Sunday, October 23, 2011

ABC of the Indian Financial and Investment Industry Chapter 1 (Part 1)


ABC of the Indian Financial and Investment Industry Chapter 1 (Part 1)

Basic Concept

1. A financial system is like spider's web of markets and institutions that smoothen the movement of funds between the various sectors of the economy. This movement of funds can take many forms, including money, financial assets and securities (debt, quasi-equity and equity). Let us understand this basic concept, which helps us traverse the financial system's web.

Money

1.1       Money is anything that is accepted as storehouse of value, which can be exchanged for payment of debts and purchase of goods or services. Money is a medium of exchange and acts as a common denominator unit for valuing goods and services for the purpose of exchange. Many articles have acted as money; for example before the origin of metal and metallic coins, ordinary article as seashells acted as Articles got acceptance as unit of money on account of being durable, easily storable and portable. It is matter of confidence that a paper currency represents something of value. Confidence is vital as can be seen in foreign currency market where two paper currencies strive to find equilibrium like price i.e. Exchange rates in game of seesaw.

Legal tender (i.e. Notes and coins) is still commonly used form of money. They are getting replaced by plastic money (debit card, smart card and credit card) and electronic money by way of electronic funds transfer. These are all “liquid assets”, and are so called as they can be quickly converted to perform the function of cash. The concept of money also includes other forms of the “financial assets”.

Financial Assets

1.2 A financial asset is a document or certificate of title or a statement of depositary account, which represents the underlying physical asset. Example of financial assets (with their respective obligations) includes: Fixed Deposit Receipt (liability of bank to pay after the fixed period at contracted rate of interest), R BI relief bond (Liability of Indian Government towards the holder) and shares (Company shareholders' funds).

Currency (notes and coins) is the most liquid form of financial asset, while investment in a long-term loan to a company is comparatively illiquid. Liquidity refers to ease of conversion to cash with little or no cost (at fair valuation of the assets) and minimal delay.

Securities

1.3        Securities are documentary evidence of ownership of financial assets. In  India securities are defined by Securities contracts (Regulation) Act, 1956 (“the SCRA”) as per SCRA securities include:
1.  Shares, scrip's, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;
2.  Derivative;
3.  Units or any other instrument issued by any collective investment scheme to the investors in such schemes;
4.  Government securities;
5.  Such other instruments as may be declared by the Central Government to be securities; and
6.  Rights or interest in securities.
Thus we see that distinguishing feature of securities is that they are tradable or exchangeable or salable in the market place. Major classification for securities is nature of reward for that investment. It can be fixed like debt or variable like equity.

Debt: It is the obligation by a borrower (person or company your legal person) to pay a specific amount of money to lender (another party). This obligation may include manner of repayment, term of loan, interest rate, and underlying security (or collateral guarantee). It may also provide for terms of takeover of security or invocation of collateral in event of default by borrower and prepayment options.

Equity: Equity stands for ownership. In context of financial markets, term 'equity' is used interchangeably with shares. When shares are purchased, you acquire part ownership in the issuer of the shares (such as company). This means you share in its profits (through the receipt of dividends) and the rise or fall in the value of its shares.

Debit securities
1.4 The debt market brings together households and institutions with surplus funds and those with shortages of funds. Certificate of paper called 'debt security ' are issued directly between the borrower and the lender.

Debt is an obligation by one party to pay a specific amount of money to another party. A simple case of debt involves the lender advancing a sum of money (the principal) to the borrower for a specified period of time: In return; the borrower pays the lender an agreed rate of interest (the charge for the borrowing) at specified intervals, and at the end of the agreed period, repays the original sum borrowed.

Both Governments and companies issue debt securities
     Government debt securities: Governments are major issuer of debt securities; they by issue of bonds to finance the gap between expenditure ad income. The Government of India borrows money by issuing both short term debt securities (Treasury notes) and long term debt securities (as those for period more than one year). These bonds on securities are held banks, financial institutions, household investors and also corporate.
     Corporate debt securities: Companies also borrow to meet their funding requirements. They issue short term debt securities in the form of bills of exchange, Commercial papers and Certificate of deposits, and are increasingly also issuing long term paper by way of debentures.

Equity
1.5 Investing in companies via shares gives investors’ opportunity to receive a capital gain or loss. If company prospers, it will grow large and the value of its shares will rise. The investor will be able to share at higher price than cost price and make profit by way of dividend to holders of share. In case of poor performance companies may skip dividend payment and investors may also face prospect of booking loss in case of share price of company falling below cost price.

Limited liability means the liability of shareholders is limited to the issue price of shares (generally the face value). If the company was wound up, shareholder who held partly paid shares would have to pay any unpaid portion of those shares. Limited liability has made investment in equities considerably attractive compared to partnership where liabilities are unlimited.

Self-Assessment exercise 1
Complete the table below by highlighting the key basic difference between the feature of debt and equity.

Feature
Debt
Equity
Capital/ Principal


Repayment


Return


Participation in profit of venture



Risk
1.6        “Risk” stands in financial market of possibility of something wrong with unknown certainty. Several of risks in financial markets are given below:
     Market risk
            The risk of adverse movement in the value of securities due to the              movements in the market price.
     Credit risk
            The risk that a counter party will default its obligations in whole or in part.
     Market liquidity risk
            The risk that a market may lack sufficient depth to facilitate efficient and    inexpensive entry into and exit from the market.
     Funding risk
            The risk that a participant may be unable to meet its payment obligation     when they are due.
     Operational risk
            The risk that inadequate internal controls or failures of risk management   systems through human or technological error may lead to unexpected            losses.
     Legal risk
            The risk that a counter party's performance obligations may not be legally enforceable or legal process to ensure enforcement takes too long time.
     Reputation risk
            The risk that a company's reputation may become tarnished through          imprudent or ill considered practices.

Primary and secondary Markets

1.7 Market is a place where buyers and sellers of goods, services, assets and instruments come together and interact. In emerging environment such places are more likely to be electronic rather than physical to ensure gathering of larger sets of buyers and sellers. The term 'primary market' is used to describe the first time issue of securities. An example is the new issue of shares y way of a prospectus.

The term 'secondary market' is used to describe all subsequent buying and selling of securities. An example is the trading of shares on the stock exchange.

The primary and secondary market usually has similar set of participants. Main difference in these two markets is issuance of the prospectus (providing legally mandated information) and increasing obligations by issuer of securities in case of primary market.