Introduction to the Securities Market — products, structure and participants

Where this chapter sits

Chapter 2 carries 2% of the paper, but it is one of the longest chapters in the Research Analyst workbook. It is a vocabulary chapter — the products, participants and transaction types defined here reappear throughout Chapters 3 to 15.

The exam: 120 minutes, 100 marks, 60% to pass, 25% negative marking. Given the weight, do not over-invest in memorising every definition; concentrate on the ones with numbers attached, since those are what get asked.

What securities are

Securities are transferrable financial claims or contracts that evidence the indebtedness/promise of the creator/sellers (typically business entities) to the holder/buyers (typically investors), or ownership interest in assets of an incorporated entity.

Security ownership allows investors to convert their savings into financial assets which provide a return. On the other hand, security issuance allows borrowers to raise money at a cost. Thus, the objectives of the issuers and the investors are aligned with negotiation.

And the secondary market changes the maturity of the instrument: raising funds through issue of securities also allows the investors to transfer their rights/interests to other Investors, through the secondary market, without impacting the issuers. Therefore, a long-term security effectively gets converted into a short term security, due to the active presence of a secondary market.

Securities market brings together many buyers and sellers and thus creates liquidity, i.e., makes it easy to buy and sell securities at close to market prices, providing channels for conversion of savings into investments.

The financial market consists of: investors/providers of funds (buyers of securities) · borrowers/seekers of funds (sellers of securities) · intermediaries (providing the infrastructure to facilitate transfer of funds and securities) · regulatory bodies (responsible for orderly development and regulating the processes of the market).

The term "securities" is defined in Section 2(h) of the Securities Contracts (Regulation) Act, 1956 and includes: shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities · derivatives · units issued by a collective investment scheme · security receipts under the SARFAESI Act, 2002 · units issued under any mutual fund scheme · units issued by any pooled investment vehicle · certificates issued by a special purpose distinct entity acknowledging beneficial interest in debt or receivables including mortgage debt · government securities · such other securities as may be declared by the Central Government · rights or interest in securities.

Excluded: "securities" shall not include any unit linked insurance policy or scrips or any such instrument or unit, by whatever name called, which provides a combined benefit risk on the life of the persons and investment by such persons and issued by an insurer.

And added by notification: Electronic Gold Receipts are declared as securities vide gazette notification dated 24 December 2021.

Equity and debt

Equity shares represent the form of fractional ownership in a business venture. Equity shareholders collectively own the company. They bear the risks and enjoy the rewards of ownership.

Debentures/Bonds/Notes are instruments for raising debt. Debentures are either unsecured or secured (backed by collateral support).

A useful piece of international vocabulary the workbook supplies: Bonds is an umbrella term in US, and Debentures in UK. Notes refer more to shorter and medium instruments, however one cannot watertight these definitions. Bonds are more related to government as an issuer with longer maturities beyond 10 years, also known as GILTs in UK. Debentures more related to corporates.

So the analyst is warned: it is advised that the analysts should always be aware of the terminology relevant for a country, by examining and reading thoroughly the features of the specific instruments.

Three convertibility types:

• Fully convertible debentures are fully convertible into ordinary shares of the issuing company. The terms of conversion are specified at the time of issue itself
• Partly convertible debentures (PCDs) are partly convertible... The non-convertible part of these debentures is redeemed as it happens in any other plain debenture
• Non-Convertible Debentures (NCDs) are pure debt instruments without a feature of conversion. The NCDs are repayable/redeemable on maturity

Thus, debentures can be pure debt or quasi-equity, as the case may be.

Short-term debt instruments are used to raise debt for periods not exceeding one year and include Treasury Bills issued by the government, Commercial Papers issued by companies enjoying high credit rating, and Certificate of Deposit issued by the banks.

Domestic, foreign and Euro bonds

The classification hinges on: (a) who is issuing the bond? (b) in which country's bond market is the bond being issued? (c) what is the currency in which the bond is being issued? (d) what is the home currency of the country in which the bond is being issued?

And the warning against the obvious misreading: it may be noted that Euro Bond does not mean that it is issued in Europe, or in a currency that is Euro.

Foreign currency bonds carry a risk that runs one way: companies in emerging markets may prefer to issue bonds in USD or currencies of other economically matured countries as they carry significantly lower interest rates. However, these bonds create significant foreign currency risk to the issuer. In case the foreign currency appreciates against the domestic currency, the issuer will need a higher amount of domestic currency to repay the loan.

Masala bonds reverse that. Euro bonds denominated in Indian rupees (INR) are referred as Masala bonds. These bonds are issued outside of India but are denominated in Indian Rupees. Masala bonds were issued for the first time in November 2014 by International Finance Corporation and was listed in the London Stock Exchange.

As against foreign currency bonds issued by Indian entities, which create currency risk for the issuer, masala bonds transfer the currency risk to the foreign investor. Since the bonds are denominated in INR, if INR depreciates against the currency of the country of issue, the amount received by the investor will be less in their local currency terms.

Other products

Warrants provide the right, but not the obligation, to the warrant holder to buy equity shares of the issuer company after a specified period of time, and at a pre-determined price.

Indices. A market index tracks the market movement by using the prices of a specific number of shares chosen as a representative sample. Most leading indices are weighted by market capitalisation, and stocks included in an index are also quite liquid, making it possible for investors to replicate the index at a low cost.

Shares are chosen based on liquidity, availability of floating stock and size of market capitalization, and the composition is reviewed and modified from time to time.

The five uses of an index: as a reference point to compare the returns of other asset classes such as gold or debt · as a benchmark to compare the returns of an active equity fund/portfolio · as a barometer of the economy or any sector of the economy · as a real time indicator of market sentiments and that of investors · as an underlying for Index Funds and derivatives like Index Futures and Options.

Mutual fund units. Each investor's share is represented by the units issued by the fund. The value of the units, called the Net Asset Value (NAV), changes continuously reflecting the changes in the value of the portfolio. Open-ended schemes allow buying and selling at any time at NAV linked prices with no fixed maturity period; the unit capital of closed-ended funds is fixed, and their units are bought or sold in the stock market where they are mandatorily listed.

Exchange Traded Funds. An ETF is an investment vehicle that invests funds pooled by investors to track an index, a commodity (e.g. Gold) or a basket of assets. Unlike an index fund, the units of the ETF are listed and traded in demat form on a stock exchange and their price changes continuously.

How an ETF is created: ETFs are sponsored by an existing mutual fund or any global asset management companies. Then larger broking houses, international banks act as authorised participants to create the bundle of assets basis which the ETF units would be created. The authorised participants deliver the bundle of assets to the sponsor of the ETF and in return get the ETF, which are later sold in the market to the retail investors.

They have the features of both: like open ended funds they can be created when the need arises, and like closed ended funds they are traded in the market with real time price fluctuations. Since an ETF is a passively managed portfolio, its expense ratios are typically lower than that of a mutual fund scheme.

Hybrids and structured products

Preference shares have preference over common/ordinary equity shares at the time of dividend and at the time of repayment of capital in the event of winding up.

They resemble equity because preference shareholders are called shareholders of the company (not creditors), payment to them is termed as dividend and the same is paid from the Profit after Tax, and dividend payment is not an obligation unlike interest. But unlike common equity shares, preference shares do not carry voting rights or a right over the residual assets of the company.

They resemble debt because they offer a pre-determined rate of dividend, and this dividend is payable before any dividend is paid on common equity, and in case of winding up, preference shareholders get paid before common equity holders.

Varieties: cumulative (unpaid dividend is carried forward), non-cumulative (unpaid dividend lapses), convertible partly or fully.

Convertible debentures pay periodic coupon/interest just like any other debt instrument till conversion, and come in three forms: FCD (the entire face value is converted), PCD (a portion is converted; the non-convertible portion continues to remain as debentures, earns interest income and gets repaid on redemption), and OCDs (convertible at the discretion of the debenture holders).

The terms specified at issue: date on or before which the conversion may be made · ratio of conversion · price at which the shares will be allotted on conversion, usually at a discount to the market price · proportion of the debenture that will be converted.

The trade-off. For the issuer, convertible debentures usually have a lower coupon rate than pure debt instruments, because the yield to the investor is not from the coupon alone but also the possibility of capital appreciation, and the issuer does not have to repay the debt on maturity since shares are issued in lieu of repayment. But stakes of the existing equity shareholders get diluted when fresh shares are issued on conversion.

For the investor: they earn coupon income in the initial stage, usually when the company's project is in its nascent stage. And, once the debenture is converted into shares, they may benefit from the appreciation in the value of the shares.

Depository receipts

Depository receipts (DRs) are financial instruments that represent shares of a foreign company. They are traded in a market of a country where they are issued, and are denominated in the local currency of the same country.

The three-step process: (i) a company or an investor delivers a specific quantity of equity shares to a depository (usually a foreign bank) where the DRs are going to be issued and traded · (ii) the depository places the equity shares in its custodian account in the country where the company is domiciled · (iii) the depository then issues a certificate (depositary receipt) against such shares to investors in the overseas market.

Sponsored versus unsponsored — this turns on who starts the process:

• If the issuing company delivers the securities and initiates the process, the DRs are sponsored depositary receipts and they can be listed in the exchanges of the country in which the DRs are issued
• If the shares are delivered by an investor, the DRs are unsponsored depositary receipts. Typically, unsponsored DRs are not allowed to be traded in the stock exchanges. They can be traded only in OTC markets. They also have less regulatory requirement

Two-way fungibility means that the equity shares issued by a company can be bought in its country's market and then converted into DRs to be traded in the foreign markets. Similarly, DRs can be bought in the foreign market and converted into the underlying shares.

The country variants: ADRs are issued and traded in U.S.A by a non-US company — Infosys, Wipro, ICICI Bank and HDFC Bank are named. IDR is a DR issued and traded in the Indian market by a non-Indian company — Standard Chartered Bank is the example. HKDR is the Hong Kong equivalent. GDRs refer to depositary receipts that are allowed to be traded in more than one country, and are preferred to be issued in the European Union member states as commonality of the regulations makes it easy for the issuing companies to comply.

SEBI's IDR guidelines include the limit on the money raised by a company in India, one year lock-in on the conversion of IDRs into shares, the availability of IDRs to only resident Indian investors.

And on rights: holding DRs gives investors the right to dividends and capital appreciation from the underlying shares, but no voting rights. However, issue of voting rights to DR holders is under consideration of SEBI at present.

Other structured products

FCCBs are foreign currency (usually dollar) denominated convertible debt securities issued by companies in international markets, generally optionally convertible and issued offshore. The payment of interest and repayment of principal on these bonds is in foreign currency. However, once conversion of the instrument happens in equity, dividend is paid in Indian Rupees with the conversion obligation (currency risk) lying with the investors. They are regulated by RBI notifications under FEMA.

Equity Linked Debentures (ELDs) are floating rate debt instruments whose interest is based on the returns of the underlying equity asset such as Nifty 50, S&P Sensex, individual shares or any customized basket. The issuer invests a pre-determined part of the principal in fixed income securities like bonds, which provide principal protection, while the balance is used to buy options which provide the exposure to returns of equity.

A caution the workbook adds: Capital Protection should not be read as non-existence of credit risk (risk of default by issuer). These instruments still carry credit risk and accordingly rated by credit rating agencies. And practically, when a typical [issuer] uses such instruments for raising debt finance and to invest in CAPEX, then the amount left out for CAPEX would be extremely less — so it is better to engage an Investment Banker or Arranger who can create this structured product.

Commodity Linked Debentures (CLDs) are the same structure with interest based on the returns of the underlying commodity asset; most of these papers globally are linked to precious metals — Gold and Silver.

MBS and ABS are debt instruments issued by institutions against the receivables and cash flows from financial assets such as home loans (MBS), auto loans, rent receivable, credit card receivables and others. The cash flows accruing from these assets are used to meet the interest and principal repayment obligations on the bonds issued. The issuer is able to create liquidity in an otherwise illiquid asset by securitizing them.

REITs and InvITs are investment vehicles that pool money from various investors and invest in revenue generating real estate projects and infrastructure projects, respectively. They are formed as a trust and issue units to the investors to raise money.

And common to both: the trust has to distribute at least 90% of the distributable surplus cash flow to the unit holders. These assets can be held directly or through a special purpose vehicle.

Commodities

Commodities are basic materials or goods that are largely homogenous in nature. These goods are interchangeable with other goods of the same type.

The workbook's test: a bar of gold is a commodity while a jewellery made of the gold is not a commodity. An investor would be indifferent to different bars of gold as long as their quantity and quality remain same. However, in the case of jewels, the buyer may prefer one design over another even though their weight and quality may be the same.

Hard commodities are essentially natural resources that are mined or extracted. This includes all types of metals and crude oil. Soft commodities on the other hand refer to commodities that are grown, i.e. agricultural products — grains and pulses.

The investment problem: since inflation and prices of commodities are directly related, investing in commodity can help protect real value of investment. However, most of the commodities involve huge storage cost and are thus not suitable investments.

Four routes around it:

• Precious metals — gold and silver have very long life and storage cost on these metals is very small compared to their values
• Commodity ETFs — since the storage is handled by the fund, the investors do not have any storage obligation. Gold ETFs are the most common commodity ETF products as they are easy to store and manage for the fund
• Managed futures contracts — a portfolio of futures contract that are actively managed by professionals. Instead of buying the actual underlying asset, the investment managers take position in the futures contract
• Warehouse receipts — a document that shows proof of ownership of goods that are stored in a warehouse. Most of these warehouse receipts are negotiable. Thus, the title to the underlying goods can be transferred by simply transferring the receipts

Structure of the market

The securities market has two interdependent and inseparable segments.

The primary market, also called the new issue market, is where issuers raise capital by issuing securities to investors. Fresh securities are issued in this market.

The secondary market facilitates trades in already-issued securities, thereby enabling investors to exit from an investment or new investors to buy the already existing securities.

The primary market facilitates creation of financial assets, and the secondary market facilitates their marketability/tradability.

The primary market routes

Public issue — securities are issued to the members of the public, and anyone eligible to invest can participate.

Initial Public Offer (IPO) — the first sale of a corporate's common shares to investors at large. The main purpose is to raise equity capital for further growth of the business. SEBI's eligibility criteria include minimum requirements for net tangible assets, profitability and net-worth, plus mandatory listing of the shares on a nationwide stock exchange and offering the shares in dematerialized form.

The allocation rules — memorise these:

Anchor investors, introduced by SEBI in 2009: "anchor investor" means a qualified institutional buyer who makes an application for a value of ten crore rupees or more in a public issue made through the book building process. Anchor investors can be allocated up to 60% of the portion allocated to QIBs. Bidding for them opens one day before the IPO opens for public subscription. However, the allocation price for anchor investors can be lower than the final issue price determined through the book building process. The volume and value of anchor subscriptions serve as an indicator of the quality of the offer.

Follow on Public Offer (FPO) — when an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public. It happens when a company wants additional capital for growth or desires to redo its capital structure by retiring debt, or when it is necessary to increase the public shareholding to meet the regulatory requirements.

Private Placement — issuing a large quantity of shares to a select set of investors. According to Companies Act 2013, the number of investors to whom shares are issued under private placement should not exceed fifty. It takes two forms:

• Qualified Institutional Placement (QIP) — a private placement of shares made by a listed company to certain identified categories of investors known as Qualified Institutional Buyers. QIBs include financial institutions, mutual funds and banks among others
• Preferential Issue — an issue of specified securities by a listed issuer to any select person or group of persons on a private placement basis, and expressly does not include a public issue, rights issue, bonus issue, employee stock option scheme, employee stock purchase scheme or qualified institutions placement, or an issue of sweat equity shares or depository receipts issued in a country outside India

The requirements of SEBI's regulations with respect to a public issue do not apply to a private placement. A privately placed security can be listed on a stock exchange provided it meets the listing requirements.

Rights and Bonus issues — securities are issued to existing shareholders as on a specific cut-off date, enabling them to buy more securities at a specific price (in case of rights) or without any consideration (in case of bonus).

A rights holder has three options: (i) exercise the right (ii) transfer the right to another investor or (iii) let the rights lapse, i.e. do nothing.

On bonus: companies can issue bonus shares only if they have sufficient amount of retained earnings. When a bonus issue is made, an amount equivalent to the value of the shares issued should be transferred from retained earnings to share capital.

Onshore and offshore — if capital is raised from domestic market, it is called onshore offering, and if capital is raised from investors outside the country, it is termed as offshore offering.

Offer for Sale (OFS) — the shares offered are not fresh shares issued by the company, but an offer by existing shareholders to sell shares that have already been allotted to them. An OFS does not result in increase in the share capital of the company since there is no fresh issuance of shares. The proceeds from the offer go to the offerors. The disinvestment program of the Government of India... is an example of OFS.

And the classification point worth remembering: OFS is a secondary market transaction done through the primary market route.

Sweat Equity — under Sec.54 of Companies Act, 2013, a company may issue shares to its employees, promoters, technocrats, or others as reward for their contribution to the company. It helps reduce the agency risk arising on account of separation of management and ownership.

ESOPs — instruments given by a company to its employees that give them an option to buy the shares of the company at a pre-determined price after a period of time (referred as vesting period). Typically, the vesting period is more than one year. The employees gain only if the company's share price rises above the exercise price of the option.

The secondary market

Two segments: OTC markets are the markets where trades are directly negotiated between two or more counterparties, with securities traded and settled over the counter among the counterparties directly. Exchange traded markets route trading and settlement through the stock exchanges, where trades executed on the exchange are settled through the clearing corporation, which acts as a counterparty and guarantees the settlement of the trades to both buyers and sellers.

Clearing activity is all about ascertaining the net obligations of buyers and sellers for a specific time period. And settlement is the next step of settling obligations by delivering shares (by the seller) and paying money (by the buyer).

The clearing corporation provides full novation of contracts between buyers and sellers, which means it acts as buyer to every seller and seller to every buyer. As a result, the counter party risk is substantially reduced for the investors.

Risk management differs by venue. In OTC transactions, counterparties are expected to take care of the credit risk on their own. In the exchange-traded world the clearing corporation charges various kinds of margins, most prominent among these being Initial or upfront margin, Peak Margin and mark to market margins. Initial margin is a percentage of transaction value arrived at based on the concept of "Value At Risk" philosophy, and MTM margin is the notional loss which an outstanding trade has suffered during a specified period on account of price movements.

Market participants

Intermediaries:

• Stock Exchanges — provide a trading platform with electronic trading terminals which feature anonymous order matching; they also appoint clearing and settlement agencies and clearing banks
• Depositories — institutions that hold securities of investors in electronic form. Currently there are two Depositories in India registered with SEBI: CDSL and NSDL
• Depository Participant — an agent of the depository through which it interfaces with the investors. The split: while the investor-level accounts in securities are held and maintained by the DP, the company level accounts of securities issued is held and maintained by the depository. Eligible to be DPs: public financial institutions, scheduled commercial banks, foreign banks operating in India with RBI approval, state financial corporations, custodians, stock-brokers, clearing corporations/clearing houses, NBFCs and Registrar to an Issue and Share Transfer Agents
• Trading Members — registered members of a Stock Exchange. All secondary market transactions on stock exchanges have to be essentially conducted through registered brokers. They may be individuals (sole proprietor), Partnership Firms or Corporate bodies
• Authorised Person — appointed by a stockbroker or trading member as an agent, with specific prior approval from the stock exchange concerned for each such person, and for a specific segment. The historical note: SEBI in its meeting held on June 21, 2018 decided that sub-brokers as an intermediary shall cease to exist with effect from April 01, 2019. All existing sub-brokers would migrate to become Authorised Persons or Trading Members
• Custodians — hold funds and securities of large clients, typically institutions such as banks, insurance companies and foreign portfolio investors, and settle transactions and keep track of corporate actions on behalf of clients
• Clearing Corporation — acts as a legal counter party to all trades and guarantees settlement of all transactions. It can be a part of an exchange or a separate entity
• Clearing Banks — every clearing member needs to maintain an account with the clearing bank, and it is the clearing member's responsibility to make sure that the funds are available on the day of pay-in
• Merchant Bankers — act as issue managers, investment bankers or lead managers, and are a single point contact for issuers during a new issue. They evaluate the capital needs, structure an appropriate instrument, get involved in pricing and manage the entire issue process until the securities are issued and listed
• Underwriters — undertake to subscribe any portion of a public offer of securities which may not be bought by investors. When the underwriters make their commitments at the initial stages of the IPO, it is called hard underwriting. Soft underwriting is the commitment given once the pricing is determined, and also comes with a clause that provides the option to exit from the commitment in the event of certain events occurring
• Farmer Producer Organizations — a collective of farmers who come together for improving their bargaining power, access to markets, and overall economic well-being, legally registered as cooperatives, producer companies, or societies

Institutional participants:

Foreign Portfolio Investors — an entity established or incorporated outside India that proposes to make investments in India, which must register with SEBI. Participatory Notes (P-Notes) are instruments issued by SEBI registered foreign portfolio investors to overseas investors, who wish to invest in the Indian stock markets without registering themselves with SEBI.

Mutual funds, insurance companies, pension funds, venture capital funds, private equity firms and hedge funds each appear with their own definition. Two are worth quoting:

On hedge funds: in that sense the term hedge fund is a misnomer as these funds may not necessarily be hedged, nor are they hedging anything for their clients.

On private equity: the money in the fund is contributed by investors, called limited partners, and invested and managed by the general partner(s).

Alternative Investment Funds are defined in Regulation 2(1)(b) of the SEBI (Alternative Investment Funds) Regulations, 2012 as any privately pooled investment fund, whether from Indian or foreign sources, in the form of a trust or a company or a body corporate or an LLP, which are not presently covered by any Regulation of SEBI governing fund management nor coming under the direct regulation of any other sectoral regulators.

Two commodity-market specialists: Warehouse Service Providers offer storage and related services, with many registered with the Warehouse Development and Regulatory Authority (WDRA) and issuing negotiable warehouse receipts (NWRs), enabling farmers, traders, and businesses to access credit against stored commodities. Quality Assayers are professionals or certified laboratories responsible for evaluating and certifying the quality of commodities, whose certifications are recognized in formal markets and are required for issuing Negotiable Warehouse Receipts.

Retirement vehicles: EPF requires every employer... to provide 12% of basic salary as contribution to the scheme and equal amount is deducted from the employee's salary, administered by EPFO, and employees do not have any say in the investments or asset allocation of the fund. NPS is a government sponsored retirement scheme where on maturity, the funds accumulated can be used to buy annuity products, and NPS offers various choices of funds and beneficiaries can route it to the fund of their choice.

Family Offices handle the wealth of a wealthy family, including investments, estate planning, and tax planning; there are single family offices and there are multifamily offices.

Corporate Treasuries invest surplus funds — large corporates have a separate treasury team, while smaller business, however, mostly park their funds through mutual funds.

Retail participants include individual investors who buy and sell securities for their personal account, plus HNIs and UHNIs.

Proxy advisory services firms — proxy advisors advise investors in relation to exercise of their rights in the company including recommendations on public offer or voting recommendation on agenda items. They are typically engaged by institutional investors.

Kinds of transactions

Note the workbook's own qualifications: cash trades in Financial Markets are unusual as most contracts are settled between two to three days from the date of trade, though Indian stock exchanges have gradually started moving for all stocks into T+1 settlement cycle. Some of the transactions in Foreign Exchange Market settle on T+1 basis, and FX markets, globally, by default, offer spot transactions.

Forwards — contractual agreements between two parties to buy or sell an underlying asset at a certain future date for a particular price that is decided on the date of contract. Both the contracting parties are committed and are obliged to honour the transaction irrespective of price of the underlying asset at the time of settlement. They are customized OTC contracts and carry counterparty risk if either of the parties fails to honour his side of the contract.

Futures — standardized exchange traded forward contracts, standardized as to market lots (traded quantities), quality and terms of delivery. Because the clearing corporation provides settlement guarantee on them, they are subject to stringent requirements of margins.

Options — a contract that gives the right, but not an obligation, to buy or sell the underlying asset on or before a stated date and at a stated price. The buyer or holder of the option pays the premium and buys the right; the writer or seller of the option receives the premium with the obligation to sell or buy the underlying asset, if the buyer exercises his right. Call gives the buyer the right to buy; Put gives the buyer the right to sell.

The workbook's worked example: Arvind buys a Nifty 50 call at a strike of 11000 for a premium of ₹100. At 11200 the option is in the money — he gains 200 on the Nifty, and after adjusting for the premium of ₹100 already paid, he gains on net basis ₹200 − ₹100 = ₹100, while Salim... loses (11000 − 11200) + 100 = −100 on net basis. At 10800 the option is out of the money and expires worthless — Arvind will not exercise the option. Salim will pocket ₹100 he collected as premium.

Swaps — a derivative contract made between two parties to exchange cash flows in the future according to a pre-arranged formula. In the interest rate swap example, the borrower pays a fixed rate to the swap dealer every quarter and receives T-bill plus spread from the swap dealer every quarter, so his net obligation is the payment of a fixed interest rate. The principal amount on which the interest will be computed is agreed upon between counterparties (called notional of the trade). Only the interest rate on this amount is exchanged.

Trading, speculating, hedging, arbitrage, pledging

Trading is usually for short term like for hours, and days, and weeks. Trading is based on price patterns extracted through technical analysis, and the assumption that historical patterns repeat themselves.

Speculating is an act of purchase or sale of an asset in the expectation of a gain from changes in the price of that asset over any period of time, though usually short term. Speculators seek to benefit from acting on private or insider information, or their own view about the fundamentals.

The distinction the workbook draws: the thin line differentiating them is the probability of gaining or losing. Traders have higher probability of gains, than the speculators. Both Traders and Speculators typically leverage their buying and selling activity with borrowed funds, which magnifies their gains as well as losses.

Hedging is an act of buying an asset/contract to offset potential losses that may be incurred due to holding an existing investment/asset. A hedged position is expected to result into a no gain or no loss situation. And the motive: unlike speculators, hedgers are not motivated by profits, rather they are motivated to avoid losses.

Arbitrage is the simultaneous purchase and sale of an asset in an attempt to profit from discrepancies in their prices in two different markets. In an efficient market, arbitrage opportunities may exist only for a short period or they may not exist at all, because the existence of an arbitrage opportunity will increase buying in the lower-priced market leading to a rise in prices, and increased selling in the higher-priced market leading to a fall in prices, ultimately eliminating the differential.

Pledging of shares — an act of taking loan against securities by the investor. The investor is called the "pledgor" and the entity giving the loan is called the "pledgee". When dematerialized securities are pledged, they remain in the pledgor's demat account but they are blocked so that they cannot be used for any other transaction. In case of default, the pledgee can take control of the pledged shares and sell them to recover the loan given, after giving due notice to the pledgor and a fair chance to repay.

Dematerialisation and rematerialisation

Dematerialization is the process of converting securities held in physical form into holdings in book entry (electronic) form. In demat form, one investor's shares are not distinguished from another investor's shares and these shares do not have any distinctive number, folio number or certificate number.

SEBI's regulations require a company making a public issue of shares to enter into an agreement with all the depositories to dematerialize its shares.

Rematerialization is the reverse — converting securities held in electronic form into physical form. Securities on rematerialization are allotted in physical form with distinctive numbers, in place of the securities held electronically in book-entry form with a depository.