitalization wighted method. Every index is associated with a base year.
For example, the base date for Sensex is 1st April, 1979 and for the Nifty is 1st
April, 1995. This means that the Sensex and Nifty were assumed to be 100 on
these respective base dates. All subsequent indices originate from this first seed,
so to speak. It may be interesting to know that Sensex actually came into
existence only on 1st January, 1986, when the index was computed at 598.53. In
fact, the base date does not have any significance beyond the introduction date,
since for all the subsequent days the index is calculated by comparing the previous
day‟s value.

The basic calculation of an index, on a particular date involves the following steps:
* Calculate the market capitalization of each individual company
comprising the index. For example, if a company has 195 million
shares outstanding and its closing price on that day at BSE was
Rs. 350 per share, then its market capitalization on that date is
195 million X Rs. 350 = Rs. 68,250 million.

* Calculate the total market capitalization by adding the individual

market capitalization of all the companies in the index. Assume
that the total market capitalization of all companies in the index
adds up to Rs. 26,175 billion on that date.

* Computing of the index now requires the index value and total
market capitalization of the previous day. If on the previous day,
the total market capitalization was Rs. 25,310 billion and the index
was 10635, the index for the next day is calculated as:

Index value = Index on previous day

X Total market capitalization for current day
Total market capitalization of previous day
Thus, the index is 10,998 = (10635 X 26,175/25,310) implying that the index rose
by 363 points over the previous day. An important aspect here is that the index
value is devoid of any unit. It is just a number.

Indices may also be calculated using the price weighted method. Here the share
price of the constituent companies forms the weights unlike in the market
capitalization methods where the market capitalization of companies governs their
importance in an index. Almost all equity indices worldwide are calculated using
the market capitalization weighted method.

20 What is a free float index?

An index based on the market capitalization weighted method takes into account
the total market capitalization of a company, regardless of the number of shares
actually available for trading (i.e. the availability of free floating shares). The free
float market capitalization method on the other hand takes into account only the
shares that are readily available for trading. The free float of shares is calculated
by excluding promoters‟ holdings, government or FI holdings and other strategic
or locked-in shares, which are not normally available for trading in the market.
Thus, the market capitalization of each company in a free float index is reduced to
the extent of its free float available in the market. For example, in the previous
question, company A‟s market capitalization was Rs. 68,250 million as it had
issued 195 million shares with the stock quoting at Rs. 350. Of these, if only 75
million shares are available for trading, then the market capitalization of free
floating stock of the company on that date would be Rs. 26,250 million ( Rs. 350 x
75 million shares). .

The free float index probably better reflects the market movements as sometimes
closely held companies with large capitalization unduly influence an index, even if
only a limited number of its shares are traded in the market. Normally, companies
representing an index are expected to submit a periodic report to the stock
exchange indicating the free float portion of their share capital This is then used
for calculating the free float index. Worldwide, many stock indices are now
calculated using the free float method.

21> How many companies are included in an index and for that matter, how does
one decide which companies to include in the index?
The first part of that question is easy to answer. Normally, in terms of statistics, a
sample size of 25 to 30 is considered reasonable for a large population. This is not
a subjective assessment but a technical fact. Thus, the Sensex represents the
market as a whole, even though it consists of only 30 stocks. Regarding the
companies to be included in the index, every stock exchange normally has an
index-tracking cell, which has the responsibility of selecting the companies that
represent the stock market movement in general and ensuring that these companies
represent a cross-section of industries. From time-to-time it closely reviews the
performance of these companies.

It is not always stock exchanges that compute stock indices. For example, a well-
known index in USA the S&P500 is managed by Standard & Poor‟s which is a
credit rating company and has a sample assize of 500 companies Thus, the sample
is selected so that it represents the stock market as a whole. The sample
companies are normally selected on the basis of three criteria, namely, proper
industry representation, maximum coverage of market capitalization and highest
possible liquidity. For example, the 50 companies comprising Nifty are the more
active, liquid and representative stocks selected from over 1350 companies listed
on the NSE with a total traded value representing about 70% of the stocks traded
in this exchange. Thus, the sample companies are usually the most actively traded
companies representing a wide variety of industry segments and forming a major
part of the local market capitalization of all companies listed on the exchange.

The index composition may be modified in keeping with the dynamics of the stock
market by dropping aexisting companies and adding new companies to the
sample. For example, on 6th June 2005, the Sensex replaced Zee Tele-films and
Hindustan Petroleum Corporation Ltd. With National; Thermal Power Corporation
and Tata Consultancy Services.

In addition to the flagship indices, stock exchanges also maintain and publish
other indices like BSE-100, Natex, BSE Dollex, BSE-200, BSE-500, S&P CNX
Nifty Junior, S&P CNX Defty, S&P CNX Midcap, S&P CNX 500 and many other
sector or industry specific indices like ET-Mindex, ET-Lifex etc..

Some of the more popular indices and their objectives are shown in Box 21.1
below. These indices are useful for certain specific purposes. For example, the
BSE Dollex or S&P CNX Defty is more relevant for a US citizen in investing in
India than the Sensex of Nifty.

Box 21.1
BSE-100 Natex BSE National Index comprising 100 companies

BSE Dollex BSE Sensex in Dollar Terms

BSE-500 Broad based BSE index comprising 500


S&P CNX Nifty Junior Companies next rung of liquid securities after
S&P CNX Nifty

S&P CNX Defty S&P CNX Nifty measured in US Dollar terms

ET-Mindex Comprises 30 companies media and information

technology sectors and calculated by the
Economic Times.

Walrus and Carpenter on the stock index
(w.a.t. Lewis Carroll in Through the Looking Glass)
If seven maids with seven stocks
Stuck out for a year,
Do you suppose, the Walrus said,
„That it would make an index, my dear?‟
„I doubt it‟, said the Carpenter,
And shed a bitter tear
22. How are the indices reported in a financial daily?

A segment of the Sensex as reported by the Economic Times on a given day is

given in Table 22.1 below:
Segment of Sensex in the Economic Times:
Company Day‟s Previous %change Free Day‟s %change
close close Float Weights in
M-Cap Weights
(Rs. Milln)
1 2 3 4 5 6 7
SENSEX 5325.9 5555.84 -4.14 3,050,591.3 100.0 0
Infos.Tech 5054.85 5126.4 -1.4 252,641.4 8.28 2.86 27.1

Rel.Ind. 489.75 519.15 -5.66 37,613.24 12.33 -1.6 13.3

ICICI Bank 283.15 300.3 -5.71 20,289.4 6.65 -1.63

ONGC 827.25 845.45 -2.15 17,694.01 5.8 2.11


ITC 936.55 1002.3 -6.56 16,234.91 5.32 -2.56


Bharti Tele-
Ventures 150.9 158.25 -4.64 5,593.47 1.83 -0.54 0

The first row of the table provides certain information about the index and the
subsequent rows provide information about the companies in the index.
Column-2 (Day‟s Close)

Indicates that Senxex closing value for the day is 5325.90 and for the closing
price of Infosys is Rs. 5054.85.

Column-3 (Previous Close):

Indicates that Sensex closing value on the previous day was 5555.84 and the
closing price of Infosys on the previous day was Rs. 5126.4

Column-4 (% change):

Indicates the percentage change of Sensex over the previous day is -4.14%
{(5325.90 – 5555.84)/5555.84)} while for Infosys it is -1.4% {(5054.85 –

Column -5 (Free Float M-Cap

Indicates that the sum total of free float market capitalization of all companies in
the Sensex is Rs. 3,050,591.3 mn. And for Infosys it is Rs. 252,641 .4 mn.

Column 6 (Day‟s Weight):

Indicates the sum total weight of 30 companies in the Sensex, which is necessarily
100 and that the weight of Infosys in the index is 8.28.

Column-7 (% Change in Weights)

Indicates that the percentage change of weights for Sensex is 0, as it remains

unchanged at 100. However, compared to the previous day, the weight of Infosys
in Sensex has increased by 2.68% over the previous day.

Column-8 (P/E):

Is the Price-Earning multiple of Sensex. It is calculated as the M-Cap weighted

average price-earning multiple of individual companies. P/E multiple of 17.92
indicates that on an average each share of individual companies in Sensex is
quoting at about 17.92 times the average earnings per share (EPS). For some
companies, the P/E ratio is higher than this average and for others it is lower. For
example, the P/E ratio of Infosys is 27.1 while that of ONGC is 11.4.
Why the P/E ratio of Bharti Televentures zero? Can P/E ratio really be zero? We
leave these questions for you to contemplate.


23. What are IPOs?

Companies raise money in the securities market only when they sell or issue a
security to the public in the primary market. The first time issue of a security in
the primary market is called Initial Public Offering (IPO).

24. Considering IPOs are first time public issues of stocks, how do companies
price them?

At the outset it must be appreciated that promoters usually invest in a company

from the very first day. Normally, there is a considerable time lag between a
company commencing its operations and issuing shares to the investing public.
During this period, the company may start making profits, develop some
interesting new products or build a good brand reputation etc. Thus, an investor
intending to own a part of the company by acquiring some of its shares later has to
pay a premium over and above the amount that the promoters might have
contributed to their share of ownership. Hence the promoters usually get in at the
„ground floor‟, i.e. at a relatively low price, which is essentially the par value of a
share. Thereafter a decision has to be taken as to how much extra the new
investors should pay per share in order to acquire a stake in the company.
Similarly, the investors wishing to buy shares in the IPO of such a company must
also give some consideration to the price they are willing to pay.

While it is not easy to analyze the performance of an established company for the
purpose of valuing its shares, evaluating a company for an IPO is even more
difficult. This is because there is not a whole lot of historical information available
about the company to the public domain, apart from what is contained in the draft
prospectus (also called the red herring prospectus) submitted to the regulator (in
this case, SEBI) prior to the IPO. This prospectus normally contains internal and
external risk factors affecting the company, how it intends to use the proceeds
from the issue, its financial performance, information about the industry, business
etc.. This document is normally quite elaborate and can at times contain as many
as 200 pages!.

In an IPO, a company pay price its shares using either the fixed price or the book
building method. If it follows the fixed price method, the price at which the shares
will be offered is determined before the issue opens and the company learns of the
demand for the shares by the investors only after the issue closes. In case the
book-building route is adopted, investors do not know the exact price at which the
securities will be offered or allotted. An indicative price range is given to investors
as a starting point and they are required to bid for different number of shares at
different prices. This is covered in more detail under the topic, fixed price and
book building method in Question 30.

25. How does it affect investors when a company tries to price its public issue of
shares as high as possible?

A well managed company will not attempt to price its public issue or its products
higher than the average market price for a similar company aor product. Why?
Because unless the higher price is qualitatively justifiable aor the
investor/customer is ill-informed , it is likely that the investor (or the customer)
will reject the offered share (or the product) outright. There are, however, many
instances where companies stream of only Rs. 9 per share. This stream of earnings
per share capitalized at 16% implies a market value per share of only Rs. 56.25
(being Rs. 9/0.16). In other words, an investor who expects 16% return from his
investment in this share will be prepared to pay only Rs. 56.25 for it since the
company earns a stream of only Rs. 9 per share. Thus, if shareholders require a
return of 16% on their investment of Rs,. 100 per share but the share earns a return
of only 9%, the share value will drop to about Rs.56.25.

In this situation, regardless of the price at which the public issue is offered, the
cost capital i.e. the return the company is obliged to earn on its investments
remains 16%. Hence when an issue is offered below the market price of a share,
there is a transfer of wealth from existing shareholders to new ones but there is no
change in the cost of capital!.

It is in the interest of a company not to price its issue too high and risk erosion of
investor confidence in the event that there is a steep fall in the share price later.
After all a company is a going concern and will repeatedly need to draw on the
capital market. Regardless of how a company prices its issue, investors must have
the ability to assess for themselves if the price is reasonable. This is discussed in
more detail in Question 133.

26. Isn‟t a public issue that is priced below the prevailing market price good for
the investors?

This depends upon how „investors‟ are defined. Is the investor someone who
already holds a share i.e. an existing shareholder or a member of public who is
going to become a shareholder? Unfortunately, there is some confusion in this
regard, although to any reasonable person, it should be clear that the existing
shareholder is the true investor since he has already invested whereas, the other is
still waiting in the wings to do so and is not into the company yet.

Where a company makes a public issue of shares at a pr5ice that is lower than the
market value of the share, some part of the wealth is transferred from the existing
shareholder to the new ones.

As an example, consider a company with one million shares outstanding, quoted in

the market at Rs. 50 each. The total wealth of the existing shareholders is thus Rs.
50 million. If the company raise another Rs. 10 million by issuing 500,000 shares
at Rs. 20 each to the public at large, the share price of the company roughly falls
Rs. 40 {or (Rs. 50 million + Rs. 10 million)/1.5 million shares)}. This implies a
loss of Rs. 10 per share to existing shareholders, totaling Rs. 10 million while at
the same time representing a gain to new shareholders from the public. Their
holding of 500,000 shares at the rate of Rs. 40a each is now worth Rs. 20 million
compared to their investment of Rs. 10 million. The loss of Rs. 10 million to
existing shareholders thus becomes a gain for the new shareholders.

However, when a public issue of shares is made at the market price of Rs. 40 as in
this case, the existing shareholders do not suffer a net loss and neither do the new
shareholders make any unreasonable gain at their cost.

It is also notable that when a public issue is grossly underpriced vis-à-vis the
market, the issue tends to be considerably oversubscribed and the probability of
applicants being allotted a share also goes down significantly.
27. What is a prospectus or an offer document?

Prospectus or an offer document must accompany a public issue of securities. A

company files the prospectus or the offer document with the stock exchange at
which it intends to list its shares. This document provides the basic information on
which investors base their decision on whether or not to invest in the public issue
or IPO. However, prior to publication of this, it files a draft offer document with
SEBI. This contains information about the public issue as well as company
information such as financial statements, company track record, background of
management and promoters, outstanding litigations, if any, the objective of raising
the capital, project risk factors, insider holdings etc.. SEBI then indicates a
„cooling off period‟ during which they make investigations and ensure that all
material information has been disclosed. In fact SEBI makes this draft offer
document available on its website for the public to view and comment upon and
many accordingly instruct the company to change certain features of the document,
if required. It is only after SEBI approves the offering that a date called the
effective date is set for the stock to be offered to the public.

After the document is approved by SEBI it forms the basis for subsequent
activities related to the entire IPO process to be undertaken. This is also called a
red herring prospectus and contains all the information about the company except
for the offer price and the effective date, which are not known at that time. The
fact that SEBI outlines a clear cut step-by-step mandate on the organization of the
prospectus and even the wordings of the disclaimer the company is required to
incorporate in the offer document, is an indication of the relevance and importance
of this document.

28. What role does an investment banker play in an IPO issue?

One of the first things a company does in an IPO (Initial Public Offering) is that it
appoints one or more investment or merchant bank(s). These are American and
British terms respectively, for the middlemen who provide a range of services in
order to bring together companies and the investing public. The most important
role of investment bankers is that of lead managers and underwriters, each
providing a distinct set of service to the company. The lead manager assists the
company in all aspects of the issue process, such as, preparing the draft prospectus,
calculating the price or indicative range at which the shares are to be issued, acting
as book runner, organizing the road shows, allotting shares to investors, refunding
money to un-allotted shares and offering any other post issue support services that
may be required.

Prior to the issue, a lead manager is also responsible for conducting due diligence,
ensuring that the issue formalities are in accordance with SEBI and other
regulations, that proper disclosures have been made and that facts in the prospectus
are accurate.

Underwriting of the issue is another important service. This is the process

whereby the investment bankers gives an assurance that the company will be able
to raise the desired amount from the public and the short fall, if any, will be borne
by them. Often a single entry provides both services to the company.

29. Exactly how do underwriters assure companies that they will be able to
mobilize the necessary capital from the public?

Entering the market with a public issue of securities entails risk. There is always a
chance that the issue may not be fully subscribed depending on the size of the
issue, the track record and reputation of the company and/or the promoters, the
nature of project for which the issue is offered, general economic conditions etc..
Companies could free themselves of this worry and attend to their operations
whole-heartedly if they could have someone else to worry on their behalf as far as
mobilizing public funds is concerned. In other words, they would like to have
their issues underwritten. Professional underwriters provide this service, for a
commission. Underwriters undertake to buy (or underwrite) the stock under issue
to the extent to which it is not fully subscribed to by the public. In other words,
underwriters, who may be large brokers, merchant bankers or banks are insurers
who insure public issues or IPOs against under-subscription.

Negotiations between the company and the underwriters to the issue are held prior
to the public issue to discuss matters such as the amount of capital the company
plans to raise, the type of securities to be issued, the issue price and all the details
of the underwriting agreement. The deal may be structured in a variety of ways.
For example, in a “firm commitment” the underwriter guarantees a certain
minimum amount that will be raised by buying the entire offer and then reselling it
to the public. In a “best efforts” agreement, the underwriter sells securities for the
company but does not guarantee the amount that will be raised. Investment banks
are hesitant to shoulder all the risk of an offering and hence form a syndicate of
underwriters where one underwriter leads the syndicate and the others sell a part
of the issue.

As mentioned in the previous questions, the lead manager puts together a red
herring draft prospectus to be filed with SEBI. The lead managers, underwriters
and the company use this prospectus to promote the issue to the investors and
create an interest in the issue (often by hyping up the details). Road shows also
known as the dog and pony show are often organized where big institutional
investors are assiduously courted.

As the effective date approaches, the underwriter and company together finalize
the price of the issue. This is not an easy decision and depends on the company,
the expected success of the road show and most importantly, current market
conditions. There is often a conflict of interest here. Typically the underwriters
prefer a lower share price in order to ensure full subscription, while the company
wants to price it as high as possible.

Underwriters are salesmen and they intentionally create hype around the entire
underwriting process in order to capture the attention of potential investors. This is
particularly true in the case of IPOs which happen only once and are therefore
presented as a “once in a lifetime” opportunity. Post IPO, some stocks do rise and
continue to soar but many fall below the offer price within a year. Hence, it is a
good policy to invest in a stock not because it is an IPO but because it is a good
investment (of course this is easier said than done).

When these preliminaries are over the company can proceed to sell the issue in the
stock market and mobilize capital.

30. What is book building? How is the issue price set in the book building

This calls for a long answer! As mentioned in Question 24, unlike in a fixed price
IPO where a company decides the price of the share prior to opening of the issue,
in the book building process the price at which the share is to be issued and the
total amount ofa capital to be raised are known only after the issue closes. The
term generally offered by these two methods are illustrated in Box. 30.1 and 30.2
respectively below:
Box 30.1 - Fixed Price IPO
Public issue of 10,00,000 equity shares of Rs. 10 par value at a price of Rs. 24
(premium of Rs. 14) each aggregating Rs. 240,000 million.

Box 30.2 - Book Building IPO:
Public issue of 72,243,300 equity shares of Rs. 10 par value at a price of Rs.
(*) each aggregating Rs. (*) million
Floor Price Rs. 115 per share

In the case of a fixed price IPO, as the terms indicate, the issue price and the total
amount of capital to be raised is fixed and known to the investor prior to
subscription. On the other hand, in the case of the book building method, neither
the exact issue price nor the amount of capital to be mobilized is known in
advance. However, a company does announce a price band, indicating the
minimum and maximum price. Alternatively, a company may provide a floor
price indicating the minimum value instead of a price band.

In a fixed price IPO, the company assisted by the investment bank, estimates the
price the investors may be willing to pay for the shares. Based on this estimate the
investment banker will agree to sell the shares to the investors at this price. In a
fixed priced IPO, the shares are normally under-priced so as to ensure that there is
considerable competition among investors for subscribing to the issue, as there is
the assurance of quick profits when the shares are listed and subsequently sold at
market value. Under-pricing of an IPO also reduces the risk of the issue not being
fully subscribed. When an issue is not fully subscribed, it is said to have devolved
on the underwriters, who are now obliged to make good the deficit – a predicament
not very pleasant either to the firm or to the underwriters. The fear of
devolvement often results in IPOs being under-priced. In India, on an average
it is believed that fixed price IPOs are under-priced to the extent of around 50%,
i.e. priced at half the level of their true potential.

The problem of under-pricing in a fixed price IPO is addressed in the book

building process, which helps in better price and demand discovery for the shares.
In a typical book-building process, as the issue opens, bids are collected from
investors at various prices, which may be above or equal to the floor price or
within the price band indicated by the company. Investors submit their bids to the
investment bankers running the book. The process of bidding is similar to an open
auction and permits investors to revise their earlier bids before the issue closes.
Companies generally segregate the total number of shares to be subscribed
according to the categories of investors in the IPO offer letter such as Qualified
Institutional Buyers (QIBs), High Net-worth Individuals (HNIs) and retail
investors, employees, etc..

The procedure adopted for the book building process is typically as follows. The
auctioneer begins the process with a high asking price and lowers it until a bid is
received on the stock. For example, for the terms indicated in Box 30.2 (above)
the auction is for 72,243,300 shares. The book runner may start the process by
annou8ncing an opening asking price of around Rs. 700 per share. He then
continues to drop the asking price until 72,243,300 shares have been subscribed.
For example, the first bid may be for 200 shares of Rs. 501 per share. The price is
dropped until there is another bid for, perhaps another 2000 shares at Rs. 400 per
share. The price is further dropped until there is yet another bid for 7,900 shares at
Rs. 250 and so on. The process of dropping the price goes on till all the
72,243,300 shares have been bid for.

Box 30.3 below shows that the bid price falls to Rs. 125, the cumulative number
of shares bid exceeds 72,243,300. At Rs. 130, the demand for the shares stands at
35,980,600 which is significantly lower than the required number of 72,243,300
shares. Thus, Rs. 125 becomes cut off price for the IPO, so that finally all the
bidders actually pay the price bid by the last bidder, namely Rs. 125 per share in
the example.
Box 30.3 - Order Book:
Bid price (per share) No. of shares bid Cumulative shares
501 200 200
400 2,000 2,200

250 7,900 10,100

200 46,500 56,600

150 607,400 664,000

140 856,100 1,502,300

135 2,548,700 4,051,000

130 31,929,600 35,980.600

125 45,486,400 81,467,000

120 184,976,400 92,425,700

115 78,101,500 98,527,200


However, at Rs. 125 the total demand is for 81,467,000 shares. If the company
intends to issue exactly 72,243,300 shares, it will have to allocate shares
proportionally and bidders will thus receive 88 shares for every 100 shares they
bid for.

Furthermore, the company may issue 81,467,000 shares by exercising its green-
shoe option (i.e. the option to subscribe to the over-subscribed portion of the
capital. More information on the green-shoe option is given in Question 33). A
company is not free to decide about the green-shoe option. It must clearly state the
proportion of over-subscription it intends to subscribe to in the offer document.

The company and the book runner together decide the final allotment of the shares.
Normally, this is in proportion to the subscription. If an issue is over-subscribed
by about 10%, an investor who applied for 100 shares at or above the cut-off price
will receive 110 shares. Alternatively, allotment may be made so that all those
applying within a certain range receive the same number of shares. For example,
everyone who applied for 100 shares or less may be allotted the same number of

Thus, in a fixed price IPO, a company ends up issuing more shares for raising a
given amount of capital than through the book-building process. This puts some
burden on a company since it will permanently have to service a large number of
shareholders. Understandably, the book building method for IPOs is becoming
increasingly popular in India.

31. How is the Dutch auction book building process different from the normal
book building process?

The book building process described earlier gives underwriters undue control over
the allocation of shares. For example, in the past investment bankers could
allocate a larger fraction of shares to investors who agreed to pay higher
commission to them (this practice is called laddering) or to those who agree to do
more business with them (a practice called spinning).

Dutch auction book building process is similar to the book building process except
that in this system, the number of shares allotted finally at the lowest bid reached,
must be the same as the original number of shares bid. For example, if the book
building example cited in the previous question is conducted through the Dutch
auction method, all bidders are treated equal. In other words, while the price for
all the final bidders will be Rs. 125, the allotment must necessarily be 200 shares
for the bid of Rs. 501, 2000 shares for those that bid Rs. 400 and so forth, so that
neither the company nor the book runner has any discretion regarding how the
allotment is done. Thus problems of laddering and spinning are eliminated, since
the share allocation is based only on price and has not related to the size of the
order or the bidder‟s relationship with the underwriter.
32. Does the book building process really help in price and demand discovery?

Theoretically yes, but recently doubts have been raised in India regarding the
usefulness of the book-building process in shaping IPO prices. The pricing in
Indian companies has often been distorted by the unprecedented interest of many
institutional investors, as evidenced by their buying large amounts of shares using
the private placement route even before the IPO (a process known as the pre-IPO
private placement).

In a private placement, companies sell securities directly to institutional investors

like mutual funds, banks, insurance companies etc.. Unlike a public offering,
SEBI‟s regulation on private placement process is less stringent and time taken to
complete a private placement process is also shorter as compared to an IPO.

When a company announces a price band during the actual IPO process,
subsequent to the private placement, the floor price is typically set above the price
paid by the institujtional investors to enable them to get an attractive return in case
they decide to offload their holdings during the IPO. Research shows that in the
case of most recent IPOs price bands have been in close proximity or little above
the price paid by institutional investors in the pre-IPO private placements.

The higher the price paid by these institutional investors, the higher is the price that
a company is able to garner from investors during the public offering, since
investments by institutional investors works as a proxy for the credibility of the
issuing company.. Companies leverage that credibility to ensure that the price
arrived at by the book-building process benefits the company as well as the
institutional investors, more than it benefits the retail investors.

33. What is Green-shoe option?

A good issue is often over-subscribed. When this happens, a company may issue
additional shares to the public to absorb the excess amount subscribed to by them.

The term indicates an option where a company can retain a part of the over-
subscribed capital by issuing additional shares. It is believed that the word “green-
shoe” is derived from the name of the company that allowed the underwriters to
use the proceeds from the over-subscribed amount to stabilize the price for the
first time. The objective behind issuing additional shares may not be to collect
additional capital but rather, to use the proceeds to stabilize the post listing share
price. For example, the green-shoe option enables a company to purchase shares
from the market, when the market price falls below the issue price.

The issuing company appoints a stabilizing agent generally, the lead manager or
the underwriter to buy shares from the open market using the funds collected from
the over-subscription of shares. This fund is kept in a separate escrow account
managed by the stabilizing agent. Thus, between the company and the stabilizing
agent, the share price of the company is given some buoyancy (or crudely put –
“the share price is propped up”).

Ideally when a company stabilizes the issue price in this way, it attempts to provide
an assurance to the investors that their investment will not bleed soon after the
issue. Often investors , especially retain investors, borrow in order to invest in
IPOs. If the price falls soon after the listing, these investors not only suffer a
capital loss but they also have to pay interest on the borrowed amount. This can
cause them to stay away from companies offering IPOs without a green-shoe
option and the inclusion of this option is now more or less a standard practice for
new IPOs.

The stabilizing agent normally stabilizes the price for a period of 30 days from the
date of listing as mandated by SEBI. After this period if the number of shares
purchased is less than the number of additional shares issued on account of the
green-shoe option, the total number of shares issued by the company stands higher
than the original number of shares issued (prior to the exercise of the green-shoe
option) to the extent of the difference. In effect, the company‟s share capital and
number of shares increases and the stabilizing agent remits an equivalent amount
to the issuer from the escrow account. If the account has any funds left (due to
price differentials etc.), the stabilizing agent is required to transfer the sum to the
investors protection fund maintained by the stock exchanges where the company‟s
shares are listed.


34. What are G-Secs and T-Bills?

Government of India‟s (GoI) long dated papers (popularly known as G-Secs) and
the short dated Treasury Bills (popularly known as T-Bills or Notes) are two sets
of securities by means of which the GOI borrows money from the market. Just as
companies raise money from the market by issuing debentures, the GOI does so
by issuing G-Secs and T-Bills through the Reserve Bank of India (RBI).

G-Secs normally have a maturity period of 1 to 20 years and cater to the long-term
borrowing program of the Government while T-Bills are issued in order to meet
the short-term requirements and have maturities ranging between 14 and 364
days. At present TBI issues T-Bills with maturity periods of 14 days, 91 days, 182
days and 364 days.

Transactions in these papers are generally by institutional investors who are

allotted T-Bills in de-materialized form and volumes are usually very large. All
T-Bills are deep discount in nature i.e. they are issued at a discount to face value.
For example a 364 day T-Bill with a face value of Rs. 100 may be issued for Rs.
94.34, to be redeemed at par at the end of one year.

In general, G-Secs and T-Bills are the most secure investment for the domestic
investors, as they represent a guarantee by the Central Government. State
Governments also routinely issue securities in order to meet their borrowing
requirements but the security of these instruments are often suspect considering the
financial conditions of many of the State Governments.

35. What exactly are debentures? How do debenture holders differ from the

A debenture represents the smallest unit of borrowing for a company and like
shares they too are securitized i.e they are represented in the form of a certificate
and can be traded. The company that issues the debenture promises to pay the
investor the face value on maturity and regular interest payments depending upon
the coupon or interest rate. The face value for a debenture in India is usually Rs.
100 and they are always issued at par. Interest is paid annually, bi-annually,
quarterly or at maturity.

Unlike ordinary shareholders, debenture holders assume very little risk on their
investment. While shareholders receive an uncertain stream of dividends, the
debenture holders receive a fixed stream of coupon interest. Payment of this
interest is a legal obligation on the part of the company. Furthermore, a
debenture is generally secured against the assets of the company. Thus, it is a
form of a secured loan. This charge of the assets of the company implies that if it
defaults in its obligations regarding payment of interest and eprincipal to the
debenture holder, its charged assets can legally be sold off in order to meet these
obligations. Thus, debenture holders are investors who assume a relatively low
risk on their investment and accordingly the returns they can expect to receive are
also lower than those of ordinary shareholders.

Since debenture holders are lenders of capital and not owners, they do not have any
voting rights other than in exceptional circumstances. Unlike dividend, interest on
debentures is deductible from corporate profits and interest payments are thus
made from the pre-tax operating profits of a company. In India, interest on
debentures is currently taxable in the hands of the debenture holders, while
dividend is not.

36. What are bonds?

A bond is more or less the same as a debenture. In India, the two terms are
generally interchangeable. There is no significant distinction between the two and
the difference, if any, is for all practical purposes negligible. While some consider
a bond as an American term for a debenture others reserve the term for public debt
securities belonging to the government and public sector undertakings. In India, it
is common to refer to the long-term debt securities issued by the GoI or the State
Governments or by undertakings owned by them or by development financial
institutions, as bonds.

Recently, “municipality bonds‟ or „munis‟ have been receiving some attention.

These bonds are similar to GOI or State Governments, but are issued by civic
bodies or municipal authorities of cities. These bonds are credit rates by rating
organizations and may or may not be guaranteed by the State Governments. The
market for „munis‟ is well developed in many western countries, particularly the
US, where it is estimated to be larger than the Government‟s long-term borrowing

37. What are the basic determinants of bonds or debentures?

A closer look at the different kinds of debentures or bonds described in the
preceding question reveals that all of them basically vary in terms of following six

These are the issuer, investor, principal, the maturity date, the coupon, the options
and liquidation status.

The determination of whether a bond is a domestic, foreign or Euro bond etc. is

dependent upon where the issuer and/or investor is located. Question 39 provides
more information on foreign or Euro bonds.

The principal represented by a bond is usually its face value or par value, or
maturity value, or redemption value. The principal or face value is designated in a
specific currency and is the amount that is borrowed and has to be repaid to the
bondholder on maturity. It is also the amount on which the interest is computed as
well as the amount as percentage of which the market value of the bond is quoted.

There may, however, be occasional deviation from this. For example, it is possible
that the fact value and the redemption value of a bond are different. This happens
when redemption is made at a premium or discount to the face value. Similarly, in
case of index-linked bonds, the principal repayment is linked to an index. Dual
currency bonds may pay interest in one currency and redeem the bonds in another.
Sometimes, the currency of issue, interest payment currency and redemption
currency may all be different. In the case of convertible debentures or
exchangeables the redemption is not the same as the principal or face value of the

Maturity of a bond implies the date on which the issuer has to repay the
porincipal and final interest to the lender or bondholder. In India, usually a bond
with a maturity of less than one year is regarded as a money market instrument,
bonds of 1 to 3 year maturity are called short-term bonds, those with 4 to 7 years
maturity are called intermediate term bonds and those with a maturity period
beyond 7 years are called long-term bonds. In the housing finance and
infrastructure sector, the maturity date of bonds may be as long as 20 years and it is
believed that an Indian company is scouting the international market for perpetual
bonds. Perpetual bonds are bonds that have no maturity and on which interest is
paid periodically, forever.
Maturity of bonds often has some type of complications. For example, bonds may
be extendibles, in which case the holder has a right to extend the maturity by a
specified period, usually at the same interest rate. Complications to maturity also
arise when the bonds are callable or putable. Callable bonds are those where the
issuer has the right to redeem them at pre-determined prices and dates before the
scheduled maturity date. Putable bonds are those where the holders have the right
to re-sell their bonds to the issuers at pre-specified prices and dates prior to the
scheduled maturity.

In practice bonds rarely mature on a single date with a bullet repayment. When the
repayment of a bond is sinking in nature, i.e. when the repayment is over a period
of time, it may not have a defined maturity. Sinking fund bonds require the issuer
to periodically repay a set amount of the principal at scheduled dates. Maturity
of bonds may also be effected on the basis of lotteries, pro-rated fractions, serial
orders or at the discretion of the company. In some cases, the issuers may have a
right to call for additional principal at various times, so that the same bond issue
may have different segments with different maturities.

Maturities may be further complicated by bonds with poison pills and poison puts,
default and cross default clauses, taxation and regulatory changes, calling for calls
and so forth. Poison pills refer to clauses where the management of a company
mandates redemption of a certain large loan in case of a hostile takeover with the
objective of frustrating the cash flow of the company making the hostile bid.
Similarly, poison puts place the determination of maturity with the lender, based
on certain events. Default and cross default clauses may link redemption of one
loan with the contingency of another, so that the element of uncertainty is
introduced into the maturity of a bond. Similarly, if changes in regulations or
taxation law are anticipated, a company may issue bonds with the redemption
based on the final outcome of these changes. In short, the maturity of a bond is not
as simple as it may appear.

Coupon is the periodic interest rate that the issuer agrees to pay the bondholder
during the life of the bond. The coupon itself has several characteristics. For
example, it may be fixed or floating. It is generally specified in a particular
currency, in the form of a periodic rate and also details the frequency of payments
and periodicity of compounding the interest. For example, the rate may be
specified as an annual rate of 6% per annum, payable semi-annually.
Alternatively, it may be compounded half-yearly at the rate of 3% per six months.
Coupons may also be odd (short or long). For example, although the coupon rate
may be 3% per six months, payable on the 1st of every July and January, the bond
may have been issued on May 1. Thus, the first odd coupon payable on July 1
may be short (for 2 months i.e. May and June). Alternatively, the terms may
require the first coupon to be paid only on January 1 so that for a bond issued on
May 1, the first odd coupon is long (i.e. for 8 months from May 1 to December

Bonds may have no coupon payments at all, in which case they are called, zero
coupon bonds. (Deep discount bonds are discussed in Question 41). Alternatively,
one may strip an ordinary bond into several zero coupon bonds (Question 42
shows how this is done). Lastly, while ordinarily coupons are flat i.e. the same rate
is paid in each period, this need not always be so. Coupons may also be step-up
or step-down. In case of a step-up coupon the rate is small to begin with and
increases with time. In a step-down coupon it is the reverse. Coupons may also be
deferred so that a bond with seven years maturity for example may not pay any
coupon in the first two years but may do so in the remaining five years. Coupons
may also be paid in kind rather than in cash. These payments are convenient in
international trade where a petroleum company may pay or receive coupon in the
form of barrels of oiul and so forth.

Bonds with fixed coupon and fixed maturity but no principal variants are known as
bullets or straights.

Finally, the liquidation status of a bond covers the security and the priority or
seniority that the bondholders enjoy. When there are tangible collaterals against
their lending, the debt is called secured. Similarly, if lenders have priority over
other lenders in the event of default or liquidation of the issuer, their debt is termed
senior while that of the others is called subordinated. Thus, a bond may be senior
secured or senior unsecured , junior subordinated or junior unsecured and so forth.

All these characteristics thus give rise to a wide variety of bonds in the markets.

Paul‟s attitude to interest
( w.a.t. Lewis Carroll in Sylvie and Bruno)

„But pay your debts! Cried honest Paul

„My gentle Peter, pay your debts!
What matter if it swallows all
That you describe as your “assets”?
Already you‟re an hour behind;
Yet Generosity is best.
It pinches me but never mind
38. What are the different kinds of debentures in the market?
At a basic level, there are essentially four kinds of debentures – full convertible
(FCD), partly convertible (PCD), optionally convertible (OCD) and non-
convertible (NCD).
A fully convertible debenture (FCD) is one, which is automatically converted into
equity at a specific time after the issue. Thereafter, the investors enjoy the same
status as ordinary shareholders of the company.
In a partly convertible debenture (PCD) as the name suggests, only a part of the
capital is convertible into an ordinary share. For example, a debenture priced at
Rs. 100 may have two components namely a convertible component (A) and a
non-convertible component (B) priced at Rs. 30 and Rs. 70 respectively.
Component A priced at Rs. 30 is convertible into an ordinary share while the non-
convertible component B priced at Rs. 70 is allowed to remain intact.
An optional convertible debenture (OCD) is a debenture where the holder has the
option to convert them into shares with in a stipulated time period. For example, a
company issues an OCD with a face value of Rs. 100 with a coupon interest of 7%
for five years. Depending on the conversion terms, each OCD may be converted
into two equity shares at the end of 12 months from the date of allotment or else
continue to receive coupon interest at the rate of 7% until maturity of the
debenture. Optionally, convertible debentures are like mezzanine financing which
is a hybrid of debt and equity. Private financers often use this to fund the
expansion of existing companies. Mezzanine financing is simply a debt, which is
converted into equity at the option of the holder.
Under SEBI guidelines, conversion must take place within 36 months from the
issue of debentures. The guidelines also require that all debentures with
conversion or maturity over 18 months be credit rates (see Question 54 on for
more information on credit rating) and that the premium amount at the time of
conversion, the period of conversion, the redemption amount, the period of
maturity and yield on redemption, be indicated in the debenture issue prospectus.
Ordinarily, a convertible debenture is converted into the shares of the company
issuing the debenture. However, in principle there is no reason why the
debentures of a company cannot be converted into the shares of another company
and such a practice does exist in some countries.
A non-convertible debenture (NCD) or plain vanilla debenture is a debenture that
cannot be converted into ordinary share(s). It is a simple straightforward debt
instrument. In case of NCDs, the face value is received after the maturity period
and may even be redeemed at a small premium to the face value.
Debentures may also be classified as redeemable and non-redeemable or perpetual.
Redeemable debentures are redeemed or extinguished or repaid on the maturity
date. A non-redeemable debenture on the other hand is perpetual i.e. it has no
maturity and hence the debt cannot be redeemed. It can only be sold in the
secondary market and the debenture holder receives the interest forever.
Historically, in India, the interest rate on non-convertible debentures is slightly
higher than that of convertible debentures and this makes them a little more
Debentures may also be classified as fixed rate debentures and floating rate
debentures (or simply floaters). In the case of fixed rate debentures, the interest
rate is fixed at the outset. In the case of floating rate debentures, however, the
interest rate is linked to some benchmark such as bank rate, a particular index rate,
etc. etc..
There are also index-linked bonds where the redemption is linked to a specific
Debentures and bonds may also be classified as secured or unsecured and senior
or subordinated. The security refers to the collaterals provided against a debt and
the seniority refers to the position in the order of redemption, in the event of a
corporate default.
In India, debentures were popular in the early nineties as corporate found it more
difficult to obtain bank credit. With bank credit currently available at relatively low
interest rates, debentures are not so much in demand.
39. Can bonds also be international in character?
Yes. In the debentures and bonds discussed, both the issues as well as the
subscriber to the debt, were Indian. But this need not always be the case. An
Indian company may mobilize debt through subscription by the citizens in
another country. For example, an Indian company may borrow in dollar terms in
the US, Such a bond is called a “foreign bond”. An Indian company may also
mobilize dollar debt from a third country e.g. England, so that the currency of
borrowing is neither that of the issuer nor of the subscriber to the debt. These are
Alternatively, a foreign company may mobilize debt in India or vice versa. This
happens when an Indian mutual fund for example, invests in a dollar denominated
debt in the US or a US fund invests in the debt of an Indian issuer. These are
examples of “direct portfolio investment”. Clearly, all international bonds carry a
currency risk since either the principal or the interest component may be in a
foreign currency. However, a detailed discussion on these bonds
is outside the purview of this book, since in India, direct lending or borrowing in a
foreign currency is not permitted for individuals, at least not to any significant
40. What are call or put options in a debenture/bond?
Companies can issue debentures with call or put options or both. A put option
gives the debenture holder the right to redeem the debentures before their maturity
period while a call option gives the issuer the right to redeem the debentures before
the maturity. The time period for call and/or put options and the redemptions
amount are clearly indicated prior to the issue of the debentures.
Investors will normally exercise their put option if they expect a rise in the
interest rate. They can then redeem the debenture and reinvest the proceeds in a
comparatively higher yielding debt instrument.
Similarly, a company with outstanding debentures may exercise the call option
before the maturity period if the interest rate is declining. The company can then
redeem the debenture and borrow afresh from the market at a lower rate of interest.
Often debentures carry both a call and a put option. The reason for this is that if a
company issues debentures with only a call option, investors will perceive it to be
more risky or disadvantageous, as the company is likely to exercise the option
only when it is beneficial for it to do so. In such a case, investors will expect a
higher coupon rate for the debentures as compensation for the flexibility that the
company enjoys over the investor. Similarly, if a company issues debentures with
only a put option, it gives the investors the option to exit when it suits them so
that the company is at a disadvantage. In such a case, the company will offer a
lower coupon rate, extracting a price for the flexibility it offers to the investor.
As debentures with only a call or a put option are by definition asymmetric, to
either the issuer or the investor, companies often issue debentures with both call
and put options. These are called mixed options. When a debenture has both call
and put options, the timings are usually staggered so that both the parties are not
able to exercise their options at the same time. Thus, each party may have the
option at alternate periods, e.g. every January 1 may be the call option date while
every July 1 may be the put option date. The section on options discusses these in
41. What is a zero coupon or a deep discount bond?
A zero coupon bond or a deep discount bond is a loan instrument that is slightly
different from an ordinary debenture. Usually, an ordinary debenture is offered at
its face value (e.g. Rs. 100) and earns a stream of interest (e.g. 8% per annum) until
its redemption and is redeemed with or without premium. A five year zero coupon
bond, on the other hand, is offered at a discount (say Rs. 68) fetches no periodic
interest and is redeemed at the face value of say Rs. 100 at the end of 5 years. A
little computation reveals that the yield-to-maturity of such a bond when
subscribed for at Rs. 68 is about 8%. (Question 169 has more on YTM). Instead
of receiving the interest periodically, the bondholder receives the principal as well
as compounded interest together, at the time of maturity of the bond. (Question
167 has more on compounding). In other words, the interest is automatically
reinvested at 8% per annum until maturity.
Typically, the interest earned on zero coupons, though received only at
redemption, invites income tax on the implicit coupon interest income for each
42. How does one strip an ordinary bond into many zero coupon bonds?
This is simple. To illustrate the procedure, consider that a simple bond with three
years remaining to maturity. Assume that the bond carries coupon rate of 6% for
the next three years, payable at the end of each year, with a bullet repayment of Rs.
100/- at the end of three years.
The bond is currently priced at Rs. 99.58 u in the market. It may be that the
prevailing interest in the market for one year loan is 5.3%, two year loan is 5.6%
and for three year loan is 6.2%
The three year bond may be stripped into three zero coupons bonds of following
i) The first three year coupon payment of Rs. 6 can be st6ripped into a zero
coupon bond with a market price of Rs. 5.70a and one year maturity, with
redemption value of Rs. 6 (= 5.7 (1.053)}.
ii) The second year coupon of Rs. 6 can be stripped into a zero coupon bond of
with a market price of Rs. 5.38 and two years of maturity, with redemption value
of Rs. 6 {=5.38 (1.056)2} .
iii) The third year principal of Rs. 100/- and coupon payment of Rs. 6 can be
stripped into a zero coupon bond of with a market price of Rs. 88.50 and three
years maturity, with redemption value of Rs. 106 {= 88.50 (1.062)3}.
It can be seen that the market price, Rs. 99.58 of the bullet is nothing but the sum
of the market values of the three stripped zero coupon bonds.
In case you are a little unclear about the workings above, you may refer to question
43. Why should one strip an ordinary bond into many zero coupons?
Well, there is a counter question. What would be one‟s selling strategy, if one had
a cart full of apples, some small and some large? Clearly, one may either mix them
all together and sell them at an average price. Alternatively one may also separate
them into two (or more) baskets of small and big apples and sell them at different
rates. Stripping an ordinary bond into zeroes is the same thing except that it is
less obvious.
44. What are the special features of floating rate debentures?
In recent years, companies in India have issued debentures where the interest rate
varies in tandem with a pre-determined benchmark over the entire maturity period
of the bond. These are called floating rate debentures since their interest rate floats
or changes with the benchmark rate.
Consider a company that issued a floating rate debenture on 1st January 2006, with
a face value of Rs. 100 offering 200 basis points (bp) over the benchmark Mumbai
Inter Bank Offer Rate (popularly known as Mibor) with the interest reset every six
months. Incidentally, 100 basis points amount to one percentage point.
Mibor represents the average inter-bank borrowing rate in Mumbai. The reset
every six months means that the Mibor-linked interest rate will change every six
months. Let us assume that the maturity of the debenture under consideration is
three years. The terms imply that the interest rate applicable to the debenture will
be reset every six months, depending upon the Mibor rate. For example, if the
Mibor was 5.1% on 1st julyk, 2006, the coupon payaments were made at the rate of
7.1% per annum (5.1% + 2%), for the six-month p;eriod January-June 2006.
Again, if on 1st January 2007, the Mibor were 4.9%, the annual interest rate
applicable for the period July-Dec. 2006 would be 6.9%.

The spread (200 bp in this case) over the Mibor is usually governed by the credit
rating of the debenture. Typically, debentures with higher credit ratings have lower
spreads and vice versa. It is also possible for the spread to be negative, i.e. for the
interest rate to be pegged below the benchmark rate. For example, a company with
a very high credit rating may issue a debenture with 150 bps below the Mibor.

When a company issues floating rate debentures, apart from the face value,
maturity period and periodicity of coupon payments, it also explicitly declares the
benchmark rate, the spread over or under the benchmark rate, the reset periodicity
etc. Floating debentures may also be issued as convertible debentures.

In India, Mibor is by far the most popular benchmark used for floating rate
debentures. Other benchmarks used are Mibid, INBMK rate and Inter Bank Call
Rate. Mibid is the Mumbai Inter Bank Bid Rate (or lending rate) that represents
the average lending rate of banks in Mumbai, while INBMK rate is the Indian
Benchmark or the one-year government T bills benchmark rate.

Many Indian companies have borrowed from the international markets by issuing
floating rate debentures. Almost all of these are linked to Libor (London Inter
Bank Offer Rate) as the benchmark.

45. What are inverse floaters?

Inverse floating rate debentures or inverse floaters are another variant of floating
rate debentures. In case of floating rate debentures, the coupon interest rate moves
in tandem with the floating rate, whereas in the case of reverse floaters, the interest
rate moves against or inversely to the benchmark. A typical structure may be
“fixed interest rate – floating rate benchmark‟. For example, for an inverse floater
paying half-yuearly coupon, the interest rate may be 15% - six month MIBOR
prevailing at the beginning of the six-months period.

Thus, it is observed that as Mibor increases, the investor‟s return decreases and
vice-versa. In other words, the holde3r of a floater will earn a higher interest as the
Mibor increased, while the holder of an inverse floater will experience an opposite
phenomenon. For the investor, the interest rate on the debenture will decrease with
an increase in Mibor.

46. Why does a company need to issue inverse floaters at6 all?

Economic conditions do not always remain the same. There are times when the
interest levels may be expected to go up and also there are times they may be
expected to go down. Of course everyone may not have the same view on the
expected direction of movement of interest rates at any given point of time.
Assuming that interest rates are likely to go down, will anyone subscribe to a
company issuing a floating rate debenture? This is unlikely since one will expect
the debenture to yield a lower interest rate as the Mibor or Libor took a dip. On
the other hand, if this company actually expected the interest rate to go up and in
order to attract those who have a converse expectation, it may well issue inverse
floaters so that if the Mibor or Libor were to go down as expected, one will expect
to earn a higher interest rate on the debenture.

From the company‟s view point, it may be risky to issue a floater or an inverse
floater on its own because if its expectations on interest rates are wrong, the cost
of borrowing will be very high. The company will be better off issuing both
floaters and reverse floaters simultaneously and as long as both the issues are
approximately of same size and both are more or less equally subscribed, it will
offset the higher cost of interest on account of one – say the floater – by the lower
cost of interest on account of the other, namely, the inverse floater.

47. How are the benchmark rates for the purposes of floaters or inverse floaters
As seen earlier, many benchmark floating rates are available in India, the more
common of which are, Mibor, Mibid, Reuter‟s Mior etc.. Each of these may be
calculated for a different length of period. For example, FIMMDA (Fixed Income
Money Market and Derivative Association of India) and National Stock Exchange
jointly calculate and disseminate the Mibor and Mibid rates everyday, while the
rates may pertain to overnight, fortnightly or quarterly periods.

Let us consider how overnight Mibor is calculated. Overnight Mibor is the average
rate the market participants in Mumbai charge for lending money for one day.
FIMMDA/NSE uses a polling method to collect data from the market participants
who are willing to lend money for a day. The FIMMDA/NSE group collects
quotes from 29 different participants including public and private sector banks,
foreign banks, financial institutions like IDBI, LIC, UTI and primary dealers. The
overnight quotes are collected daily between 9.40 a.m. and 9.45 a.m. by polling
th4ese 29 market participants.

After receiving the quotes from all of them outliers are identified and excluded
from the calculation, as extreme observations tend to influence the mean value.
Once the overall data is trimmed, random data sets are drawn from the remaining
data points. Mean and standard deviations for each of these are then calculated.
The mean corresponding to the data set with the lowest standard deviation with at
least 12 data points is finally reported as the Mibor for that day.

The Economic Times publishes Mibor/Mibid daily for different durations ranging
from overnight to 3 months.

The same procedure is followed to arrive at other rates, such as the overnight
Mibid rate, 14-day Mibid and 14-day Mibor and so forth. A 14-day Mibid and
Mibor represent - no prizes for guessing – the average rate at which the
representative market participants are willing to lend or borrow for a period of 14
days respectively. The BBA (British Bankers Association) who are responsible for
calculation and dissemination of Libor rates follow a similar procedure.

Table: 47.1 – Mibid/Mibor Rates:

Period polling Time Rate Std.Dev. Rate
Overnight 9.40 am 4.20 0.0213 4.44

14-day 11.30 am 4.32 0.0354 4.53


1-Month 11.30 am 4.41 0.0379 4.66


3-Month 11.30 am 4.55 0.0412 4.86

--------- 48. What is a secured premium note (SPN)?

This is not a standard term but became current when Tata Steel (formerly known as
TISCO) launched its issue in 1992. Notwithstanding the formidable sounding
terminology, it was night bu5t a zero coupon bond, with some share warrants
attached. A share warrant gives the holder, the right to buy an underlying share at
a certain price in the future (see Question 218) under financial derivatives for more
details on warrants). Moreover, the redemption of these SPNs was spread over
several periods.

It is obvious that any security, no matter how high sounding its name, is merely a
permutation or combination of the various characteristics which have already been
dealt with. Hence there are likely to be as many names for securities as there are
permutations and combinations of their characteristics. Rather than get foxed
with the name of a new security, one is well advised to understand the basic
characteristics of any new security to unravel its mysteries.

And now that you know a good deal of stock exchange jargons,
here are some more from Lewis Carroll
(with apology in Through the Looking Glass)
:Twas brilling, and the slithy toves
Did gyre and gimble in the wabe;
All mimsy were the borogoves,
And the mome raths outgrabe.

49. Why is interest tax-deductable for companies, while dividends are not?

There is no logical explanation for this, but it might appear that for some reason
the governments all over favor debts over equity. Whether this also encourages
companies to prefer debt over equity and how such a preference affects
entrepreneurship in an economy are poin6ts to ponder. There are however some
special circumstances in which a few countries do have tax shields for dividends
also. Similarly, in some countries interest on loan may not always be fully tax-
deductible. For example, in India in the mid-70s only upto 85% of the interest on
corporate fixed deposits was tax-exempt. Until recently, in the case of partnership
firms, the interest on loan from a partner to the firm was not tax exempt. Again,
the favorable treatment of interest vis-à-vis dividend in legal terms is not a
universal; phenomenon. In many Islamic countries, interest is viewed with
considerable distaste even in the eyes of the law. Incidentally, it may be
remembered once again that in India dividends are tax-free at the hands of the
investor, while the interest payments are not. In some ways, this position offsets
the asymmetry of taxation of dividends and interest at the corporate hands.

Tweedledee on the logic of tax deductibility of interest
(w.a.t. Lewis Carroll in Through the Looking Glass)
„If it was so, it might be, and if it were so, it would be:
but as it isn‟t, it ain‟t.
50. How does one read debt market quotations in a financial daily?
In India, debt securities do not enjoy extensive secondary trading. Whatever debt
trading does occur is limited largely to bonds issued either by the Government of
India (GOI) or to a lesser extent by the State Governments. Trading of debentures
issued by corporate is relatively insignificant. In order to increase the volume of
trading in government securities, the RBI intends to allow transactions in these
securities even before they are issued. (Question 52 has more on pre-issue trading
of government securities).

As debt trading in India is largely limited to institutional investors, financial dailies

do not public trading information regularly unlike share trading details, which
normally occupy a great deal of space. The following table extracted from the
NSE website data archive, lists some of the debt prices and other information
related to debt trading.

Column-1 (Issue description)

Indicates the institution or company name suffixed by the maturity of the debt
instrument. As companies and especially institutions and governments issue a
series of debt instruments, suffixing the name with the maturity date uniquely
identifies the particular series.

Column-2 (Coupon Rate)

Indicates the coupon rate applicable.

Column3 and Column-4:

Indicates the issue and maturity date respectively.

Column-5 (Coupon frequency):

Indicates the frequency at which an investor will receive the interest in a year. As
expected, the GoI 364-day T-bill maturing on February 2007 does not have any
explicit coupon rate as it is deep discount in nature.

Column-6 (Next Interest Payment date:

Indicates when the debt holder will receive the next interest payment.

Column-8 (Trading Price):

Indicates the price at which the debt certificates are traded.
It may be interesting to note that unlike shares, the trading price of debt securities
may be clean or dirty, depending upon the pricing convention applicable in a

Table 50.1 - Debt Prices and Other Information Related to Debt Trading:
Issue Des- Coupon Issue Maturity Coupon Next Last Traded
cription Date Date Date Frequen- Int. Date Price
cy Pay.
1 2 3 4 5 6 7 8
---------Bank of
Baroda 2008 11.15% 31.3.01 30.4.08 Yrly 1.10.06 17.1.06 101.3721

GE Shipping
2008 10.25% 25.5.01 25.5.08 Yrly 25.5.06 6.1.06

LIC Hous.
Fin.2018 7% 27.6.03 27.6.18 Yrly. 27.6.06 31.1.06
GoI Loan
2012 7.40% 3.5.02 3.5.12 Hlf.yrly 3.5.06 23,2,06

State Govt.
2015 7.33% 16.12.05 16.12.15 Hlf.yrly. 16.6.06 1.2.06

GoI 364-day
2 Feb.2007 N.A * 3.2.06 2.2.07 N.A* N.A* 20.2.06
---------* Not applicable
Source: NSE website archive on 26th February 2006.

51. What are pricing conventions for debt securities?

There are several conventions that surround the reporting of various aspects of
debt. For example, prices of bonds may be quoted as clean or dirty. Dirty (Gross)
price is essentially the clean price plus the accrued interest. Clean price is the
present value of future coupons and redemption amount discounted at the
applicable interest rate in the market. Globally, the price quoted or reported is
usually the clean price and if this is so on the date of purchase, then in addition to
the clean price, the buyer of the bond also pays the seller the accrued interest. This
total sum is then the dirty price.

The subject of accrued interest needs some elucidation. Assume that the coupon
payment on a bond is six-monthly, i.e. on April 1 and October 1. However, an
existing bondholder sells it on say, June 25. On this day the ownership of the bond
changes hands but the accrued interest for the period April 1 to June 25 really
belongs to the seller. However, the coupon for the entire six month period will, in
fact, be received by the buyer of the bond. Ideally, the buyer should pay back the
accrued interest for April, May and 25 days of June to the seller and if one is
pricing the bond on June 25, a correction for this accrued interest must be made.
This is the difference between clean and dirty prices. The clean price ignores
accrued interest while the dirty price takes this into account.

It is unfortunate that the dirty price is so called because in reality there is nothing
dirty about the adjustment. In fact, it is more finely tuned and takes into account
the reality. The term „dirty‟ merely represents the hassles involved in making little
adjustments on account of accrued interest.

Conventionally, the simple interest method is used for calculating accrued interest.
Again, day-count conventions vary from market to market worldwide and may
range from actual/actual, actual/365, actual/360, 30/360 etc.. This is explained in
Table 5.3

Depending upon the convention used the exact computation could vary slightly.
Assuming that the coupons are 3% per six months and the face value of the bond is
Rs. 100/-, the interest accrued under each of these conventions for the period April
to June 25, can now be computed. It is important to bear in mind the actual
number of days in each month of the six-month period whgile making this

Table 51.1 – Day-count Conventions:

Conventions Methodology
Actual/Actual Actual number of days the bond is held divided by the
actual number of days in a year (366 days in leap year and
365 days otherwise)
Actual/365 Actual number of days the bond is held divided by
365 days irrespective of whether it is a leap year or not
Actual/360 Actual number of days the bond is held divided by 360
days irrespective of whether leap year or not

30/360 Each month has 30 days with 360 days year


Conventions Outcome
Actual/Actual = 3% X 86/183 = 1.410% (normal year)
Actual/365 = 3% X 86/182.5 = 1.414%
Actual/360 = 3% X 86/180 = 1.433%
30/360 = 3% X 85/180 = 1.417%

While it may appear that the different conventions yield fairly close results, the
fact is that in the debt markets, where the volume of any single transaction runs
into millions of rupees the effect of the different conventions on the final payments
made or received could vary significantly in absolute terms.

In India, the 30/360 convention is commonly used for all GoI and state government
debt securities. The dirty price is quoted for retain trading in these securities, while
in the wholesale market they are quoted at the clean price. Both BSE and NSE
have separate trading platforms for retain and wholesale debt market participants
thus ensuring that two separate prices are available. All other debentures are
normally traded at the dirty price while corporate debt securities are traded mostly
over-the-counter and pricing is typically negotiated.

52. What is pre-issue trading in Government securities?

Pre-issue trading refers to trading of securities even before they are issued. The
Central Government of various countries issue securities from time to time. Future
issuance is generally authoorized before the actual issue is made and there is a time
lag between the two. During this period , certain designated traders may be
authorized to trade in these securities popularly known as “when issued
securities”. Trading in these when issued securities ends when the government a
actually issues the securities.

Unlike in India, the “when-issued” market is very vibrant in many advanced

countries. However, RBI is in the process of formulating plans to introduce this
53. What kind of risks do bonds and debentures entail? Are they not supposed to
be risk free?

There is no doubt that bonds and debentures are low risk instruments compared to
shares. However, they are not entirely risk free in every sense of the word. For
example, most debt securities do entail credit risk or default risk. There is always
the risk that the borrower may default on his obligation for various reasons. In the
case of corporate, default risk may be linked to their credit rating. Government
bonds are usually rated the best in terms of default risk afor its own citizens and
hence loosely referred to as „risk-free‟ bonds. A government will be unable to
function effectively if its bonds are considered risky, as it will be unable to borrow
money from its citizens at affordable rates. However, people of a country may not
consider the bonds issued by the government of another country to be safe. For
example, not many people today may be prepared to invest in bonds of
Afghanistan or Iraq but for nationals of these countries the bonds may offer the
best credit risk. Thus, there are political risks as well as economic risks involved.

Another major element of risk is currency. For example, when a US citizen invests
in a GoI bond, he invests in dollars and receives his returns and principal
redemption in rupees. This involves first converting US dollars into Indian rupees,
investing the rupees in bonds and then re-converting the interest and redemption
payments back into US dollars. Such an investment entails currency risk i.e. risk
on account of currency fluctuations. If, for example, the Indian rupee weakens
against the dollar while it is invested in the GoI bonds, the effective return for the
investor goes down. Thus, a combination of all the risk factors namely political,
economic and currency, ensures that the credit rating of government bonds of a
country are generally rated lower outside that country. Hence, while GoI bonds
may enjoy the best rating in Inia (e.g. credit rated AAA), the same bonds may be
rated a mere BBB in the US>

The other important source of risk in regard to a bond is known as interest rate risk.
This risk arises from the fact that interest rates may change over a period of time
and impact the bond prices as well as coupon reinvestment rates, so that unless one
invests in a bond and stays invested until its maturity, the returns from the
investment may be different from the return originally envisaged.
It is important to note that while holding a portfolio of several different bonds or
debentures can diversify default risk, the interest rate risk cannot be diversified.
More on interest rate risk is covered in question 171.

54. What is the role of credit rating agencies in measuring the risk of debt

Credit rating of debt securities is normally undertaken by specialized credit rating

agencies. The five credit rating agencies operating in India are Credit Rating and
Information Services of India Limited (CRISIL), Investment Information and
Credit Rating Agency Limited (ICRA), Credit Rating, Advisory and Information
Services Limited (CARE) , Duff and Phelps Credit Rating India Private Limited
(DCR India) and ONICRA Credit Rating Agency Limited, Standard & Poor
(S&P), Moody‟s Investor Service (Moody‟s) and Fitch Ratings are the best-known
international credit rating agencies.

Debentures are rated as AAA, AA., A and BBB, BB, B , C and D depending upon
their risk element. AAA rating is reserved for the lowest risk or the highest-grade
debenture, whereas D signifies an extremely risky debenture which is virtually in
default. Thus, AAA and AA ratings signify high investment grade debentures,
which offer the highest safety in terms of prompt payment of interest and
principal. Ratings A and BBB indicate „investment grade‟ debentures, which offer
adequate safety vis-à-vis interest and principal payments. BB, B, C and D rated
debentures are „speculative grade‟ debentures, which are deemed to be
increasingly susceptible to default.

SEBI guidelines require that all debentures with maturity periods greater than 18
months must be credit rated. The ratings are also compulsory in the case of short-
term money market instruments. Term-lending institutions as well as stock
exchanges also now require that borrowing companies have their securities rated.
Often, these ratings are not publicly available and it is only when a company
receives a good rating that it chooses to make it public. Even so, the rating does
make a difference in the market and the prices of debentures that are rated AAA
have shown some rise. The market is already looking skeptically(penalizing with
lower prices) at instruments which have not been credit rated or made their ratings
known to the public. Over a period of time, as credit ratings become more widely
publicized the prices of various instruments may better reflect their intrinsic worth.

55. How does one measure the default risk of a bond or debenture?

This is normally based on the credit rating of the instruments. The rating agencies
determine the default risk of companies by closely examining their business,
financials, suppliers, customers, industrial relations, product, the relevant
government policies etc. and awarded a rating to each of the debt securities.
Generally, the ratings are awarded as described in the previous question, but the
agency may also apply a “+” (plus) or “-“ (minus) sign for ratings from AA to D
to reflects relative standing within a given category, for example BBB+ or BBB-
etc. A rating may also be described as having a positive, stable eor negative
outlook, indicating the possible direction in which a rating may be expected to

Short-term bonds are rated more or less similarly through with a slightly different
nomenclature, which may appear as P1, P2, P3, P4 and P5 with P1 standing for the
most timely payment and P3 indicating expected or actual default.

Needless to say, the higher rated instruments yield a lower return (interest rate) in
keeping with the principle of „lower risk-lower return‟ and „higher risk-higher


56. How are shares traded in stock exchanges?

Investors wishing to trade securities in a stock exchange have to channel their trade
through a stockbroker who is a member of that stock exchange. The stock broker
may be a corporate or an individual though of late individual stock brokers are on
their way out, as stock exchanges now tend to favour corporate memberships over
individuals. In any case, there are specific guidelines for admitting a person or an
organization as a member broker and various criteria such as net worth, education
and experience of the aspirants (promoters/management team in case of corporate
membership), track record etc. are considered before granting the membership.
These criteria may change depending upon the nature of membership. For
example, determination of whether or not a member may undertake trading in
derivatives or debt market instruments, may require a particular level of education
and expertise. Each member is also required to maintain a suitable security deposit
with the exchange and pay annual membership fees.

The brokers act as agents to trade in securities i.e. buy and sell securities, on behalf
of clients (individual investors, companies etc.) for a commission and may also act
on their own account and risk.

Until the emergency of electronic trading in the form of dematerialized shares in

1993 (Question 110 deals with dematerialization of shares), trading on Indian
bourses was conducted in the age-old style of „open outcry system‟ whereby
brokers physically assembled on the floor (also known as the ring) of the stock
exchange and indulged in some high energy physical trading involving a
combination of vigorous gesticulation and lung power, creating an ambience not
unlike that of a fish market. During trading hours (which was between 12.00 noon
and 2.30 p.m. in most stock exchanges in India) brokers made bids to buy and
offers to sell shares, indicating the name, volume and price of shares sought or
offered, with a wide variety of signals using their hands, fingers and voices to
communicate with other dealers.

The emergence of electronic trading spelt the end of the era of open outcry. With
the advent of electronic trading, investors from distant areas of the country were
able to trade in securities through brokers and sub-brokers with on-line
connectivity to the stock exchanges.

Both NSE and BSE offer fully computerized screen-based trading facilities to
investors. The on-line trading system of BSE is known as BOLT (BSE‟s On-Line
Trading System), while that of NSE is known as NEAT (National Exchange for
Automated Trading). Both BOLT and NEAT use satellite communication for
trading, using V-SAT. Thanks to these trading systems, brokers merely enter their
buy and sell orders on the computers installed in their premises instead of
assembling in the trading ring. Retail investors can also communicate their buy or
sell orders through the internet. The ease of electronic trading has also resulted
in a significant increase in trading hours i.e. from 9.55 am to 3.30 pm on all
weekdays or almost six hours daily.
In India, investors may trade in equity shares using two different methods – cash
account (or cash market) or margin trading.

57. What it trading in the cash market?

The term „cash market‟ is a misnomer since trading in the cash market does not
really involve any cash transaction. They are all either delivery based or non-
delivery based transactions.

A delivery based transaction happens in the trade-to-trade segment. The actual

delivery of share certificate (electronic delivery) and the payment for the purchase
takes place before the next settlement date, when outstanding accounts arising
from trading on cash account for individual investors are settled.

Non-delivery based trading in the cash market is known as „day trading‟. During
trading hours, day traders buy and sell stocks in the hope of making profits from
intra-day price variations. They take reverse position to set off their original
positions in stocks within the day. At times, these trades may be reversed within
minutes. In other words, these traders do not keep their positions open until the
settlement date.

Incidentally, an open position implies a bought or sold position. Reversal of a

position implies that the original open position is nullified by a reverse position so
that if one has bought a position for 100 shares of a stock, by selling 100 shares of
the same stock, this can be reversed and one is back to a neutral position vis-à-vis
that stock.

Thus, in delivery based trading in the cash market, shares are traded with intention
to deliver (or take possession of), while in the case of day trading positions are
squared off within the day. In Inadia, day trading now accounts for almost 80% of
cash market equity trading in terms of volume of trade.

The main feature of trading in the cash market is that the total value of the shares
bought or the total number of shares sold, has to be delivered on or before the
settlement date.

58. How exactly does one engage in trading in cash market?

One requirement of trading in a cash account is that the total value of the shares
one intends to buy has to be deposited with the broker and only those shares that
one owns can be sold. As soon as an order to buy or sell a particular stock is
placed, the broker sends it along with the quantities and price, to the trading system
of the stock exchange (either BOLT or NEAT). Determination of whether this is
sent to BOLT or NEAT is dependent upon one‟s choice and the membership of the
broker. The system pputs the order into the order book (also known as regular-lot
order book) and generates a unique number for each trade and time-stamps each of
these. This number is to be referred to afor if all enquiries relating to the
transaction in the future.

The trading system then processes the eorder by finding a match among the
pending orders in the order book.

At any given point in time the electronic order book contains the bid and offer (or
ask) prices and quantities for all stocks being traded, along with the date and time.
Bid and offer are merely smart jargons for buying and selling. Thus, the bid rate is
noghing but the price at which the buyer is willing to buy a certain stock.
Similarly, the offer rate is the price at which an investor is willing to sell a stock.
Bid and ask quantities are the total number of shares the buyers and the sellers
desire to buy and sell respectively.

A buyer must be aware of the offer rates prevailing in the market, as these are the
prices at which sellers are prepared to sell the securities. Similarly, a seller must
know the bid prices at which buyers are willing to buy the securities.

The system continuously matches the best buy or bid orders with the best sell or
ask orders in the order book to enable their execution. In terms of order matching,
the best buy order has the highest price and the best sell order is the one with the
lowest price. This is obviously because a seller will consider all the buy orders
available and sell at the highest possible buy price. Similarly, a buyer will
consider all sell prices and will buy at the lowest sale price. Thus, the system
matches the orders so that the bid-ask spread is as thin as possible. If the best offer
price is greater than the best bid price, no order can be executed, as the situation
implies that the maximum price buyers are willing to pay for a stock is less than
the lowest price that the seller are prepared to accept.
The entries in the order book change on a real-time basis with every new order.
The trades are executed electronically as and when there is a match between the
best bid price and best offer price. This electronic match ing and execution of
orders is continuous right through the trading hours.

While placing an order to buy and sell shares it is important to know the tick size
or the increment by which prices move for a particular share. Thus, the tick size is
the minimum difference in rates between the two orders entered on the system for
a particular stock. While different stock exchanges may set their own tick size,
at both BSE and NSE, it is Rs. 0.05 (5 paise) – so an investor can quote a price in
multiples of 5 paise. This means that the bid/offer price cannot, for example, be
Rs. 369.67. Tick size is an important parameter of any stock market since the finer
this is, the better is the accuracy in establishing the fair value of securities. Thus, it
enables investors to place orders at finer rates resulting in thinner bid-ask spreads,
which is the hall mark of a good stock market.

59. What are the different types of orders one may place while trading in shares?

While trading in stocks is conducted on the basis of the bid and ask prices,
investors may in reality, place their orders in a variety of ways or with a variety of
conditions attached to each of the orders. This allows them to be more specific
about when the order may enter the order book or how long the order may remain
active. Orders may be categorized with respect to three important criteria
namely :

- time related conditions;

- price related conditions and
- quantity related conditions.

Each of these conditions is further divided into many sub-categories. For example,
a time related condition may be a day order, a GTC (Good Till Cancelled) order, a
GTD (Good Till Date/Days) order, or an IOC (Immediate Or Cancel) order. A day
order remains valid for a day and if it not executed it gets cancelled automatically
at the end of the trading day and will not be reflected in the order book on the next
trading day. A GTC order remains valid till explicitly cancelled by the investor.
In a GTD order, investors may specify the number of days or the date until which
the order may remain valid. The stock exchanges periodically disclose the
maximum number of days for which an order may be allowed to remain valid as a
GTC or GTD order. An IOC order allows the investor to buy or sell the share as
soon as the order reaches the trading system of the stock exchange, otherwise the
order is automatically cancelled. In case of a partial match, the unmatched portion
of the order is automatically cancelled.

Price related conditions may be classified as „limit‟, „market‟ or „stop-loss‟. In a

limit price order, the investor specifies the limiting price at which the trade is to be
executed. Understandably, the price limit given by an investor has a different
connotation for a buyer vis-à-vis a seller. For a buyer, the limit price is the ceiling
price i.e. the order will be executed at any price equal to or less than the limit
price specified by the investor. On the other hand, for a seller, the limit price is the
floor, which means that the order will be executed at any price equal to or higher
than the limit price specified by the investor. In a market price order, an investor
indicates his willingness to trade at the best price obtainable at the time the order
reaches the trading system of the stock exchange. A stop-loss order is one that is
placed with a broker with instructions to buy or sell when the stock reaches oer
passes through a certain price. The investor is required to specify two prices at the
time of communicating the order - a „trigger price‟ and a „limit price‟. The trigger
price indicated by a buyer is the price at which the buying or selling must
commence and the limit price indicates the price beyond which the buying or
selling should stop. Until the trigger price is activated, stop-loss orders are
maintained in a special order book known as the „stop-loss book‟. Once the
market reaches the trigger price specified by the investor, the order is transferred to
the regular lot order book for execution and is governed by the limit price. Those
who own a stock and want to ensure that they sell it if the price begins to drop
often use a stop-loss order. Typically, the trigger price placed on the stop order
must be below the current bid price of the security.

For example, assume that 5000 shares of a company have been purchased at Rs.
265/- per share and the price begins to fall soon after. In order to maintain the
potential loss, it is decided to sell the stock if the price touches Rs. 255/- and to
continue selling till it drops to Rs. 250/-. Therefore, an order is placed with a
trigger price of Rs. 255/- and a limit price of Rs. 250/-. This order will be moved
into the stop-loss order book and will be trigger5ed into action as soon as the
market price touches the Rs. 255/- mark. The order to sell 5000 shares will then
move to the regular-lot order book at a limit price of Rs. 250/- per share. Needless
to say, the actual execution of the order will occur only when there are buyers
available between the price range of Rs. 255/- and Rs. 250/-.

Quantity related conditions allow one to choose whether or not to disclose the
quantity of the trade. Thus, the disclosed quantity condition allows one to hide the
actual number of shares one wishes to buy or sell, by disclosing only a portion of

60. What happens after the trade is executed? How exactly are the transactions

Once transactions have been completed in the trading system, each of these has to
be settled. Settlement is the process that involves transfer of money from the buyer
to the seller and the transfer of securities from the seller to the buyer on the
settlement date.

The settlement of trade is done at the end of each trading day and both at BSE
and NSE this is currently based on T + 2 rolling settlement cycle. Since 2001, both
BSE and NSE have uniform settlement cycles.

Under a rolling settlement system the trades completed on a particular day are
settled after a given number of business days. At present in NSE and BSE it is
after two days and is hence called T + 2 settlement, implying trading date + 2 days.
In other words, the settlement cycle is completed on the third day after the
execution of the trade. For example, trades completed on Monday are settled on
Wednesday, Tuesday‟s trades are settled on Thursday and so on.

Assume for example that on a Monday, an investor undertook the following

transactions which are to be settled on Wednesday.

Box 60.1
Transactions Sale Value Purchase Settlement on Pay out
on Monday Rs. Value Rs. Wednesday pay in
Sold 40 shares
of XYZ Co., at 9,430/-
per share
Bought 75
shares of
XYZ Co. at
Rs. 231.00
per share 17,325/-

Gross Basis 40 shares of 75 shares

XYZ Co. and of
Rs. 7,895/-
Net Basis Rs. 7,895/- 35 shares

If the buy and sell orders pertain to shares held in physical form, the settlement is
done on gross basis while for shares traded in demat form, the settlement is on net
basis. Thus, assuming the orders pertained to physical shares, by 11.00 am on
Wednesday, the investor must pay Rs. 7,895/- (being Rs. 17,235/- of purchase
value - Rs. 9,430/- of the sale value) and 40 shares of XYZ Co.. At 3.30 pm on
the same day which is the pay out time at both NSE and BSE, the stock exchange
will pay out 75 shares of XYZ Co. towards this purchase to the respective broker
in favour of the client. It is important to note that the terms pay in and pay out
relate to what goes in and out of the stock exchange. All payments and receipts
are routed through the broker.

If the shares are held in the demat6 form,. The settlement will take place on a net
basis since the buy and sell positions are in the same script. By Wednesday 11.00
am, the pay in of Rs. 7,895/- is required and at 3.30 pm on the same day the stock
exchange will pay out 35 shares of XYZ (i.e. the difference between the number
of shares bought and sold) to the broker in favor of the client. In other words, the
buy and sell trades in the same stock are netted and adjusted in the demat account.

When the broker receives the shares from the stock exchange on behalf of his
client, he may update the client‟s demat account accordingly or, if the delivery is in
physical form, send it to the Registrar and Transfer Agent of the company for
effecting the change in ownership. In case of dematerialized or dematted trades,
these changes are also reflected in the electronic databases maintained by the
National Securities Depository Ltd. (NSDL) and Central Depository Services
Limited (CDSL) (Question 112 has more on NSDL and CDSL).

Although it is said that the stock exchanges receive and give out securities and
cash during pay in and pay out, in reality, the settlement, pay in and pay out are
done by the clearing houses associated with the stock exchanges and not by stock
exchanges themselves.

National Securities Clearing Corporation (NSCCL) and Bank of India

Shareholding Ltd. (BOISL) are the clearing houses associated with NSE and BSE
respectively. These two clearing houses also assume the counter-party risk for
each broker and guarantee financial settlement. Such a guarantee is essential for
the investors to have confidence in the system and to be assured that the trades
undertaken will be honoured or settled. The clearing houses transfer the securities
and the funds to brokers who in turn transfer them to the investors through the
clearing banks.

Over the years, due to efforts on the part of SEBI, the proportion of securities
traded in physical form has steadily declined and at present, almost 99.9% of the
trades are settled in demat form under the T + 2 settlement cycle.
Lewis Carroll on T + 2 Settlement in Indian Stock Exchanges
(with apologies in Creature with a Long Beak)
No Admittance till the day after next!
61. What is margin trading?

As already seen, one can buy or sell shares in the cash market only if one has
adequate money or if one owns the stock. However, under margin trading, it is
possible to buy shares even if one does not have the required money or sell shares
without owning them.

Interesting – is not it? It works like this. Suppose, one wants to buy a promising
security today so that when its price rises sufficiently one may sell it for a profit.
However, as the money necessary for buying is not available, a loan is raised for
this purpose. If in the future the price of share does increase as anticipated, one
can sell the share and repay the loan along with the interest. Thus, the increase in
the price of the share minus the interest on borrowing will be the profit. However,
if the price goes down contrary to expectations, there will be a loss.

Similarly, when the price of a share is expected to go down in the future, it is

possible to borrow a share certificate from a lender and sell it. When the price falls
as anticipated, the share is purchased at the reduced price and the share certificate
returned to the lender along with a fee for the borrowing. Thus, the fall in the price
of the share minus the borrowing charge for the share certificate will be the profit.
If, however, the share price goes up contrary to expectations, one will suffer a loss.

Margin trading is the mechanism that facilitates the borrowing of money and
shares for the investors. Under this system, one can buy shares of a company by
paying only a part of the total value of the shares as margin, while the rest is
financed by the broker and hence the term, margin trading. Naturally, the broker
will charge an interest for providing the loan and retain the shares thus purchased,
as collateral. In practice though the broker may have arrangements with private
financers who will fend the money required for such trading.
Margin orders are intended for squaring off within the agreement period. Hence,
if one bought some shares of a company, one has to sell an equivalent number of
shares of the same company or vice-versa, prior to settlement. It is important to
remember that margin trading leverages one‟s position enormously and is a
double-edged sword; it is possible to make a big killing; but one may also lose
one‟s shirt.

62. How exactly does one engage in margin trading?

Here is how. Assume that one has Rs. 1,00,000/- to invest in a stock with a market
price of Rs. 50/- per share. One may either buy the stock in the cash market or
through margin trading.

As seen earlier, the cash market does not permit trade beyond one‟s current
capacity and without taking into account any transaction charges, one can at best
purchase 2,000 shares with this money. If the share price increases to Rs. 70/- in
the next two days, these 2,000 shares can be sold for Rs. 1,40,000/- for a profit of
Rs. 40,000/-. On the other hand, if the price falls to Rs. 30/-, there will be a loss of
Rs. 40,000/-.

What happens if this share is bought through margin trading? Assume that the
broker prescribes a margin of 50%. Thus, with Rs. 1,00,000/- as the margin, one
can borrow another Rs. 1,00,000/- from the broker at an interest of say 1% for
every two days and buy 4,000 shares (the broker himself may borrow from banks
or RBI registered non-banking finance companies). In other words, one is
supposed to have bought long or taken a long position on this stock to the extent
of 4,000 shares. If the price increases to Rs. 70/- after two days, the shares can be
sold for Rs, 2,80,000/-. The borrowed amount of Rs. 1,00,000/- + Rs. 1,000/- i.e.
1% interest charged by the broker, is repaid and there is a profit of Rs. 70,000/- on
the investment of Rs. 1,00,000/- (excluding transaction costs). On the flip side, if
the price falls to Rs. 30/- per share, the sale realizes only Rs. 1,20,000/-. From this
realization, the borrowed amount of Rs. 1,00,000/- has thus shrunk to just Rs.
19,000/- and the total loss is a whopping Rs. 81,000/- (not including transaction

Thus, with a 50% margin one was able to trade in double the number of shares
through margin trading and both the profits and losses are nearly double what they
would have been in the cash market. That is why margin trading is considered a
highly risky proposition, particularly for small investors.

If this is so, why does one indulge in margin trading rather than stay with the cash
market, which is safer? One may have a strong belief that the share price will rise
shortly and want to capitalize on this expectation by leveraging one‟s wealth with
a dash of borrowing. If this expectation proves to be true there will be a gain but if
one is wrong there may be huge losses. If for example, the price falls to Rs. 20/-
not only will the entire margin of Rs. 1,00,000/- be wiped out but one may also fall
into debt.

Now what if one was expecting the price to go down, rather than up? How can
this be used to one‟s advantage? Well in such a case one may borrow the stock
from the broker for a fee and sell it. When the price falls as anticipated, one may
buy it at a lower price in the market and return the security along with the fee to
the broker. The difference between the selling price and the purchase represents
the profit. However, in practice one may not do this. Instead what one does is to
short sell the stock which has the same effect as the process described above.

Here is how short selling works in the bourses. Assume that one expects the price
of a stock to go down presently but does not own any shares of this company. The
broker is instructed to short sell 2,000 shares at the prevailing market price of Rs.
50/-. The sale is executed and the proceeds orf Rs. 1,00,000/- go into the margin
trading account of the investor held with the broker. (The short seller cannot touch
it as what he actually sold is thin air). And when it is time to pay in the securities
to the stock exchange, the broker, on behalf of the short seller does so by
borrowing 2,000 shares from anothe4r broker or client or from his own account.
Assume also that the charge for borrowing the securities is 2% for every two days.
Normally, the cost of borrowing stocks is higher than the cost of borrowing money,
as securities are typically in shorter supply than money. Also since this market is
still relatively unorganized, the rates tend to be rather high and vary from broker to

If two days later the price of the stock drops to Rs. 30/- as anticipated, well, one is
in luck. One asks the broker to square the position. This means that he will buy
2,000 shares of the same company at Rs. 30/-, return the borrowed shares along
with 2% borrowing charge (2% on the selling price), i.e. Rs. 2,000/-. Thus, the
profit is Rs. 38,000/- (Rs. 40,000/- being the difference between the sale and
purchase value less the borrowing charges of Rs, 2,000/- for the shares), not
reckoning the transaction charges.

What if the price goes north to Rs. 70/- after two days instead of goes south?
Rotten luck. Squaring the position will mean buying the 2,000 shares at Rs.
1,40,000/- while the sale value is only Rs. 1,00,000/- implying a loss of Rs.
42,000/- (Rs. 40,000/- being the loss on account of price increase and the
borrowing charges of Rs. 2,000/- for the shares0. Again this does not include the
transaction costs. The situation would be a lot worse, if the stock had gone up to
Rs. 80/- or beyond. Many a promising career in stock market has come 5to grief
taking the short selling route. Short selling is thus a dangerous pastime in the
topsy turvy world of stock markets!

In order to trade in such a manner, one must maintain a margin of around 50% with
the broker so that he has a cushion every time when prices go in a direction
contrary to expectations. Thus, if one is short selling stocks worth Rs. 1,00,000/-
one would have been called upon to put in a margin of Rs. 50,000/-. It can be
seen that the margin would have come in handy to absorb the loss of Rs. 42,000/-
if the price had indeed gone up to Rs. 70/- per share.

Thus, irrespective of whether one takes a long or short position (not again the
respective terminology for buying without enough money on hand or selling
without the securities in hand) it is important to maintain a margin account with
the broker. The modalities of margin account are discussed in the next question.

63. How is the margin account with the broker operated?

As already discussed, a margin account must be opened with a broker by

depositing a certain amount of money to enable one to trade in margins. This is
different from the regular cash account that one may have afor trading in the cash
market. Assume that this account is opened with an initial deposit of Rs. 5,000/-.
This may be the minimum balances required to operate the account. With this
margin account, one may now borrow money or shares in order to take a long or a
short position.
Let us consider how exactly the margining system works when one borrows money
for taking a long position (buying shares). If for example, one wants to buy 200
shares of a company with a prevailing market price of Rs. 50/- each, the
investment required will be Rs. 10,000/- From time to time stock exchanges
mandate the maintenance margin amount that is to be maintained by the investors
for margin trading. If in this case, the maintenance margin is 35%, it implies that
there must be at least 35% of total investment, in the margin account while the
balance 65% may be borrowed from the broker. One may borrow less but not
more and a broker is well within his rights to demand that a higher margin be
maintained. This will depend upon the broker‟s willingness to accept risk and
assessment of the client‟s credit-worthiness. In fact SEBI allows brokers the
freedom to decide the margin as long as it is more than what the stock exchange

Assuming that the broker requires a margin of 35% for the share, a minimum of
Rs. 3,500/- has to be deposited in the margin account, if the amount to be invested
in these shares is Rs. 10,000/-. The balance of Rs. 6,500/- may be borrowed from
the broker who will then execute the purchase of 200 shares at Rs. 50/- each on day
T. These shares now become the collateral for the Rs. 6,500/- that is borrowed
from the broker. He will recover (debit) the relevant transaction charges from the
margin account and will also charge necessary interest on Rs. 6,500/- on the
amount borrowed until the long position is squared off by selling the same number
of shares that were originally bought.

However, this is not quite so simple and although the intention is to square off the
position within two days, prices may change overnight. Thus, if on day T, a long
position was taken, the price may go either up or down on day T + 1. If it goes up,
the broker credits the margin account to the extent of the increase; but if the price
goes down, the account is debited and the account balance falls.

Let us assume that a long position is taken and on day T + 1 the price of the share
falls from Rs. 50/- to Rs. 37.50 and goes up again to Rs. 42.50 on day T + 2. On
day T + 1,with the decline in share price, the market value of the investment is
reduced. In other words, there will be a loss if one chooses to square off the
position at this point by selling the shares at Rs. 37.50 per share. On day T + 2,
some of the losses are recovered as the price climbs up to Rs. 42.50. The
following boxes show how the maintenance margin and margin calls work on day
T + 1 and T + 2 respectively.

Margin calculation for short sales is also done in a similar manner, except that in
this case the margin call is paid (debited) when the share price goes up and the
margin account credited when the share price falls.

If on day T 100 shares of a company are sold short at Rs. 225/- each and the
maintenance margin is again 35%, then Rs. 7,875/- is paid as the margin. Once
these shares are sold, Rs. 22,500/- is received but this amount is not credited to the
client‟s margin account, as the shares were borrowed. The broker holds this
amount as collateral against the borrowed shares.

Box 63.1: Maintenance margin with decrease in market value for a long position
on day T + 1;
a Margin available on account
of initial margin Rs.
b Loss arising due to decline in (Rs. 50 – Rs.37.50) Rs. 2,500/-
share price X 200 shares
c Effective available margin a–b Rs. 1,000/-
d Required margin (35%) 0.35 X Rs. 37.50 Rs.
X 200 shares
e Additional margin required/
margin call amount d–c Rs.
f Margin available after the
margin call c+d Rs.

Box 63.2 - Maintenance margin with increase in market value for a long position
on day T + 2:
a Margin available Rs.
b Gain due to increase in (Rs. 42.5 – Rs. 37.50) Rs.
share price X 200 shares
c Effective available margin a+b Rs.
d Required margin 0.35 X 42.5
X 200 shares Rs.
e Excess margin the investor can c–d Rs.
withdraw to his cash account
f Margin available after the d–c

If on day T + 1 the price of the share goes up to Rs. 250/-, it implies a loss since in
order to square off this position, one will have to buy shares of Rs. 25/- higher
than what they were bought for originally. On day T + 2, some of the loss is
recovered as the price falls to Rs. 220/-. This margining is shown in the following

Thus, margin trading positions for investors are calculated daily, based on the
closing price of the security (Question 18 shows closing price and other related
price information) as announced by the stock exchange at the end of the trading
day. Hence in all the examples, the assumed prices are closing prices. Payment for
the margin call is usually made either by cheque or bank account transfer.

This margining process goes on till the position is squared off. T This process of
calculation of maintenance margin is also known as „ marking-to-market margin‟
as the investor‟s open positions are valued at market prices for calculation of the

Since one may be trading in several stocks at any given point in time, and the
prices may go up and down all the time, whenever the account balance falls below
the minimum required maintenance margin level, one may be called upon by the
broker to top up the margin account from time to time. In case the margin falls
below a certain level, e.g. below 30% of the minimum required level, the broker
may sell the stock in the market in order to recover his dues without any prior

Incidentally, not all shares can be bought and sold through margin trading. Shares
that can be traded on margin are specified by the stock exchange and they also vary
the maintenance margin from share to share depending upon the volatility of their
prices. Normally, the higher the volatility, the higher is the maintenance margin
Box 63.3 – Maintenance margin with increase in market value for a short position
on day T + 1
a Margin available Rs.
b Loss arising due to increase in (Rs.250 – Rs.225) Rs. 2,500/-
X 100 shares
c Effective available margin a–b Rs.

d Required margin(35%) 0.35 X (Rs. 250 X 100 Rs.

e Additional margin required/ d–c Rs.
margin call amount
f Margin available after the
margin call Rs.
Box. 63.4 – Maintenance margin with d decrease in market value for a short
position on day T + 2:
a Margin available Rs.
b Gain due to decrease in (Rs.250 – Rs.220) Rs.
share price X 100 shares
c Effective available margin a+b
d Required margin (35%) 0.35 X Rs. 220 X Rs.
X 100 shares
e Excess margin the investor can c–d Rs.
withdraw to his cash account
f Margin available after the
withdrawal Rs.

64. Can one keep one‟s long or short position open indefinitely?
The answer to this is „no‟. It is important to note that currently all margin trading
positions must be squared off on the settlement date, which is day T + 2. In other
words positions have to be squared off on or before the third day from the date of
trading (counting the day of trading as 1). SEBI has also given brokers the
mandate to square off the open positions on their won if investors fail to do so on
the settlement date. In fact, as already stated, the position can be squared off even
g before the settlement date, if an investor fails to pay the margin call. Like
trades in the cash segment, all settlement in margin trading is done by NSCCL and

Given the highly risky nature of margin trading, small investors should properly
understand the risks involved in margin trading. SEBI stipulates that only
corporate brokers with a net worth of more than Rs. 30 million may carry out
margin trading on behalf of their clients. Not all brokers are permitted to provide
margin trading facilities to investors. NSE and BSE have laid down certain
specific criteria like minimum net worth, track record etc. to permit a broker to
provide a margin trading facility to investors. Stock exchanges also require
brokers to provide various other margins depending on the mark-to-market open
position for all clients and the trades the broker may have done on his own
account. These could be „daily margin‟, „ad-hoc margin‟, „special margin‟,
volatility margin‟, carry forward margin‟ and so forth.

65. There was something called „badla‟ trading until a few years ago. What was it
and what happened to it?

Trading in the Indian stock market has undergone unrecognizable changes in the
last decade or so. After a major scam that rocked the country‟s stock market in
1992, extensive changes were undertaken in the trading and settlement processes.
Prior to 1994 when electronic trading of shares were introduced in NSE and shortly
thereafter in BSE, it was the „badla‟ system of trading that ruled the Indian capital
market or rather the BSE, which , for decades, had remained the dominant bourse
in the country.

Actually „badla‟ trading was an antiquated form of margin trading, except that the
system for borrowing money or securities was not quite streamlined. The system
also involved the practice of carrying a transaction forward, something that is
extremely restricted today.

When settlement was due, a buyer borrowed funds and paid interest to the lender .
This was called „contango charges‟ (vyaj badla‟. . Conversely, a short seller
borrowed securities and paid interest on the total value of the security borrowed.
This was called „backwardation charges (undha badla)‟. A unique feature of this
trading mechanism was that the settlement could be postponed indefinitely and
there was no formal margining system. While the system probably had its
strengths and uses, the regulators considered the system lacking in transparency.
Occasionally, or perhaps more than occasionally, some unscrupulous brokers
stretched the system more than somewhat and perhaps this is what led to the major
stock market scam of 1992. SEBI banned the badla system of trading between
1994 and 1996. In 1996, it introduced an improved version of badla trading –
known as „Modified Carry Forward System‟. In 2001, this system too was
completely banned after yet another major scam rocked the capital market. This
ban led to the introduction of T + 5 period of rolling settlement explained earlier.

In the last five years, the settlement period has been reduced to T + 2 and may not
be too long before the international norm of T + 1 settlement is adopted. Margin
trading in its present form was reintroduced in 2004, and while it is similar to badla
trading, it has more stringent disclosure norms, norms for margin payment,
settlement cycle, etc. For example, the current margin of trading system requires
brokers to disclose their position vis-à-vis each client, scrip and lenders, to the
stock exchanges on a daily basis. This provides the basis for the various other
margins that are applied in order to minimize defaults or other wrong doing on the
part of brokers.

66. What happens if the electronic communication fails during trading hours?

Normally the electronic systems have several layers of protection to ensure that
communication failure does not occur. The systems are capable of handling
different kinds of exigencies, such as, security of data, interruptions in power
supply, computer crash etc. However, there are still days when the trading
terminals come to halt as a result of natural causes. During an equinox (around
the third week of March and September). VSAT links do not function properly
when solar flares interfere with satellite transmission between the satellite station
and earth. On these days trading comes to a temporary halt for about 45 minutes or
thereabouts around 11.00 am. The trading hour is then extended by 45 minutes in
the afternoon. Indian Space Research Organization (ISRO) informs BSE and NSE
about the sun outage dates and the durations during these two months. BSE and
NSE in turn communicate the change in the trading timings to the brokers.

67. Essentially, margin trading, like its older cousin the badla trading, is

Speculating in the stock market may or may not be a dubious pursuit; but it is
definitely one that is rather misunderstood.. The editor of a leading newspaper
once compared politicians to „loan sharks and stock market speculators‟ (we are
not aware of speculators have objected to their being compared with politicians).
Little wonder then that in spite of the immense popularity of stock market
operations in recent years, the term speculator still evokes a mixed reception.
Since epithet seems to be considerably value loaded, it must be understood in its
proper perspective.

The term „speculation‟ refers essentially to the high default risk arising from
indiscriminate trading based on anticipated price movements. Default risk refers to
the possibility that due to large-scale fluctuations in share prices, buyers or sellers
may fail to meet their financial commitments thus creating a wave of defaults in
the market.

Essentially, a speculator differs from an investor in that the former participates in

the secondary market with the sole intention of making money by anticipating
price fluctuations of shares while the latter invests in shares with the intention of
holding them for a long period in order to benefit from the operations of the
company he invests in. For this reason, a speculator may have relatively little
interest in taking or making delivery of shares either purchased or sold by him.
Hence, a speculator is generally more active in trading in margins than in the cash
market. The reason a speculator is viewed with suspicion is because large-scale
speculation leads to huge volatility in market prices, which in turn could result in
terrible losses for investors.

There may be two kinds of speculators – those who trade within the boundary of
their wealth and those who trade beyond their wealth level. The former do not
cause any harm to the market mechanism. In fact, they inject extra buoyancy into
the markets. It is the second category of speculators, with insufficient wealth to
enable them to honour the commitments arising from their transactions, who bring
in the element of default risk and bring the market into disrepute. For the purposes
of this discussion, the former are termed as „cautious‟ while the latter are called
„reckless‟ speculators.

The reckless speculators depend greatly on their expectations of price movements

and/or lady luck. If events turnout as expected, they make a „killing‟ far beyond
their previous wealth level. However, should events turn out otherwise, they
default on their obligations, since their wealth is inadequate to cover the attendant

It may be argued that there is nothing intrinsically wrong with being a speculator,
or in being interested in short-term gains arising from price movements of shares.
What is wrong is reckless speculation i.e. speculation beyond ones means and the
exposure of oneself to the risk of insolvency. Such speculation cause wide
fluctuations in prices and consequent large-scale defaults can drastically erode the
confidence of t5he investing public in the institution of capital markets. However,
in recent years, the problems arising from such volatility have been significantly
curtailed with measures like „circuit breakers‟ etc.. (Question 69 has more on
circuit breakers).

Paradoxical as it may appear an element of speculation may in fact be good for the
capital markets. Firstly, speculation gives extra buoyancy or volume to trading
activity in the secondary market, which is the very purpose of settlement trading .
Secondly, since the speculators make their living by predicting price movements of
shares, they have the incentive to understand the company, market conditions and
the economy more carefully. Due to their participation in the market, the prices
are relatively better determined and to that extent their presence in just the right
quantity gives the market a great flavor?

Margin trading in its current form addresses many of the ills that dogged the old
badla trading vis-à-vis speculation, so that the nuisance caused by reckless
speculators has been by and large contained. Since margin trading enables
investors to trade in greater volumes, the margin system, like the badla system
earlier, provides greater liquidity to the securities in the secondary market but
without the serious ills of the latter. This in turn helps in „better pricing‟ of the
shares, resulting in thinner bid-ask spreads. Thus, prices are neither too high nor
too low; instead they represent fair values. It is well-known that the best prices are
achieved only unde3r situations of intense competition. Since margin trading
enables a larger number of traders to transact in a larger volume of shares, it
provides more competitive conditions. The prospect of intense trading in the
secondary market and the consequent liquidity of a share in turn ensures
successful issuance of that share in the primary market. Thus, good companies
with shares that are very liquid or actively traded do not find it difficult to raise
money from the public whenever required.

In other words, margin trading helps generate an active secondary capital market,
which in turn strengthens the primary capital market, thus facilitating productive
investment in the economy. However, the mere mechanism of margin trading
alone cannot generate the interest of the investors in a security. When a company‟s
performance is good and its shares attract the attention of investors who trade
actively in them, it creates some basic competitive conditions. It is only then that
the share may effectively benefit from margin trading. For this reason not every
company‟s share qualifies to be traded on the margin in India.

68. Is all price volatility due to speculation?

Not all large price fluctuations may be a result of speculation. There are many
other factors that may cause large swings in security prices. For example, the
price of share may rise steeply if somebody is trying to takeover a company by
buying large quantities of its shares in the market. Once the details of such a
takeover bid becomes public, several other investors also start buying the shares
and the price of the share increases further. For reckless speculators, this may be a
god sent opportunity to aggravate the situation further.

At times, there may be unusual buying or selling activity in the share of a company
due to knowledge of inside information on the part of some, such as its plan to
enter into a profitable collaboration with another company aor other sensitive
information. Some senior members of the company‟s management are most
certainly likely to know of such information much ahead of the general public.
Based on this inside information, these members may indulge in speculative
buying of the company‟s shares, with a view to selling the shares when this
information becomes public and the share price rises. As the volume of individual
transactions in such cases often tends to be large, the fluctuation in share prices
also tends to be greater. This kind of trading that is based on inside information is
known as „insider trading‟ When insider trading prevails, a few individuals with
prior inside information tend to make large fortunes at the cost of common
investors. The resulting wide fluctuations in share prices baffle the common
investors and this tends to erode the faith of the investing public in the institution
of capital markets in general. Channeling of savings into the industrial sector
becomes that much more difficult hampering industrial development.

Unfortunately in India, even though the rules and regulations exist against insider
trading, their enforcement like the enforcement of any law in our country, is rather
weak and the practice abounds. Nor may it be restricted to unscrupulous traders in
the private sector villains alone. Most of the top financial institutions and giant
insurance companies hold massive investments in the corporate sector. By virtue
of this, these institutions are represented on the boards of these companies.
Whether or not these government institutions are also guilty of insider trading is
anybody‟s guess, especially since they are themselves under pressure regarding
their performance, which is mainly related to profitability.

Another factor affecting large price fluctuations may be related to the floating
stock available in the market for trading. In India, financial institutions hold
approximately 35% of the shares of a company and the promoters and controlling
groups closely hold (i.e. in close control and not easily available for sale) another
30-35% Only the residual (of about 30-35%) may be truly regarded as being
available for public trading. Given the increasing public interest in the capital
markets in recent years, it is reasonable to believe that the floating shares
available to the public for trading are far from adequate. When financial
institutions (with or without inside information) decide to buy or sell vast numbers
of shares of any company at a time, the huge changes in the supply and demand of
the shares undoubtedly adds to the fluctuations in its share prices.

Thus, non-availability of an adequate number of floating shares, takeover bids,

insider trading, large volume operations by financial institutions and mutual funds
etc. with speculators may all be equally responsible for the observed imbalances
and fluctuations in stock prices. The ability to diagnose the exact cause of price
fluctuations is of considerable importance for taking appropriate remedial actions.
Perhaps it is the inability of the bourses and regulators to separate the effect of
each of these on the price volatility that has led to the „popular wisdom‟ that
speculation is at the root of all price volatility in the markets.

69. How do the regulators control price volatility? What are circuit breakers and
how do they help to reduce price volatility?

Regulators dislike price volatility in capital markets as high degree of volatility

scares genuine investors away from the market. Regulators, therefore, lose a lot of
sleep containing the gene of volatility under the lid. Apart from the different kinds
of margins discussed, one of the most important pieces of artillery regulators
deploy in their war against speculation is the „circuit breaker‟

Circuit breakers or trading halts are imposed by stock exchanges to limit trading in
wildly volatile shares. Circuit breakers work like an electrical circuit reaker, which
is a safety mechanism that cuts off the power if the voltage exceeds a certain limit.
Without it, spikes in current would wreak havoc on appliances and may burn down
the house. The circuit breaker in the stock market works on a similar principle. It
halts trading when the price fluctuates beyond a certain range lest the market
should get overheated in either direction and causes a potential havoc of defaults.

Circuit breakers may be imposed on individual shares based on the movement of

share price and/or on the market as a whole, depending upon the fluctuation in
stock index. The market wide circuit breaker is controlled by SEBI, while stock
wise circuit breakers are controlled by the stock exchanges. For stock specific
circuit breakers, price fluctuation beyond a certain range (either way) brings
about a halt in trading for the remainder of the day. Currently, three categories of
price changes invoke the circuit breakers, viz. 2%, 5% and 10% on a single day,
for different specified shares. These are called „price bands or price filters‟ . For
example, if a share falls under 5% band or filter and as share price fluctuates so as
to touch the 5% band on either side (e.g. a Rs. 100/- share crossing Rs. 105/- or
Rs. 95/-), the circuit breaker is activated and the shares are not available for trading
for the rest of the day. These triggers are of course, liable to change from time to
time and the stock exchanges regularly announce these on their changes.
Similarly, SEBI imposes market-wide circuit breakers called „index-linked‟
circuit breakers, depending on the movement of indices. Currently, a market-wide
circuit breaker is applied at three stages of the index movement either way – at
10%, 15% and 20%. The indices considered are both Sensex and Niafty.
Movement of either of the indices (whichever is breached earlier) triggers the
circuit breakers. When this happen in either of the indices, the trading halt applies
to all the exchanges in the country – bringing all the bourses to a grinding halt.

SEBI mandates not only the circuit breaker for indices, but also the duration of the
trading halt. For example, when a 10% circuit breaker is triggered, all trading in
shares in all the bourses in the country halts for one hour, before 1.00 pm and for
half-an-hour between 1.00 pm and 2.30 pm; and is resumed thereafter. Similarly,
for a 15% circuit breaker, the trading halt increases to two hours before 1.00 pm
and one hour from 1.00 pm to 2.00 ;m respectively. For 20% circuit breaker, the
trading is suspended for the rest of the day.

Incidentally, the price bands for individual shares for trading halts are based on the
opening price of the day. However, the index-based circuit breakers are converted
into absolute indices at the end of a quarter and remain in place for the next three
months. For example, if BSE Sensex closes at 7,852 points on September 30, the
10% market-wide circuit breaker will be triggered if the Sensex swings by more
than 785.2 points in a single day, any time in the next three months - i.e. up to
December 31.

70. Do circuit breakers have a flip side?

Everything has a flip side and circuit breakers are no exception. A gun may be a
great protection against an enemy; but it is with a gun that the enemy shoots us as
well! Though stock exchanges put in place „circuit breakers‟ to reduce the
volatility in stock prices, there are times when the intervention acts negatively. For
example, one may argue that trading halts are meaningful when price changes are a
result of manipulations but when pure market forces are the cause of the volatility,
stock specific circuit breakers merely delay the process of price discovery.

In fact some believe that they do more harm than good, since circuit breakers
encourage people to exit faster than they would otherwise, particularly in a
downturn, thus worsening the panic. Also, by interfering with the price discovery
process irrespective of the reason for that interference, they go against the grain of
capital market efficiency. An efficient stock market in one where stock prices
quickly adjust to any new information. In case of circuit breakers, this happens in
bits and pieces over an extended period of time. This, it is argued, imposes
additional cost on investors – particularly small investors, who are normally among
the last to know about major corporate actions – and they are penalized unduly by
not being able to trade during the trading halts.

Tow-way circuit breakers are unique to the Indian stock market. In more mature
capital markets, circuit breakers are imposed only during major bear runs i.e. the
downward movement of the market. This is because of the belief that a sharp fall
in the market is probably due more to panic of investors than to a fundamental
correction. Trading halts help panic-stricken investors to calm their nerves by
giving them time to adjust to the market.

Even though circuit breakers do temporarily hinder continuous trading and delay
the price discovery process, circuit filters help in checking excessive speculation
and violent price fluctuations which ultimately benefit the investors.

The two-way circuit breakers in India are probably driven by fears, either real or
perceived, that bull runs are more likely a result of market manipulations. Hence,
the concern that when the markets returns to equilibrium, prices may drop and the
straight investors who took long positions are sure to lose money as well as
confidence in the capital market. The fact is that there have been situations when
during extraordinary bull runs (upward spiraling prices) even investors who went
short were in serious peril as they were unable to deliver the securities they had
sold short thus, putting the entire market mechanism in disarray. Besides, there is
no reason to believe that Indian investors do not need to cool off their euphoria
over a bull run, just as they do to get over their panic in a bear run. Perhaps,
therefore, the regulators are justified in their action even if it is relatively unique.

71. What are the other measures authorities use to curb excessive speculation?

To begin with, the authorities may impose a higher daily margin on the settlement
trading (and sometimes even on the cash trading) of the concerned security. They
may stop day trading and margin facility in a scrip and move the scrip to the trade-
to-trade segment. Trade-to-trade requires traders to take delivery of share
certificates and make payment for the purchase before the next settlement date,
unlike in day trading where investors can square off the transaction on the same

SEBI also requires insiders, namely directors and employees of companies to

preserve unpublished price sensitive information with strict confidentiality or
release such information in a manner that no section benefits unduly at the cost of
others. It also requires the directors and employees of a company to seek formal
approval of designated authorities if they intend to buy/sell shares of the company
beyond certain prescribed limits. In addition companies must appoint compliance
officers to ensure that the directors and employees adhere to the regulatory
requirements. SEBI has also defined the concept of temporary insiders
indicating persons connected with the company by virtue of being consultants or
business associates and thus having access to price sensitive information.

SEBI‟s Electronic Data and Information Filing System (EDIFAR) system is a

great step towards dissemination of price sensitive information. Listed companies
in India file information such as financial statements, corporate governance
reports, shareholding pattern, action taken against the company by any regulatory
agency etc.. The system helps in increasing the transparency by making available
the right information equitably and at the same time, to all. As the company is
required to file the information concerned directly and this is then available for
verification to all investors, the scope for rumours and consequent price
fluctuations are minimized.

To curb excessive speculation, stock exchanges may impose higher margins for
buying/selling of shares than usually permitted under margin trading. In addition,
RBI in consultation with SEBI may direct banks and NBFCs (Non-Banking
Finance Companies) to charge higher interest rates for loans provided for margin
trading during overheated conditions in the market.

In 2003, SEBI also introduced the unique identification program under MAPIN
(Market Participant and Investors Database) to trace the trades ahead of any
public announcements of activities relating to a company and check if they can be
connected to any insiders. MAPIN is a database of individual investors where
distinguishing feature of individual investors is their fingerprints. Though
introduction of MAPIN has been slow on account of various policy issues and
objection to fingerprinting by a majority of investors, it is an important milestone
towards prevention of insider trading and other stock market malpractices. If
implemented properly, it can curtail insider trading and market manipulation

SEBI also has the power to undertake search and seizure of books, registers and
other documents maintained by stockbrokers and other intermediaries if it finds
that they may be abetting insider trading and manipulation. SEBI is also
empowered to levy fines up to Rs. 250 million if it finds that they are guilty.

Apart from these measures, SEBI is also implementing various surveillance

system and processes to analyse the trading data in order to detect any unusual
activity on the part of a trader or stockbroker.

Even with these powers, SEBI does not have the judicial authority to enforce its
decisions and penalties, which can be appealed in the Courts of Law and before
the Securities Appellate Tribunal of the GoI.

Notwithstanding SEBI‟s efforts, a good Indian corporate or individual is nothing if

not an innovator of circumventing regulations. Thus, in spite of all these stringent
measures, in early 2006 several financial institutions and banks were found guilty
of large scale scams involving multiple applications in „benami‟ names in the IPO
of Yes Bank with manipulated amount running into thousands of million rupees.

72. Securities traded in BSE have been classified into “A”, “B1”, “B2”, F and Z
category etc.. What do they mean? Does NSE have a similar categorization as

Ordinary shares listed on the BSE are divided into six groups and debt securities
into two groups as follows:

While A, B1 and B2 categories in Table 72.1 (below) are self-explanatory, the

shares in C group need some elucidation. This category is used for trading in
physical shares in smaller lots or odd lots of companies in A, B1 and B2
categories. This offers an opportunity of selling physical shares in compulsorily
dematerialized scrips and is called the „exit route scheme‟.
Often, small investors may hold a small number of physical share (e.g. 100 to 200)
which have compulsorily to be traded or delivered in demat form only. In such
cases, these investors may not find it economical to open a demat account just for
this purpose. Investors can sell up to 500 shares of any company by using this exit
route scheme. Understandably, however, the realized price per share of a company
in C group is normally lower than the same shares traded in demat form, as the
liquidity in C category is usually much less.

Table 72.1 - Grouping of Shares and Debentures:

Category Nature of Security Specific Nature
A Ordinary shares of companies with large Margin trading and
capital base, large shareholder base, good day trading is allowed.
growth record with regular dividends and
high trading volume in secondary market.

B1 Ordinary shares of companies of having Cash trading and day

less liquidity but with good management trading is allowed but
and satisfactory growth prospects. Not margin trading.

B2 Ordinary shares other than A & B1 Cash trading and

shares trading is allowed
not margin

C Physical shares of companies in A, B1, Trading has to be

B2 categories delivery based.

T Ordinary shares of companies under Trading has to be

watch by BSE surveillance committee delivery based.
Z Ordinary shares of companies not conform- Trading has to be
ing to certain requirements of BSE delivery based.

F Non-convertible debentures

G Central and State Government securities


T group known as trade-to-trade segment, lists shares of companies where each

trade culminates in delivery. Buy and sell orders for a given company cannot be
netted as each trade is settled separately and day trading is not possible in this

BSE regularly shuffles the shares in A, B1 and B2 category and transfers some of
them to T category and back from time to time. For example, in December 2004,
BSE shifted 136 companies to T category and moved 136 other companies from T
segment back to their original segments. Shares are shifted to T category when
stock exchange authorities have an indication of possible rigging of the stock
prices or when they perceive sudden spurts in volumes traded, indicating unusual
or suspicious trading activity. As such buyer has to take delivery of the number
of shares bought, this acts as a deterrent for speculation but does not stop genuine
investors from trading in the shares.

Z group introduced in 1999 lists shares of companies that have failed to comply
with listing requirements of BSE, failed to resolve investors‟ complaints, did not
pay the listing fees or did not publish their audited annual reports etc. Table 72.2
lists the seven criteria considered by BSE for determining the Z category. Non-
compliance of any three leads to a company being moved to this category.

Table 72.2 - Criteria for BSE Z category:

Criteria afor BSE Z category:

Not giving required notice of book closure and record dates

Not submitting its annual reports

Not submitting quarterly shareholding pattern

Not paying annual listing fee

Not publishing audited/unaudited results on a quarterly basis

Non-redressal of investor‟s complaints like dividend payment, bonus, rights issues


Non-implementation of corporate governance code.

Source:; as on March 14,2006.

Shifting a company to the Z group by the BSE is a way of penalizing erring

companies and conveying a clear signal to potential investors that the company
has not been good corporate citizen and investors should, therefore, exercise
caution and care before investing in these companies. Companies in Z category
are also traded like those in the T group i.e. trade-to-trade mode.

The F group is for debentures while G group is reserved for Central and State
Governments securities.

In NSE, bonds and debentures are not specifically categorized as in BSE.

However, their trading and settlement mechanism is more or less similar. For
example, equity shares are categorized as „listed‟ and „permitted‟ Listed shares
constitute equity shares of companies which are listed at NSE while permitted
shares are the shares of companies listed in either stock exchanges but permitted
to be traded as NSE. Again, from among these two categories , some shares are in
the trade-to-trade segment while others may be traded through margin trading.
NSE also permits physical shares to be traded to a limited extent. Preference
shares, bonds and debentures and warrants are categorized and trade separately.

73. What is the recourse available to investors regarding their complaints against

Basically, the complaints of investors against companies generally relate to:

- Late or non-receipt of refund order;

- Late or non-receipt of allotment letter;

- Late or non-receipt of share certificates, mutual fund units (even in demat


- Delay in transfer of securities;

- Non-receipt of letter of offer following right issues;

- Late or non-payment of dividends for shares as well as mutual fund units;

- Late or non-payment of interest on debentures;

- Late or non-payment of principal on redemption etc..

The Companies Act, 1956 provides for several in-built protection measures for
investors in virtually all these cases. For instance, according to the Companies
Act, a company is obliged to refund the oversubscribed amount within a specific
number of days of the amount becoming due. Nevertheless, it is not uncommon
for investors to face problems from companies in this regard. Many of these
companies come under the jurisdiction of SEBI and investors can complain
directly to SEBI in writing regarding these. However, SEBI advises investors to
first try and settle the matter with the company and approach them only if the
problem remains unresolved. When complaints are outside their jurisdiction,
SEBI directs investors to the appropriate authorities such as the RBI, the stock
exchange, Department of Company Law Affairs, Registrar of Companies etc..

SEBI also publishes the status of investors grievances and the redressal statistics
fortnightly. It also publishes the name of the companies alongside the nature of
grievances and identifies these with the maximum number of grievances etc..
Often it also imposes fines on companies for failing to redress investors‟

All listed companies are required by SEBI to appoint compliance officers to liaise
with it on matters relating to investor grievances. The importance of redressing
these complaints may be judged from the fact that the corporate governance code
requires companies to have a shareholders/investors grievance and share transfer
committee, besides the audit and remuneration committee.

Shareholders may also write to the stock exchanges where the shares are traded
about their grievances. Both BSE and NSE have Investors‟ Services Cell (ISC)
and Investors‟ Grievance Cell (IGC) respectively which formally takes note of the
investors grievances and initiate suitable action. Upon receipt of grievances, they
get in touch with the companies to address the issue. If a company does not
address the grievance within a designated time period, the stock exchange has the
power to suspend trading in shares of the companies or to transfer them either to
the Z category or to the trade-to-trade segment.

Several towns and cities have shareholder associations and membership of these
provides yet another avenue for investors to lodge their complaint, with the support
of others with similar grievances. Hence it is worthwhile for a serious investor to
become a member of such an association . However, the association must be
recognized by SEBI and have a track record of committed work.

The internet has made the sharing of problems with others with similar experiences
and problems much easier and aggrieved shareholders can use this as an avenue for
exerting pressure on erring companies.

Lastly, a vigilant and responsible financial press also plays a significant role in
bringing errant companies to book. Perhaps, there is a greater need for the
industry itself to evolve more stringent self-regulatory guidelines and to recognize
that free market regulation and self-regulation go hand in hand.

The Walrus on Shareholders‟ Problems
( w.a.t. Lewis Carroll in Through the Looking Glass)

“ I weep for you‟, the Walrus said:

“ I deeply sympathize”
With sobs and tears he sorted out
Those of the largest size,
Holding his pocket handkerchief
Before his streaming eyes.


74. What is the remedy for complain5tsa against brokers?

There has been a remarkable change in the way investors interact with brokers.
Due to the emergence of electronic trading of shares and demat accounts, many
investors today can afford the luxury of sitting in front of their computers and
execute trades. The transparency and efficiency of the trading mechanism as a
result of electronic order matching, demat accounts and improved clearing and
settlement procedures have brought in a sea-change in the quality of the market
environment that investors face today. In fact execution of orders at unfair prices
is now rare. However, this does not exclude all problems related to trading.
While some complaints are the same as before, new ones have replaced others.
Typical complaints against stock exchange members frequently relate to:

+ Non-receipt or delays in receipt of funds after sale of securities;

+ Non-receipt or delay in receipt of securities after purchase;

+ Non-receipt of dividend/interest/bonus etc.;

+ Non-issuance or non-receipt of contract or purchase/sale note;

+ Excess brokerage charged by the trading member/sub-broker;

+ Non-confirmation of trades (contract note/confirmation memo)

conducted on the exchange;

+ Misuse of the power of attorney (POA) vested by investors in

the brokers to operate their bank and demat accounts.

The last item is a recent phenomenon. By granting brokers with a POA, many
customers empowered their brokers to trade using their demat accounts and to
operate their bank accounts. The POA gives the brokers unlimited power to trade
and there are instances where brokers have misused this power by taking
speculative buying and selling positions on behalf of their clients.
For all such complaints against brokers or sub-brokers, investors can directly write
to the concerned stock exchanges. The Investors‟ Services Cell (ISC) and
Investors‟ Grievance Cell (IGC) which are the investor grievance arms of BSE and
NSE respectively formally takes note of these and attempts to address them.

When complaints are brought to the notice of the stock exchange authorities, they
usually caution the erring broker to adhere to the rules and norms. If, however,
the dispute is serious, the authorities may also call for the verification of books,
records or deals made by the broker.

Each stock exchange also has its own arbitration mechanism and all contracts
made are subject to arbitration proceedings as provided under the relevant bye-
laws. Whenever a dispute arises among members, the matter may be referred to
the arbitration committee who help to resolve it. Stock exchanges normally have a
panel of arbitrators and investors and brokers can choose from among them.

Generally, disputes are resolved within three months and if no arbitration

proceedings are filed within three months of the origin of a dispute, it becomes

Most stock exchanges also have investor protection funds, which are used for
compensating a genuine investor in case of default of payment or delivery of
shares by a member broker. Both BSE and NSE have an Investor Protection Fund
(IPF)/Customer Protection Fund (CPF) and Trade Guarantee Fund to make good
the losses suffered by by an investor if a broker or sub-broker fails to settle after
execution of the trade. Stock exchanges also have guidelines for utilization of
IPF/CPF and afor fixing compensation limits. Special officers are also appointed
by stock exchanges to deal with investor complaints.

While the regulators and bourses have achieved a great deal with regard to
investor protection, the fact is that the current penal provisions for errant brokers
who violate prescribed norms are far too mild to be an effective deterrent. A visit
to the website of the SEC (the US regulator) shows the severity of penalties
awarded even for the slightest misdemeanor. It is well known that companies have
been fined several hundred thousand or even millions of dollars for inadvertently
shifting a decimal place while reporting financial information. Often companies
pay without contesting the fine but at the same time without admitting their guilt.
However, the extent of financial penalty ensures that they exercise greater care in
the future.

Closer home, one would like to see more vigorous measures on the part of the
Government and Stock Exchange authorities, SEBI is well aware of this problem
and most of its guidelines concerning the functioning of securities market
intermediaries have investor protection uppermost in mind. One of the tasks
before SEBI is also to promote and guide self-regulatory organizations to
encourage greater investor protection, which today is still a far cry.

Even without any specific complaints from investors, SEBI frequently investigates
suspected market manipulations by intermediaries. In the beginning of 2006, it
barred 13 companies from trading in Yes Bank shares for manipulation of the IPO

In the final analysis, however, the best investor protection is investor education.
The stock market is not a playing field for the ignorant; particularly not the
ignorant small investor! During the stock market boom of the early nineties, it
was rumoured that someone in Saurashtra was delivered a school leaving
certificate in lieu of a share certificate and the buyer accepted it. Whether the
anecdote is reliable or not, the message is clear; investors must be better educated
in the affairs of the market.

Alice on Investors and Brokers
(w.a.t. Lewis Carroll in Alice‟s Adventures in Wonderland)
I passed by the bourse, and marked, with one eye.
How the Bull, the Bear and the Broker were sharing a pie.
The bull took pie-crust, and gravy and meat,
While the Bear had the dish as its share of the treat.
When the pie was all finished, the Broker as a boon:
Was kindly permitted to pocket the spoon………
75. How can an investor educate himself suitably?
You can start with reading this book! But apart from that, it is essential that
investors make it a habit to read some serious business periodical or financial
daily in order to get a feel for the market. The website of companies provide
detailed information about their financial performance, the industry and
competitors. Many investment newsletters or analysis by popular business
channels on TV can be misleading so it is essential to be guided by someone
knowledgeable who can also recommend relevant reading material. Most cities
are likely to have a local management association where brief weekend sessions on
investor education are conducted. Many reputed institutions also conduct investor
education programmes from time to time.

SEBI has been in the forefront of promoting investors‟ awareness and education.
It frequently conducts various shareholder awareness programs to educate
shareholders of their rights and responsibilities etc. and also extends financial
support to various investor forums registered with it, for conducting such seminars
and workshops. Today, even blogs on the internet give some interesting views
about various companies and their activities.


76. What are mutual funds?

A mutual fund is a common pool or fund of capital mobilized from a large number
of investors and invested on their behalf in several securities in the market. All the
returns from such investments, both in terms of dividends and capital appreciation,
net of various incidental expenses, accrue to the investors.

A mutual fund provides many financial and non-financial benefits to the investors.
Like shares, all mutual funds provide returns in the form of dividends and capital
appreciation and even bonus issues. But by far the most significant benefit is one
of risk reduction or risk diversification.

When one invests in the stock of any one company, one is exposed to several
random risks. For instance, the company may go bankrupt, it may suffer huge
unexpected losses or the management may not be honest or efficient. Investing in
a mutual fund protects investors from such random or non-systematic risks.
How does this protection work? It is well known from one‟s grandma that one
should not put all one‟s eggs in a single basket. Thus, any investment portfolio
must be well diversified. It is difficult for a small investor or diversify the
investment over 30 or 50 different securities or more. Also being lay persons, it
may be wiser to leave the selection of securities to an expert agency. This is where
the mutual fund steps in by pooling together investments from a large number of
small investors and then investing the accumulated proceeds in a well diversified
basket of securities. Thus, investors get the benefit of diversification without
actually doing to themselves.

It is, therefore, usually better for small investors to invest in a mutual fund
directly rather than invest in 30 to 50 securities on their own. The capital
required for investing in several securities on one‟s own is considerably higher
than that needed for investing in a mutual fund. For example, if one wants to
invest Rs. 10,000/-, it is not sufficient to build a diversified portfolio. However,
this amount can be easily invested in a mutual fund, which typically invests in a
large number of companies.

Thus, a mutual fund offers the benefit of diversification even at a lower level of
investment. As a consequence of wide diversification, its expected returns tend to
be lower and less volatile than the returns from any security.

Furthermore, transaction costs for the investors tend to be lower while dealing with
a single mutual fund as against transacting in a large number of securities. There
is also no need to research or track a large number of different companies or
regularly keep a check on the dividend returns from dozens of different companies.

Thus, much of the value of mutual funds to small investors comes from risk
diversification or risk mitigation, professional management, switching among
schemes, affordability, liquidity, lower transaction costs, research, international
investment facilities etc..

Mutual funds render a large range of service that are not available to an investor
who invests in securities directly. A mutual fund is thus, as much a financial
product as a financial service. Of course, the services rendered by a mutual fund
are not free. Nothing worthwhile ever is .Unit holders have to pay for the
recurring transactions, annual fees, entry and/or exit loads and so forth,
irrespective of whether the fund generates returns or not!

All this should not create the impression that mutual fund investments are only for
small investors. Large entities including banks, insurance companies and financial
institutions routinely invest in mutual funds.

Investors subscribe to units of a mutual fund just as shareholders subscribe to

shares of a company. Also a mutual fund, like a company, does not guarantee any
dividend. Mutual fund managers use their discretion to decide whether or not to
declare dividends, based on the profitability of the fund, market conditions etc..
Even when they do so, the dividend per unit may vary from period to period and
these variations may be considerably higher than in the case of shares. This is
because companies normally like to smoothen out the equity dividends over a
period of time. This means that they strive hard to maintain dividends even in a
bad year to convey the impression to the market that all is well with the company.
But such considerations do not constrain mutual funds since their major pre-
occupation is to provide well-diversified portfolio returns, whatever they may be.
Mutual fund dividends can be paid only from the revenue income and realized
capital gains of the underlying portfolio and not from previous profits as in the
case of shares.

Each unit of a mutual fund represents a unit-holder‟s proportionate ownership of

the fund‟s portfolio holdings. The investors of mutual funds are known as „unit
holders‟. The companies that operate the mutual funds are known as „Asset
Management Companies – (AMCs)‟ or „Investment Managers‟. Appendix 1 lists
the AMCs operating in India. An AMC may float more than one fund (also called
„schemes‟), each with an objective and investment mandate of its own. The terms
„mutual fund, fund or scheme‟ are often used interchangeably.

77. What are the different categories of mutual funds?

Mutual funds may be categorized in many ways. At the most fundamental level,
mutual funds may be close-ended or open-ended, which are the types of mutual
funds categorized by their structure.
Close-ended funds are3 redeemable funds having a pre-specified life, at the end of
which the capital is returned to the investors. These are listed in the stock
exchange. After one has subscribed the units at he time of the initial public offer,
these cannot be sold back to the AMC until the end of the fund‟s life. Nor can one
buy new units from the mutual fund. However, if one wishes to redeem (sell) the
holdings or buy into such a fund before the date of maturity of the fund, one may
do so in the stock exchange, where the units are listed. Morgan Stanley Growth
Fund is an example of a well-known close-ended mutual fund.

Open-ended funds, on the other hand, have no finite life or maturity period,
having no finite life. They are also far more prevalent than close-ended funds.
They are open for investment and redemption throughout the year. But they are
not listed in a stock exchange. It is the AMC of the fund that offers to sell and buy
the units from the investors at what is called the “Net Asset Value – (NAV)”. New
investors can also buy units of a mutual fund directly from the AMC and not from
the secondary market. So, in an open-ended scheme, the number of outstanding
units varies on a daily basis, while in a close-ended scheme, the outstanding units
at any point in time remain constant. Thus, in an open-ended scheme, the fund size
constantly increases or decreases on a daily basis depending on whether
redemption by existing unit holders is less than subscriptions from new investors
or vice-versa.

The next level classification of mutual funds is based on their characteristics with
respect to the risk level of the asset invested, nature of asset invested, the fund‟s
objective, industry to which the invested assets belong, trading and investment
strategies adopted, structure, frequency of dividend payments and so forth.

Mutual funds, based on an asset class of investment, may be „equity funds‟, „debt
funds‟, „money market funds‟, „gilt funds‟, „real estate funds‟ and so forth. As the
names suggest, equity funds, primarily invest in a portfolio of equity shares; debt
funds in fixed return instruments; money market funds in short-term money market
instruments like certificates of deposit, commercial paper, inter-bank call money
market etc; gilt funds in gilt or bullion or related securities; and real estate funds
invest in real estate.
Growth funds, Balanced funds and Income funds describe the extent of the
combination of different asset classes in the investments. For instance, a growth
fund invests predominantly in equities and very little in debt e.g. a ratio of 80 :
20. Also, a growth fund concentrates more on growing the value of the fund by re-
investing rather than on paying out dividends. An income fund on the other hand
invests in the reverse ratio e.g. around 20 : 80 in equities and debt securities
respectively. The accent here is more on paying out a steady dividend or income
stream. A balanced fund strikes the golden mean, investing in a more or less equal
m ix of equity and debt securities. In general, however, all funds keep a small
fraction, perhaps around 5 to 10% of the corpus, invested in money market
instruments for easy liquidity. This ensures that the mutual fund is able to pay for
the units as and when they come for redemption from unit holders.

Industry specific or sectoral funds focus upon specific industries or sectors. For
example, the sector of focus could be information technology, biotechnology,
pharmaceuticals, banking, emerging stocks, small and medium enterprises, or
even geographic sectors, such as emerging markets, Asia Pacific, India, China and
so forth. For example, a FMCG fund limits its investments to securities issued by
companies engaged in the business of fast moving consumer goods and other
similar businesses. An MNC fund invests in multinational or trans-national
companies. Often the name of a sectoral fund fairly describes the investment
objective of the fund. For example, HSBC Floating Rate Fund Short Term Plan
invests mostly in floating rate short-term debt instruments.

A real estate fund basically invests in real estate properties. Like regular mutual
funds, real estate funds pool money from investors but unlike other funds, they
predominantly invest in securities issued by real-estate companies and in the
absence of these securities they invest in real estate properties. Again, unlike
other funds, calculation of the daily NAVs for these funds is not as straightforward
as the valuation of the underlying investment units. This is because real estate is
typically much more liquid than securities and real estate prices are not available
with as much frequency as securities on a day-to-day basis. Real estate funds are
only just making an entry in the Indian capital market. Recently SEBI spelt out
guidelines for these funds and some AMCs are in the process of launching these
Then there are index funds that invest in companies belonging to specific indices
such as Sensex Nifty.

Schemes or funds may also be characterized by their investment objective. For

example, a fund may be called „Children‟s Fund‟ or „Young Citizen‟s Fund‟ etc.
A children‟s fund may enable parents or relatives to invest with the specific
purpose of generating savings to meet the anticipated expenses of their children in
the future. Young citizen‟s fund may be directed at young professionals. A
dividend re-investment plan may not pay out periodic dividends but may re-invest
the dividends into new units. Typically, these schemes are open-ended in nature
and often carry a lock-in provision, so that the unit holders have to wait till this
period is over before redeeming the units.

Often AMCs suffix their funds with G/ Q/ MD/ WD/ DD along with the name
to indicate a growth plan or quarterly/monthly/weekly/daily payment of dividends
(See Box 77.1 below):

Box 77.1
Name Option
Floating Rate Short Term Plan (G) Growth
Floating Rate Short Term Plan (MD) Monthly Dividend
Floating Rate Short Term Plan (WD) Weekly Dividend
Floating Rate Short Term Plan (DD) Daily Dividend

For example, HSBC Mutual Fund offers the above options for its HSBC Floating
Rate Fund Short Term Plan. Mostly the fund invests in floating rate debt

Incidentally, even when a mutual fund offers a „daily dividend option‟ in reality
there may not actually distribute cash on daily basis. They may simply re-invest
the daily dividend back into the scheme so that additional units are allotted to unit

As stated earlier, a single AMC may offer many different mutual funds or
schemes. Appendix 2 provides a list of various mutual categories of mutual funds
being offered by the HDFC Mutual Fund.

Lewis Carroll on Types of Mutual Funds
( with apologies in Alice‟s Adventures in Wonderland)

“Never imagine mutual funds not to be otherwise than what they might
appear to others that what they are or might have been was not otherwise than what
they had been would have appeared to them to be otherwise‟

78. What are the different kinds of mutual funds available in India?

With the growth of the mutual fund industry in India, the AMCs offer schemes
with many innovative features to cater to different clients. Table 78.1 lists a few of
the schemes along with their objectives that are offered by various AMCs in India.

Even though these schemes have many common features, the AMCs of each of
these try to incorporate some unique features into each fund in order to create a
special appeal for some select group of investors. The offer document of each
scheme of the AMCs, provide this information in greater detail in their websites.

Table 78.1 - Some Schemes Offered by AMCs in India:

Name of the Name of Objective/Nature
Scheme the AMC
CANGIGO Canbank Mutual Open-ended debt scheme with no
Fund assured return
Generates income by investing in a
wide range of debt securities and
money market instruments of differ-
rent maturities and risk profile and a
small portion in equities and equity
related instruments.

Prudential ICICI Prudential ICICI Open-ended liquid scheme

Sweep Plan Mutual Fund Seeks to provide reasonable returns
commensurate with low risk while
providing a high level of liquidity
invests in primarily money market
and debt securities.

Prudence Fund HDFC Mutual Fund Open-ended balanced scheme

Aims to provide periodic returns
capital appreciation over a long
period of time and invest in
mix of equity and debt
with the aim to prevent or
any capital erosion.

Media & Enter- Reliance Mutual Open-ended media and entertain-

tainment Fund- Fund ment sector scheme.
dividend plan The scheme intend to generate
consistent returns by investing in
equity/equity related or fixed
income securities of media and
entertainment and other associated

India Bluechip Franklin Templeton Open-end equity fund.

Fund Seeks to achieve steady and
consistent capital appreciation
through investment in well-
established, large size bluechip

Magnum Taxgain SBI Mutual Fund Open-ended equity linked saving


Seeks to generate return by

investing equity securities and
helps in saving income tax
investments under Section 88.

Tata Young Tata Mutual Fund An open-ended balanced-portfolio

Citizen‟s Fund growth scheme.
The objective of the scheme is to
provide long-term capital growth
while emphasizing capital
tion . Around 50% of the funds
invested in equity capital,
preference capital, non-voting
capital, warrants, convertible
securities of emerging growth
companies. The balance is
in debt securities.

Floating Rate UTI Mutual Fund Open-ended income fund

STP (D) Seeks to generate regular income
through investment primarily in
floating rate debt or money
instruments and also fixed rate
or money market instruments.

HDFC Sensex HDFC Mutual Open-ended index fund

Plan Fund The objective of this scheme is
generate returns that are
commensurate with the
performance of the Sensex.

Morgan Stanley Morgan Stanley Close-ended diversified equity

Growth Fund scheme.
Started in 1994 with maturity
period of 15 years.
Focuses on long-term capital

Lotus Arbitrage Lotus Indian Equity oriented interval fund.

Fund AMC Pvt. Ltd. Investment objective is to
generate income through
arbitrage opportunities
out of mispricing between
market and derivatives market
and deployment of surplus
in fixed income instruments.

Note: The schemes listed are at random and do not indicate anything with respect
to their quality in any manner whatsoever.

79. What is the structural arrangement of an average mutual fund?

Mutual funds in India function under a 3-tier structure as indicated in Box 79.1
Box 79.1 – Entities in a Mutual Fund Business:

| | | | |
Custodian Registrar Transfer Agent AMC
& Depository |
| | |
| | |
MF Scheme-1 MF Scheme 2 MF
Scheme 3

The promoters or sponsors intending to float a mutual fund appoint trustees and
set up an AMC, which in turn appoints a custodian/ depository, registrars, transfer
agents and auditors.

The mutual fund industry in India and all the participants involved in this business
are governed by SEBI. A sponsor or promoter first applies to SEBI to get a
registration in order to start mutual fund activities. SEBI grants a certificate of
registration if the sponsors fulfill the necessary criteria of experience,
profitability, positive net worth etc..

Next, the sponsor forms a trust under the provisions of the Indian Trusts Act, 1882,
appoints trustees and forms a board of trustees. The composition of the board of
trustees is governed by SEBI. For example, a certain number of trustees have to
be independent persons, not associated with the sponsors in any manner
whatsoever. The trustees play a critical role as they „hold in trust‟ the
investments of the investors/unit holders of the mutual fund. The trust deed
contains clauses that are necessary for protecting the interests of the unit holders.
In general, the trustees act as a self-regulating body and protectors of the unit
holders‟ money.

The board of trustees does not manage the day-to-day activities of the mutual fund
directly. Instead, it appoints an Asset Management Company (AMC) to perform
that task. Normally, an AMC is registered under the Companies Act, 1956. It may
be a private limited company or a wholly owned subsidiary of a public limited
company or even a joint venture. Table 79.1 lists three AMCs under different
forms of ownership.

SEBI also requires that AMCs have a certain minimum net worth contributed by
the sponsors. Thus, de facto an AMC manages a mutual fund scheme while, de
jure the trustees manage them. The trustees also monitor the performance of the
AMC and ensure that it complies with various regulations of SEBI.

Table 79.1 - AMC‟s Ownership Structure:

Name of the AMC Name of the Trust Sponsor(s)-
Tata Asset Tata Trustee Joint venture between
Management Ltd. Co. Pvt. Ltd. Tata Sons Ltd. and Tata
Investment Corporation

Prudential ICICI Prudential ICICI Joint venture between

Asset Management Trust Ltd. ICICI Bank Ltd. and
Company Ltd. Prudential Plc. Of UK.

Bank of Baroda BOB Mutual Wholly owned subsidiary

Asset Management Fund Ltd. of Bank of Baroda.
Company Ltd.

A custodian holds the securities of various schemes of the fund in their custody.
Before dematerialization of shares was introduced, share transfers were done in
physical form. As mutual funds regularly buy and sell huge volumes of securities,
the custodians used to receive, transfer and hold the physical certificates on behalf
of an AMC. However, following demat of securities, the term custodian has given
way to the depository. A depository maintains an on-line record of ownership of
securities bought and sold by a mutual fund in dematerialized form , just as bank
records the balance in one‟s account.

The registrar is appointed in order to accept and process the unit holders‟
applications, and inform the AMC regarding the amount received for subscription,
redemption and so forth.

Transfer agents are responsible for issuing and redeeming units of the scheme and
provide other related services such as preparation of transfer documents and
updating investor records. They are the conduit through fresh units are issued to
new buyers or units sent back to the AMC for redemption.

The trustees appoint the top management of the AMC, such as Chief Investment
Officer or Chief Executive Officer as well as fund manager(s) for the various
schemes. The trust company also appoints an auditor to audit the books of
accounts of all the schemes. Auditing the financial details for a specific scheme
is an important aspect as in the past there have been several instances where AMCs
have resorted to inter-scheme transfer of securities to make a specific scheme more
attractive. Such manipulations acquire ominous proportions particularly when the
transfer of securities from one scheme to another is done at a price different from
the market price. In such cases, unit holders of one scheme benefit at the cost of

Having organized its structure comprehensively, an AMC is ready to float various

schemes, each one tailored to the requirements of different sections of the public.
An AMC may appoint separate fund managers for each scheme under its umbrella
or may assign two or three schemes to a specific fund manager.

One of the important aspects of this multi-tiered organization structure in the

mutual fund business is to clearly segregate the involvement of sponsors. The trust
company and the board of trustees form the proverbial Chinese wall between the
promoters of the mutual fund business and the money invested by millions of unit
holders. Apart from their other supervisory roles, the trustees also ensure that
aggregate investment by the sponsor promoted AMC into the listed securities of
group companies of the sponsors, does not exceed a certain limited. In short, the
trustees ensure that sponsors do not use the AMC as a vehicle to channel the unit
holders‟ money to their own group companies.

80. Can we have a specific example of the above structural arrangement?

Yes. Let us consider the mutual funds floated by Kotak Mahindra, Kotak
Mahindra Bank Limited (KMBL) as the sponsor, established Kotak Mahindra
Trustee Company Limited (KMTCL) as the trustee company. KMBL also floated
Kotak Mahindra Asset Management Company Limited (KMAMC) as the
AMC/Investment Manager. KMAMC offers many different kind of schemes such
as Kotak Global India, Kotak Savings Plan, Kotak MNC, Kotak Tech. etc.
Computer Age Management Services Private Limited are the registrars, Deutsche
Bank and ABN AMRO are the custodians and Price Waterhouse are the auditors
for the fund.

81. How do the IPO of a mutual fund differ from the IPO of a company?

Depending upon the type of mutual fund an AMC expects its potential investors to
be interested in; it makes an initial public offer (IPO) for a suitably designated
scheme. Until the middle of 2005, AMCs announced an IPO every time they
launched a new scheme. But this confused the investors somewhat, as normally
only the first public issue of a company is called an IPO (all subsequent issues to
public merely being public issues). Hence the AMFI (Association of Mutual
Funds in India) and SEBI instructed the AMCs to use the term NFO (New Fund
Offer) rather than IPO for launching their new schemes. AMFI is the association
of all AMCs registered with SEBI, which promotes professional and ethical
standards in the mutual fund industry in India.

But this is not only point of difference between the IPO of a company and the NFO
of a mutual fund.

One other difference pertains to the issue of pricing. In an IPO, a company may
issue shares at a premium over the par value. For example, an IPO may be priced
at R. 60/- per share, representing Rs. 50/- premium over the face value of Rs. 10/-
per share. But the concept of a „premium‟ is not applicable in case of mutual fund
units, which carry only their face value.

Another difference pertains to the matter of over subscription. In an IPO, a

company is normally required to return the oversubscribed amount to the investors
(though companies can exercise green-shoe option). However, in an NFO, the
AMC retains the entire amount that it mobilizes. Incidentally, it may be noted that
this also impacts the pricing of shares vis-à-vis units following the public offer.
This is because when an IPO of a company is oversubscribed by large margin,
there is a huge unfulfilled demand and that pushes up the price of shares following
the public offer. However, nothing like that happens in case of NFOs of mutual
funds. The fund starts trading at the Net Asset Value (NAV), (Question 85 has
more on calculation of NAV) which in turn depends upon the value of the
underlying portfolio of the relevant scheme.

Lastly, the price of a share may be influenced by speculation, rumors, corporate

performance, forces of demand and supply etc. so that there could be significant
swings in share prices. However, the NAV of a mutual fund scheme is largely
governed by the value of the underlying securities (which could add up to 30, 50 or
even more securities) into which the fund stays invested and is hence far less
volatile. For example, it is not unknown for the market price of a share to double
over a relatively short period of time. But for the NAV of a particular scheme, to
double in the same time, each and every one of the underlying securities will have
to double in their market price, which is highly unlikely.

82. Does a mautual fund also send out an offer document while launching a new
Yes. When launching any new scheme, the AMC prepares an offer document.
This provides the name of the scheme, its specific investment objectives, entry/exit
load structure and other attributes such as minimum investment requirement, face
value, periodicity of dividend payments and so forth. The document often contains
so much information that it runs into 60-70 pages, although in newspapers there is
usually only a quarter-page highlights in the form of an advertisement. Almost all
mutual funds put their offer document on their websites.
Once the offer closes, the AMC issues the units of the scheme to the investors and
the funds mobilized are invested according to the broad investment objectives
indicated in the offer document. For example, the investment objective or
investments mandate of a certain scheme may be to invest at least 70% in equity
and equity-related securities issued by service sector companies and the balance in
debt and money market instruments. Thus, such a scheme targets itself at those
investors who feel that investing a sizeable amount in the service sector affords a
good opportunity of investment. This mandate indicates that if one is an investor
looking for a regular income from the investment and/or if one has a very short-
term investment horizon, then this scheme may not be suitable. The offer
document also indicates whether a unit holder will receive a return through regular
dividend or only the capital appreciation on the investment or a combination of
both. It may also require the unit holder to specify whether dividends should be
paid daily, weekly, monthly or quarterly and so forth. The document also
specifies the face value of a unit (which may vary depending on the scheme) and
the minimum application amount for a single unit holder, etc…

83. Does the offer document also tell us all about the costs associated with
investing in mutual funds?

Yes, the offer document provides details of the various costs associated with
investing in the funds.

Needless to say, an AMC incurs several expenses in managing the fund on behalf
of the investors. Some of these are recurring expenses while others are one-time.

The annual recurring expenses recovered as fund management fees from the
investors include trustee fees, custodian fees, registrar fees, investment
management and advisory fees and other recurring operating expenses. This
includes ongoing marketing and selling expenses, brokerage and transaction costs,
audit fees, cost related to providing accounting statement, dividend/ redemption
cheques and warrants, insurance premium paid by the fund, salaries to staff etc.. In
general, mutual funds cannot exceed the fund management fees indicated in the
offer document. The AMC passes on these annual recurring expenses or fund
management fees to the investors as entry or exit loads.
The annual recurring expense is normally expressed as a percentage of the net
assets and is referred to as expense ratio. SEBI has given directives on the expense
ratio to be charged by AMCs. This ratio is a graded ratio. For example, equity
funds may charge upto 2.5% of the average weekly net asset of the fund for the
first Rs. 1,000 million, 2.25% on the next Rs. 3,000 million, 2% on the following
Rs. 3,000 million and 1.75% on any amount above this. Debt funds, balanced
funds, and liquid funds may charge different amounts as prescribed by SEBI.
These expense ratios form an upper limit. Given the structure of expenses, the
bigger funds will obviously have lower expense ratios.

Entry load or the front-end charge is applied when investors buy units of a
scheme. Thus, if the entry load is 2%, then the AMC deducts 2% of the total fund
mobilized straight away and invests the balance 98% of the corpus to create the
investors‟ portfolio. Hence, if the face value of a scheme is Rs. 10/-, the opening
NAV will be only Rs. 9.80 and not Rs. 10/- since 2% is deducted towards

Exit load or the back-end load is levied when an investor exits the scheme (i.e.
sell his units0. For example, if a fund charges an exit load of 2% and the NAV of
the scheme is Rs. 20/- only, Rs. 19.60 will be received when the units are
redeemed or sold. Normally, AMCs do not charge both entry and exit loads for
a given scheme. A scheme may also be a no-load scheme, if the AMC chooses not
to levy any load whatsoever on a scheme.

There are some variations to these loads. One of them goes by a rather pompous
terminology as contingent deferred sale charges (or CDSC). CDSC is a back-end
load with a difference. It varies depending upon the duration for which an investor
remains invested in the scheme. Typically, it rewards an investor for loyalty i.e.
for remaining with the scheme longer. For example, a fund may levy a CDSC of
2% if the investment is for less than one year from the time of investing; 1.5% if it
is between one and two years; 1% for between two and three years; 0.5% if it is
between three and four years; and there is no charge if the investment is for more
than four years. CDSC is normally computed on the face value of the unit or the
NAV whichever is lower. More often than not, CDSC is levied by debt funds
more than equity funds.
Exit loads are generally structured so as to discourage large redemptions and in a
certain period they carry higher exit loads while smaller redemptions during the
same period may carry smaller exit loads. Similarly, large investors are rewarded
with lower or no entry load in order to attract a bigger corpus while small investors
are levied a higher load. Surprisingly, there have been occasions when some
AMCs have inexplicably done the opposite i.e. levied lower exit load (in
percentage terms) to higher redemption amounts and higher loads to smaller
redemptions. Perhaps the large exiters are also viewed as potentially large

As mentioned earlier, characteristically, a fund levies either an entry or an exit load

but not both. Also index funds tend to levy smaller loads than equity funds, since
the annual recurring expenses towards research and management time tend to be
much less in case of index funds, which merely mimic the underlying index.

Another interesting aspect of the entry/exit load is that usually funds charge a
fixed percentage irrespective of the fund‟s performance. Occasionally, it has been
noted that a fund increases the exit load when it is performing poorly to try and
discourage unit holders from exiting the fund. But with increasing competition
among mutual funds, load structures have changed. Not long ago, one AMC
devised an innovative fee structure for a particular scheme. The fee was variable
depending on the performance of the fund. The loads had a fixed and variable
component, the latter component being linked to the performance of the fund.

The one-time expenses of mutual funds pertain to initial issue expenses. Initial
issue expenses or pre-issue expenses cover the initial advertising, marketing and
promotional expenses, commission to agents/brokers/bankers, registrar‟s expenses,
printing and postage charges etc. that are undertaken primarily during the NFO.
SEBI guidelines allow mutual funds to levy a maximum of 6% of the corpus
mobilized as initial issue expenses for a new scheme. In other words, for every Rs.
100/- mobilized, the fund may charge Rs. 6/- straight away towards initial issue
expenses and invest only the remaining Rs. 94/-.

Thus, if a fund has a 2% entry load and 6% initial issue expenses charged
initially, then a unit having a face value of Rs. 10/- may well open at an NAV of
Rs. 9.20 on day one, as Rs. 0.20 and Rs. 0.60 are charged towards entry load and
initial issue expenses, respectively. Lest the charges appear too intimidating to the
potential investors, an AMC may choose to levy a lower issue expense or no issue
expenses at all to the investors. However, in such cases, it increases the annual
recurring expenses in terms of higher entry/exit loads. Occasionally, an AMC may
also decide to amortize the expenses over a period of time. For example, it may
decide an amortize the initial expenses of 6% over 5 years (at the rate of 1.2% per
year). If its entry load is for example, 2%, then the NAV of the unit may open at
Rs. 9.68 (net of 1.2% of initial issue expenses and 2% of entry load).

As entry and exit loads as well as charges towards initial issue expenses can affect
the return of a scheme significantly, an investor should analyze these expenses
carefully before investing in a scheme. In fact, in India, the schemes have been
offered with such myriad features and options that it is difficult to generalize the
characteristics of the funds. So, it is important that as a unit holder, one must
understand the options given by an AMC for a specific scheme properly so that
one is certain that the scheme satisfies one‟s risk, return and service expectations.