Module: 1 - Investment Basics (contd.) - Page 2 of 2

Capital Seekers, Financial Intermediaries & Capital Market

We know that living objects have the characteristic to grow in physical dimension as time passes on, but how money stored with financial intermediaries appreciates in value to provide a regular return over the deposit-period? Here it is necessary to introduce new players in the financial market, end-users of our savings i.e. capital seekers, and capital market, which is a significant part of the financial market, and about the various financial intermediaries. When commodities are sold the ownership of the products is transferred to the buyer. Money, which serves as a medium of exchange in all such sale transactions, cannot be sold, but it has to be invested. It is like leasing a machinery or a building, where the lessee gets the benefit of the use of the asset leased (not its ownership) and the lessor earns the lease rent along with retaining the ownership. Temporary use of money or savings can be transferred to those who need their deployment as capital in business. Here the financial market is able to arrange long-term use of money (capital) by business and industry, while it can satisfy the investor to make a short-term investment and retrieve his money much before the long-term user is able to return. How the money market/capital market intermediaries manage this phenomenon is explained later in the second module, while discussing about the role of secondary securities market i.e. the stock exchanges. For the individual or provider of funds it is called savings. For business and industry or even the Government who seek use of these funds from the savers, it is called capital. The capital market links the capital savers and capital seekers, through the service of financial intermediaries.

The capital market is part of the financial market. The other constituents are the money market (for short-term investment or working capital) and forex-market (for foreign investment). In India Government has liberalized the foreign exchange transactions in the Current Account, but not the Capital Account. As a result Indian investors will not be able to invest in securities abroad. But this need not cause them any anguish to investors of our country, since they are able to get a better return on their financial investments made in India compared to what is offered in western countries.

In India the Capital market consists of-

• Government Securities market (Dated Government Securities),

• Bonds issued by PSUs; and

• The equity and debt market covering equity shares, preference shares. And debentures floated by corporate entities.

Financial Intermediaries like the commercial banks, insurance companies, mutual funds, stock exchanges etc. help to pool savings of individuals and channel them to the corporates business houses. They act as an essential link between the millions of individual investors in the country and comparatively smaller number of capital seekers. In the post reform era return on savings offered by commercial banks is less attractive, though it may provide safety and liquidity. Insurance companies essentially provide risk cover and as medium for parking our savings they are not attractive. Comparatively Mutual Funds, which make investments of the savings pooled in stock exchange securities, may offer a higher return, but it is an indirect mode of investment in equities, debts and gilt securities. Stock exchanges on the other hand enable an investor to make a direct investment in capital market securities. A portfolio investor has necessarily to look to the stock exchanges and understand everything about them before he can commence his task. We will discuss about stock exchanges in the second module.

In a liberalised market set up the Government does not directly involve itself in the day to day operations of the market. Every unit of each group or category (like banks, insurance companies, Mutual funds, NBFC, Corporates raising funds from the public) is allowed to compete freely inter-se within its group. But they are also to follow the regulations and discipline pertaining to the respective groups. This supervisory and regulatory monitoring responsibility is entrusted with market regulators, who safeguard the interests of the small investors. Thus RBI licenses Banks (Commercial, Cooperative, RRBs) and NBFC and regularly supervises their proper functioning. IRDA discharges similar responsibility over Insurance Companies and SEBI in respect of Stock Exchanges and all those intermediaries relating to the stock market that the investors have to deal with, while conducting operations through the stock exchanges like-

• Brokers,

• Sub-brokers,

• Merchant bankers,

• Registrars,

• Portfolio managers,

• Underwriters,

• Credit rating agencies etc.

This ensures that all transactions in the financial market are carried out in a transparent and bonafide manner and the individual investors do not face hardship. We deal more about intermediaries of the securities market in the second module.

Based on the comparative weight given to the three investment goals viz. security, liquidity add profitability, opting for extreme combinations of the mix can result in deployment of investible funds in different styles, which may be described variously as hedging (exercise of utmost caution) arbitrage (look to advantage from inter-market variations in price/quotations) Speculation (over ambition in investing) and gambling (reckless investments based on greed for quick profits in huge quantity). When the three criteria are equitably or prudently adhered, it is a bonafide investment decision.

Hedging is a risk management tool. Investors take a view on the market and buy or sell securities accordingly. Instead of investing in a particular stock and holding the stock and thereby taking on the risks of price movements associated in that particular stock, they can invest in diversified securities (different industries and different corporates). Investments are usually made with the expectation that a certain stream of income or a certain price has existed will not change in the future.

Hedging is a mechanism to reduce price risk inherent in open positions. Its purpose is to reduce the volatility of a portfolio, by reducing the risk. Hedging does not mean maximization of return. It only means reduction in variation of return. It is quite possible that the return is higher in the absence of the hedge, but so also is the possibility of a much lower return. Reduce the risk associated with exposures by taking counter positions in the futures market, i.e. buy stock, and sell futures.

Speculation, on the other hand, act usually based on the expectation that some change will occur. An expected change is a basis for speculation but not for an investment. In general, the speculator takes a view on the market and plays accordingly. Section 43(5) of Income-tax Act defines `speculative transaction "as those which are periodically or ultimately settled otherwise than by actual delivery or transfer." The difference between hedging and speculation was cleared by CBDT in its circular dated September 19, 1960. It states that `where the forward transactions are entered into by an investor to guard against loss his holdings of shares through price fluctuations, then such a transaction will be treated as hedging and not as speculation. If the transaction was undertaken to hedge - to protect a portfolio/position then the gain or loss will need to be offset. This gain/loss will coincide with the gain or loss of the actual positions being protected.

If the transaction was undertaken to hedge - to protect a portfolio/position then the gain or loss will need to be offset. This gain/loss will coincide with the gain or loss of the actual positions being protected. We will discuss more about hedging using derivatives in part-2 of this project.

All transactions apart from hedging in index & equity futures, options will be treated as speculative transactions as only cash-settlement is possible. This exception for hedging is applicable only to the extent of the stock in hand.

While Hedging as a risk covering tool is selectively advisable in portfolio management to protect the interests of the investor, the portfolio manager, who deals with money belong to others is not justified to speculate indiscriminately.

Arbitrage takes advantage of the price difference between different markets like Futures and Cash markets. Arbitrage is an investment technique used by big Wall Street firms and high-rolling investors to cash-in on seemingly insignificant differences between stock indexes and futures contracts on those indexes. Indexes, and futures contracts on those indexes, don't always move in lock step. "Arbs," as they're called, depend on computers. Anytime the stock market dramatically surges or falls, it's a pretty safe bet that the arbitrageurs were somehow involved. That said, arbitrage could also function as a market equalizer, restoring price equilibrium. With advent of screen trading extending territorial jurisdiction of major stock exchanges throughout the country, arbitraging taking advantage of difference in the physical market due to locational factor is no longer possible.
[Government have recently liberalised exchange control provisions and an Indian Investor can now remit foreign exchange equivalent US $25000, which can be invested in the forein country or used for purchase of immovable property or any other asset to be retained in the foreign country - for more information refer page CLICK HERE]

Gambling is a high-risk venture, where the investor plays for high stakes. It is a reckless venture to look for very quick profits at the short term Gamblers are motivated by the burning fire of greed. They do not look to long term investments. Gambling may pay well in a short run, but ultimately gamblers frequently face their defeat/ruin. Gambler on account of over-greed frequently violates the discipline of the market resulting in securities market scams, throwing out of gear the whole market equilibrium.