The Functions of International Financial Capital Markets - Assignment Example

International Financial Markets Assignment Question The function of Capital Markets in India “Capital markets channel savings to finance the longer-term investment plans of business, individuals and governments” (Viney, 2009). These are institutions that provide a market to raise capital for longer-term investments and also facilitate trading of financial assets. Capital markets include markets for stocks, bonds and derivatives. It has two mutually supporting and indivisible segments: the primary market and the secondary market. In the primary market companies issue new securities to raise funds. Hence it is also referred to the new issue market. The secondary market deals with securities that have already been issued by companies and are listed on the stock exchange. Since the securities are listed and traded in the stock exchange, the secondary market is also called the stock market. In primary market, companies interact with investors directly while in the secondary market investors interact with themselves. In both cases, the capital market intermediaries play an important role .The secondary market, based on all available information, determines the price and risk of the issued securities, it provides useful signals to both listed companies and investors to act in the primary markets. The secondary market may also include the over the counter market and the derivatives market. In the stock market share prices are determined by the demand and supply forces. On the other hand, in the over the counter market prices are negotiated between the buyer and the seller. The derivatives market deals in futures and options. In the derivatives markets, securities or portfolios of securities are traded for future delivery. In case of options, the future delivery is conditional as the buyer has a right to exercise or not to exercise the option. Primary capital market in India Primary capital market is a conduit for the sale of new securities. New or listed companies may make the public issues of shares. The initial public offerings are the public issues of securities by new companies for the first time. In the initial public offerings or public offerings by the established companies, securities are sold to the public all individuals and institutional investors. Private corporate sector did not show much enthusiasm to offer capital to the public till 1980, because of the following factors: Small size of the operations and narrow capital base. Availability of loan capital on easy terms from the term lending institutions. Fear of losing control over the company. Highly regulated environment. The decade of eighties, however witnessed a sea change in the funds mobilization efforts of companies through public issues of equity and debt, encouraged by the deregulation of capital markets and other economic reforms. As a result, the annual funds mobilization in the new issues market, which was annual funds mobilization in the new issues market, which was only to the tune of about Rs 70 crore in sixties and Rs 90 crore in seventies, increased substantiality during the 80s.The funds raised through the public issues of corporate securities by the non-government companies amounted to Rs 4312 crore in 1990-91 which increased to a phenomenal level of Rs 26417 crore in 1994-95. Equity and debt are the two basic instruments of raising capital from the primary markets. Equity was more important source of capital until 1995-96.The share of equity in funds mobilization through public issues was 72 per cent in 1995-96 which declined to 15 per cent in 1998-99.After showing an increase in 1999-00 and 2000-01, the share of equity has dropped to about 17 per cent. Hence once again debt has dominated the public issues. Secondary markets in India Secondary capital market deals in securities that have already been issued. Stock exchanges are secondary markets where buyers and sellers trade in already issued securities .A stock exchange provides the following useful economic functions: Help determining fair prices based on demand and supply forces and all available information. Provides easy marketability and liquidity for investors Facilitate in capital allocations in primary markets through price signaling Enable investors to adjusting portfolios of securities India has one of the oldest stock markets in Asia. The Bombay stock exchange was established in 1985.Later on, many more stock exchanges were established in other in other Indian cities like Ahmadabad, Calcutta, Madras, Kanpur and many more. This number has now increased to 23. However, in terms of business activity, the two most prominent all-India stock exchanges are the Bombay Stock Exchange and the national stock exchange, which was set up in 1994. The national stock exchange started the screen based trading in India which has been now adopted by Bombay Stock Exchange and other stock exchanges as well. The relatively high level of issued capital required for a company to be eligible to be listed in a stock exchange prompted the government of India to grant recognition to the over the counter exchange of India which was promoted by unit trust of India, industrial credit and Investment Corporation of India ltd and others. The securities contracts Act 1956 was the first all India legislation regulating the stock exchanges in the county. Now the security exchange board of India regulates the operations of the primary and secondary markets in India. The establishing of the securities and exchange board of India (SEBI), on the lines of the securities and investment board of the UK, is a major development in the Indian capital market. SEBI, which was established on the 12 April 1998, is required to take a holistic view of the Indian securities markets. It is required to regulate and promotes the securities markets by: Providing fair dealings in the issue of securities market by ensuring a market place where funds can be raised at a relatively low cost. Providing a degree of protection to the investors and safeguard their rights and interests so that there is a steady flow of savings into the market Regulating and developing a code of conduct and fair practices by intermediaries in the capital market like brokers and merchant banks with a view to making them competitive and professional There has been impressive growth in the number of shareholders, number of listed companies, market capitalization and stock turnover in India over last two decades. The number of shareholders is estimated to be one million. Thus, India after USA has the second largest population of shareholders. Most of the transactions take place in the secondary market. There are few companies that issue new securities to raise capital in India. Therefore, we can say that with the development of capital markets, it has brought more benefit to investors than to companies who want to raise capital. Question 2 Rights Issue This gives the existing shareholders the right but not the obligation to buy common shares of the company or firm at a specific price which is lower than the market price during a specified period of time on a prorate basis. The offer price/subscription price is the price at which shareholders will buy the additional shares and is usually lower than the current market price for the following reasons: To make the issue attractive and therefore encourage shareholders to buy new shares To pass the savings of transaction costs to the shareholders mainly because the rights issue incur less transaction costs than a public issues To create a value on the rights this is given by the difference between the current market price per share before the rights issue and the theoretical ex-right price To safeguard against decrease in the market price per share upon the announcement of the rights issue which may make the issue attractive Advantages 1. If the shareholder exercises or sells his wealth right his wealth will not be affected 2. If all the shares in the rights issue are subscribed the company will be able to raise the funds it needs for expansion or investment 3. I f the existing shareholders subscribe for all the shares ownership of the firm is not diluted Disadvantages 1. The shareholders wealth will decline if he ignores the rights 2. Where the rights issue is not fully subscribed the company will not raise the target financing 3. It could send a negative signal in the market that the company is having financial problems Privileged Issues In addition to enjoying a prior claim for fixed amount of principal and income, a bond or preferred stock may also be given the right to share in benefits accruing to the common stock. These privileges are of three kinds: a)    Convertible – conferring the right to exchange the senior issue for common stock. b)    Participating – additional income may be paid to senior security holder, usually based upon the amount of common dividends declared. c)    Subscription – holders of bond or preferred stock may purchase common shares, at prices, amounts and during periods stipulated. These issues must be considered very attractive in form, since they permit the combination of maximum safety with the chance of unlimited appreciation in value. In spite of this impressive argument in favor of privileged senior issues as a form of investment, real experience with this class has not been generally satisfactory. This divergence between promise and performance is mainly due to only a small fraction of the privileged issues having actually met the rigorous requirements of a sound investment. Advantages 1. Utilization of idle funds 2. It enhances the earning per share 3. It consolidates ownership to a few investors who will be able to make decisions efficiently Disadvantages 1. Loss of market share will lead to a decline in profitability 2. Increase in financial risk of the company 3. It may lead to negative signals Question 3 Internal equity is more commonly known as retained earnings. Since the retained earnings are a component of equity, the cost of internal equity is equal to the cost of equity and is given by the formula below. If a company wants to use its retained earnings to finance an expansion, then there must be some cost associated to using retained earnings as a source of finance. The cost of retained earnings (internal equity) will be equal to the opportunity cost. The opportunity cost of retained earnings is best estimated by the cost of equity. Ks = Cost of internal equity di = Dividend per share Po = Market per share Fc = Floatation costs g = Growth Fc = 12% *€41 Fc = €4.92 Ks = 0.136 Ks = 13.6% Floatation cost is the cost a listed company incurs when it issues new securities. The floatation cost increases the cost of equity. It is also evident from the formula above. When floatation cost increases the cost of equity increases. When a firm uses internal equity to finance a business activity it does not issues new securities. Therefore, it does not incur floatation cost. As a result the company’s cost of internal equity decreases. It finds it cheaper to finance using retained earnings than using external equity. References Fabbozi, F. J & Modigliani, F. (2003). Capital markets: Institutions and markets. New York: Prentice Hall. Benning, J. (2007). Trading strategies for capital markets. New York: McGraw Hill. Chakrabarti, S. (2010). Capital markets in India. Bombay: SAGE publications. Kothari, R. (2010). Financial services in India, Concept of application. New Delhi: SAGE publications. Tripathy, K. (2007). Financial services. Boston, MA: PHs learning. Gomez, Financial markets institutions and financial services, Phi learning PVt.ltd Peters, E. (1994). Fractal market analysis, applying chaos theory to investments and economics. New York: John Wiley and sons. Viney, C., (2009). Financial Institutions, Instruments and Markets. McGraw-Hill Australia. Read More