Unit I: Investment

Securities Market

Objectives:

At the end of the topic, the student should be able to:

 Describe the dynamics of the financial market

 Provide the difference between the money market and the capital market
 Discuss the participants in the financial market both in the primary and secondary
markets
 Explain the process of floating new issues
 Discuss how book building works

Corporate securities and government securities constitute important investment avenues

for savers. These are traded in the securities market. Creation of a portfolio and periodic
revision of the portfolio involves buying and selling of securities in the securities market.
An understanding of the working of securities market is, therefore, essential
for practicing portfolio management. However, the functioning of the securities
market is too vast a subject to be confined within a single chapter. The basic features of
the securities market will be discussed in this lesson.

Financial Market

A market is a place used for buying and selling goods. This is the most common
meaning of the word „market‟. The usual features of a market are a place, some buyers,
some sellers, some commodity to be exchanged for money or some other commodity.
What transpires in a market is an exchange of a commodity between a buyer and a
seller. However, such an exchange can take place even without a common meeting
place or physical space. Hence, a physical place is not an essential constituent of a
market. It is rather the mechanism used for the exchange of goods.

In an ordinary market what is usually exchanged is a physical commodity such as fruits,

grains, etc. In modern day markets, these commodities are valued in monetary terms
and exchanged for money. A commodity that is in demand is exchanged between buyers
and sellers in the market.

In an economy, the various economic units such as individuals in the household sector,
business units in the industrial and commercial sector, and government organisations
and departments in the government sector are engaged in various economic activities
and transactions involving money. Some of them spend more money than they earn and
end up in financial deficit while others earn more money than they spend, thus ending
up in financial surplus. The deficit generators are usually the units in the industrial,
commercial and government sectors. The surplus generators are mostly the units in the
household sector. The deficit generators who are known as ultimate borrowers would
like to borrow funds from the surplus generators who are the primary lenders. Such

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transfer of funds is possible and also necessary to sustain the development of the
economy.

The transfer of funds between primary lenders and ultimate borrowers takes place
through the creation of securities or financial assets. If an individual is not spending all
his income on consumption, he will want to find a temporary repository for his current
savings until they are required to finance future consumption. This involves the purchase
of a financial asset or security. If the investor deposits the money in the fixed deposit of
a commercial bank, the bank issues him a fixed deposit receipt which is a financial asset.
The individual is purchasing a financial asset and thereby transferring the surplus funds
at his disposal to a financial intermediary. The bank, in turn, may lend the money to a
business unit through the creation of a loan agreement.

Let us consider another instance of transfer of funds. A company in need of funds may
issue shares to mobilize funds. In a public issue of shares, any individual with surplus
funds may participate. If shares are allotted to such an individual, the company which is
the borrower of funds will issue a share certificate to the investor who is the lender of
funds. In such a situation a financial asset in the form of a share certificate is being
exchanged. This exchange represents a marketing transaction and presupposes a
market which nevertheless has no physical location.

The commodity being exchanged is a financial asset instead of a physical asset. The
lender of funds (or investor) is the buyer of the asset and the borrower of funds is the
seller of the asset (or issuer of the security). The mechanism or system through which
financial assets are created and transferred is known as the financial market. When the
financial assets transferred are corporate securities and government securities, the
mechanism of transfer is known as securities market.

Segments of Financial Market

Different types of securities are traded in the securities market. These may include
ownership securities, debt securities, short-term securities, long-term securities,
government securities, non-government or corporate securities. The nature of return
and risk involved in short-term securities is vastly different from that of long-term
securities. Hence, on the basis of the maturity period of securities traded in the market,
the securities market is segmented into money market and capital market.

Money market is the market for short-term financial assets with maturities of one year
or less. Treasury bills, commercial bills, commercial paper, certificate of deposit, etc. are
the short-term securities traded in the money market. These instruments being close
substitutes for money, the market for their trading is known as money market.
Money market is the main source of working capital funds for business and industry. It
provides a mechanism for evening out short-term surpluses and deficits. The short-term
requirements of borrowers can be met by the creation of money market securities, which

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can be purchased by lenders with short-term surpluses to park their funds for short
durations.

Capital market, on the other hand, is the market segment where securities with
maturities of more than one year are bought and sold. Equity shares, preference shares,
debentures and bonds are the long-term securities traded in the capital market. The
capital market is the source of long-term funds for business and industry.

Types of Financial Market

The financial market may be classified as primary market or secondary market

depending on whether the securities traded are newly issued securities or securities
already outstanding and owned by investors. Private companies and public sector
enterprises, in need of money, may issue securities such as shares, debentures, bonds,
commercial papers, etc. to raise required capital. Individual investors and institutional
investors may invest in these securities. The market mechanism for the buying and
selling of new issues of securities is known as primary market. This market is also
termed as new issues market because it deals in new issues of securities.

The secondary market, on the other hand, deals with securities which have already been
issued and are owned by investors, both individual and institutional. These may be
traded between investors. The buying and selling of securities already issued and
outstanding take place in stock exchanges. Hence, stock exchanges constitute the
secondary market in securities.

Participants in the Financial Market

A financial market is essentially a system by which financial securities are exchanged.

This system is composed of participants, securities, markets, trading arrangements and
regulations. The major participants are the buyers and sellers of securities or the
investors (who are the buyers of securities) and the issuers (who are the sellers of
securities). Financial intermediaries are the second major class of participants in the
financial system. They play a crucial role in the smooth functioning of the financial
system. The investors who are the primary lenders in the financial system would prefer
to „lend short‟, that is, invest their surplus for short durations as they generally have a
preference for liquidity. On the contrary, the issuers of securities who are the ultimate
borrowers would prefer to „borrow long‟, that is, borrow for long durations as the funds
are generally required for financing long-term investment in fixed assets. This situation
gives rise to a fundamental problem in the financial system which was described as the
„constitutional weakness‟ of unintermediated financial markets by Hicks (1939).‟ The
problem is to match the preferences of the surplus sector to lend short with those of the
deficit sector to borrow long. It is the financial intermediaries who resolve this problem.
They borrow for short durations from the primary lenders and lend for long durations to
the ultimate borrowers. Through the intervention of the financial intermediaries, the

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ultimate borrower is able to get long-term funding and the primary lender is able to get
liquidity on his lending.

There are two types of financial intermediaries in the financial system, namely banking
financial intermediaries and non-banking financial intermediaries such as insurance
companies, housing finance companies, unit trusts and investment companies. However,
it may be noted that the traditional distinction between banking and non-banking
institutions is slowly disappearing. As a result of technological innovations and increasing
competitive pressures, the traditional distinction between banking and non-banking
activities is rapidly disappearing and a universal banking system in which a single
institution provides the complete range of financial intermediation services is slowly
emerging.

Another group of participants in the financial system comprises the individuals and
institutions that facilitate the trading or exchange process in the system. They are
primarily brokers who act as agents for the primary lenders or the ultimate borrowers
in the purchase or sale of securities. There are also broker dealers who act on their own
account by buying and selling securities for a profit. This group also includes institutions
which act as registrars, managers, lead managers, share transfer agents, etc. at the time
of issue of shares by companies.

Difference between Primary and Secondary Market

Primary Market Secondary Market
Meaning Marketplace for new shares Place where formerly issued
securities are traded
Another Name New Issue market After market
Type of Purchasing Direct Indirect
Financing It helps to supply funds to It does not provide funding
budding enterprises and to enterprises.
also to existing companies
for expansion and
diversification.
How many times a security Only once Multiple times
can be sold?
Buying and Selling Between company and Between investors
investors
Who will gain the amount Company Investors
on the sale of the shares?
Intermediary Underwriters Brokers
Price Fixed Price Fluctuates, depends on the
demand and supply force
Organizational Difference Not rooted in any specific It has physical existence
spot or geographical
location

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Regulatory Environment

The financial system in a country is subject to a set of regulations in the form of various
Acts passed by the legislative bodies. The regulatory environment may differ from one
country to another. In each country, the regulatory control of the financial system is
exercised by designated regulatory authorities. In the Philippines, SEC, Insurance
Commission, BSP, Philippine Deposit Insurance Corporation (PDIC), Department of
Finance, Philippine Stock Exchange, Securities and Exchange Commission (SEC) and
Bureau of Treasury are the major regulatory bodies exercising regulatory control and
supervision over the functioning of the financial system in the country.

The securities thus issued may be traded or exchanged between investors in securities
markets with the help of intermediaries, within the regulatory framework approved by
the Government and other regulatory bodies.

New securities are directly issued by the issuing companies to the investors.

All the participants in this process of issuing new shares to investors together constitute
the primary market or new issues market. Let us analyse the functioning of this primary
market.

Primary Market/New Issues Market

When a new company is floated, its shares are issued to the public in the primary
market as an Initial Public Offer (IPO). If the company subsequently decides to include
debt in its capital structure by issuing bonds or debentures, these may also be floated in
the primary market. Similarly, when a company decides to expand its activities using
either equity finance or bond finance, the additional shares or bonds may be floated in
the primary market.

The primary market or new issues market (NIM) does not have a physical structure or
form. All the agencies which provide the facilities and participate in the process of selling
new issues to the investors constitute the NIM.

The NIM has three functions to perform. They are:

1. Origination
2. Underwriting
3. Distribution.

Origination
Origination is the preliminary work in connection with the floatation of a new
issue by a company. It deals with assessing the feasibility of the project, technical,
economic and financial, as also making all arrangements for the actual floatation of the

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issue. As part of the origination work, decisions may have to be taken on the following
issues:

1. Time of floating the issue

2. Type of issue
3. Price of the issue.

Timing of the issue is crucial for its success. The floatation of the issue should
coincide with the buoyant mood in the investment market to ensure proper support and
subscription to the issue. The type of issue whether equity, preference, debentures or
convertible securities, has to be properly analysed at the time of origination work. Pricing
of the issue is a sensitive matter, as the public support to a new issue will depend on the
price of the issue to a large extent. In the primary market, the price of the security is
determined by the issuer and not by the market. New issues are made either at par or at
premium. Well- established companies may be able to sell their shares at a premium at
the time of a new issue. Further, the pricing of new issues is also regulated by the
guidelines on capital issues issued by SEC.

Underwriting

The second function performed by NIM is underwriting which is the activity of

providing a guarantee to the issuer to ensure successful marketing of the issue. An
underwriter is an individual or institution which gives an undertaking to the stock issuing
company to purchase a specified number of shares of the company in the event of a
shortfall in subscription to the new issue. The stock issuing company can thus ensure full
subscription to the new issue through underwriting agreements with different
underwriters, even if there is no proper response to the new issue from the investors.
Underwriting activity in the NIM is performed by large financial institutions such as
general insurance companies, commercial banks and also by brokers. The underwriters
earn commission from the issuing company for this activity.

Distribution

The new issue market performs a third function besides the functions of
origination and underwriting. This third function is that of distribution of shares. The
distribution function is carried out by brokers, sub-brokers and agents. New issues have
to be publicised by using different mass media, such as newspapers, magazines,
television, radio, Internet, etc. New issues are also publicized by mass mailing. It has
become a general practice to distribute prospectus, application forms and other
literature regarding new issues among the investing public.

Methods of Floating New Issues

The methods by which new issues of shares are floated in the primary market in
India are:

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1. Public issue
2. Rights issue
3. Private placement

Public Issue
Public issue involves sale of securities to members of the public. The issuing
company makes an offer for sale to the public directly of a fixed number of shares at a
specific price. The offer is made through a legal document called Prospectus. Thus a
public issue is an invitation by a company to the public to subscribe to the securities
offered through a prospectus. Public issues are mostly underwritten by strong public
financial institutions. This is the most popular method for floating securities in the new
issue market, but it involves an elaborate process and consequently it is an expensive
method. The company has to incur expenses on various activities such as
advertisements, printing of prospectus, banks‟ commissions, underwriting commissions,
agents‟ fees, legal charges, etc.

Rights Issue
The rights issue involves selling of securities to the existing shareholders in
proportion to their current holding. When a company issues additional equity capital it
has to be offered first to the existing shareholders on a pro rata basis. However, the
shareholders may forfeit this special right by passing a special resolution and thereby
enable the company to issue additional capital to the public through a public issue.
Rights issue is an inexpensive method of floatation of shares as the offer is made
through a formal letter to the existing shareholders.

Private Placement
A private placement is a sale of securities privately by a company to a selected
group of investors. The securities are normally placed, in a private placement, with the
institutional investors, mutual funds or other financial institutions. The terms of the issue
are negotiated between the company and the investors. A formal prospectus is not
necessary in the case of private placement. Underwriting arrangements are also not
required in private placement, as the sale is directly negotiated with the investors. This
method is useful to small companies and closely held companies for issue of new
securities, because such companies are unlikely to get good response from the investing
public for their public issues. They can avoid the expenses of a public issue and also
have their shares sold.

Principal Steps in Floating a Public Issue

In a public issue, investors are allowed to subscribe to the shares being issued by
the company during a specified period ranging from a minimum of three days to a
maximum of ten days. The issue remains open during this period for subscription by the
public. This is the principal activity in the process of a public issue. Before the issue is
opened for public subscription, several activities/ legal formalities have to be completed.
These are the pre-issue steps or obligations. Similarly, after the issue is closed, several

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activities are to be carried out to complete the process of public issue. These activities
may be designated as the post-issue tasks. Thus, we can identify three distinct stages in
the successful completion of a public issue.

1. Pre-issue tasks
2. Opening and closing of the issue
3. Post-issue tasks.

Pre-Issue Tasks

These are the preparatory obligations to be complied with before the actual opening of
the issue.

1. Drafting and finalisation of the prospectus

Prospectus is an essential document in a public issue. The Companies Act 1956

defines a prospectus as: “Any document described or issued as a prospectus and
includes any notice, circular, advertisement or other document inviting deposits from
the public or inviting offers from the public for the subscription or purchase of any
shares in or debentures of a body corporate”.
 It is the offer document which contains all the information pertaining to the
company which will be useful to the investors to arrive at a proper decision
regarding investing in the company. It is a communication from the issuer to the
investor. The prospectus contains detailed information about the company, its
activities, promoters, directors, group companies, capital structure, terms of the
present issue, details of proposed project, details regarding underwriting
arrangements

2. Selecting the intermediaries and entering into agreements with them.

1. Merchant Banker: Merchant banker is any person or institution which is

engaged in the business of issue management either as manager, consultant,
adviser, or by rendering corporate advisory service in relation to such issue
management. Merchant bankers play an important role in the process of managing a
public issue. It is the duty of the merchant bankers to ensure correctness of the
information furnished in the prospectus as well as to ensure compliance with SEC
rules, regulations and guidelines regarding public issue of securities. Merchant
bankers are registered with SEC in four categories, with different eligibility criteria for
each category

2. Registrar to an Issue: Registrar to an issue is any person or institution

entrusted with the following functions in connection with a public issue:
(a) Collecting applications from investors.
(b) Keeping a record of applications and monies received from investors

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(c) Assisting the stock issuing company in determining the basis of allotment of
securities in consultation with the stock exchange.
(d) Finalising the list of persons entitled to allotment of securities.
(e) Processing and despatching allotment letters, refund orders, certificates and
other related documents.

3. Share Transfer Agent: Share transfer agent is a person or institution which

maintains the records of holders of securities of a company on behalf of that
company. The share transfer agent is authorised to effect the transfer of securities
as well as the redemption of securities wherever applicable.

4. BANKER TO AN ISSUE: Banker to an issue is a scheduled bank entrusted with

the following activities in connection with a public issue:

(a) Acceptance of application and application monies

(b) Acceptance of allotment or call monies
(c) Refund of application monies
(d) Payment of dividend or interest warrants.

The stock issuing company has to select the intermediaries such as merchant
banker, registrar to the issue, share transfer agent, banker to the issue,
underwriters, syndicate sellers, brokers, etc. and sign separate agreements with each
of them to engage them for the public issue.

All of these transactions must be approved by the SEC

3. Attending to Other Formalities

The prospectus and application forms have to be printed and despatched to all
intermediaries and brokers for wide circulation among the investing public. An initial
listing application has to be filed with the stock exchange where the issue is
proposed to be listed. An abridged version of the prospectus along with the issue
opening and closing dates has to be published in newspapers.

 Similarly, after the issue is closed, several activities are to be carried out to
complete the process of public issue. These activities may be designated as the
post-issue tasks. Thus, we can identify three distinct stages in the successful
completion of a public issue.

Opening and Closing of the Issue

 The public issue is open for subscription by the public on the pre-announced
opening date. The application forms and application monies are received at the
branches of the bankers to the issue and forwarded by these bankers to the

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Registrar to the issue. Two closing dates are prescribed for the closing of the
public issue.

 The first of these is the „earliest closing date‟ which should not be less than
three days from the opening date. If sufficient applications are received by
the company, the company may choose to close the issue on the earliest closing
date itself. The other closing date is the final or latest closing date which shall
not exceed ten days from the opening date.

Post-Issue Tasks

After closing of the public issue, several activities are to be carried out to complete the
process of public issue. They are:

1. All the application forms received have to be scrutinised, processed and

tabulated.
2. When the issue is not fully subscribed to, it becomes the liability of the
underwriters to subscribe to the shortfall. The liability of each underwriter has to
be determined.
3. When the issue is oversubscribed, the basis of allotment has to be decided in
consultation with the stock exchange.
4. Allotment letters and share certificates have to be despatched to the allottees.
Refund orders have to be despatched to the applicants whose applications are
rejected.
5. Shares have to be listed in the stock exchange for trading. For this purpose.
the issuing company has to enter into a listing agreement with the stock
exchange.

Book Building

Companies may raise capital in the primary market by way of public issue, rights
issue or private placement. A public issue is the selling of securities to the public in
the primary market. The usual procedure of a public issue is through the fixed price
method where securities are offered for subscription to the public at a fixed
price. An alternative method is now available which is known as the book building
process.

 Under the book building process, the issue price is not fixed in advance. It is
determined by the offer of potential investors about the price which they are
willing to pay for the issue. The price of the security is determined as the
weighted average at which the majority of investors are willing to buy the
security. Thus, under the book building process, the issue price of a security is
determined by the demand and supply forces in the capital market.

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 Book building: “A process undertaken by which a demand for the securities

proposed to be issued by a body corporate is elicited and built up and the price
for such securities is assessed for the determination of the quantum of such
securities to be issued by means of a notice, circular, advertisement, document
or information memoranda or offer document”.

 A public issue of securities may be made through the fixed price method, the
book building method, or a combination of both. In case the issuing
company chooses to issue securities through the book building route, then as per
SEC guidelines the issuer company can select various methods:

 1. 100 per cent of the offer to the public through the book building process.
 2. Seventy-five per cent of the offer to the public through the book building
process and twenty-five per cent through the fixed price method at the price
determined through book building.
 3. Ninety per cent of the offer to the public through the book
 The issue of the fixed price portion is conducted like a normal public issue after
the book built portion is issued

The steps involved in the process of book building may be listed out as
follows:

 1. The issuer appoints a merchant banker as the lead manager and book runner
to the issue.
 2. The book runner forms a syndicate of underwriters. The syndicate consists of
book runner, lead manager, joint lead managers, advisors, co-managers and
underwriting members.
 3. A draft prospectus is submitted to SEC without a price or price band. The draft
prospectus is then circulated among eligible investors with a price band arrived at
by the book runner in consultation with the issuer. Such a prospectus is known
as a Red Herring prospectus.

 Red Herring Prospectus is a prospectus, which does not have details

of either price or number of shares being offered, or the amount of issue.
This means that in case price is not disclosed, the number of shares and
the upper and lower price bands are disclosed

 4. The book runner conducts awareness campaigns, which include advertising,

road shows and conferences.
 5. Investors place their orders with syndicate members. These members collect
orders from their clients on the amount of securities required by them as well as
the price they are willing to pay.
 6. The book runner builds up a record known as Book after receiving orders from
members of the syndicate. He maintains detailed records in this regard. The book
is thus built up to the size of the portion to be raised through the book building

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process. When the book runner receives substantial number of orders, he

announces closure of the book. A book should remain open for a minimum of
three working days. The maximum period for which the bidding process may be
allowed is seven working days.
 7. On the basis of the offers received, the book runner and the issuer company
then determines the price at which the securities shall be sold.
 8. The book runner finalises the allocation to syndicate members. Procurement
agreements are signed between issuer and the syndicate members for the
subscription to be procured by them.
 The final prospectus along with the procurement agreements is then filed with
the Registrar of companies within two days of the determination of the offer
price.
 9. The book runner collects from the institutional buyers and the underwriters the
application forms along with the application monies to the extent of the securities
proposed to be allotted to them/subscribed by them.

Book building is a process wherein the issuer of securities asks investors to bid for their
securities at different prices. These bids should be within an indicative price band
decided by the issuer. Here investors bid for different quantity of shares at different
prices. Considering these bids, issuer determines the price at which the securities are to
be allotted. Thus, the issuer gets the best possible price for his securities as perceived by
the market or investors.

Role of Primary Market

 Primary market is the medium for raising fresh capital in the form of equity
and debt. It mops up resources from the public (investors) and makes them
available for meeting the long-term capital requirements of corporate business
and industry.

 The primary market brings together the two principal constituents of the market,
namely the investors and the seekers of capital. The savings or surplus funds
with the investors are converted into productive capital to be used by companies
for productive purposes. Thus, capital formation takes place in the primary
market. The economic growth of a country is possible only through a robust and
vibrant primary market.

 In the secondary market, shares already purchased by investors are traded

among other investors. Operations in the secondary market do not result
in the appreciation of capital resources of the country, but indirectly
promotes savings and investments by providing liquidity to the
investments in securities, i.e. the investors have the facility to liquidate
their investments in securities in the secondary market.

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Regulation of Primary Market

 For companies, raising capital through the primary market is time consuming and
expensive. The issuer has to engage the services of a number of intermediaries
and comply with complex legal and other formalities. The investor faces much
risk while operating in the primary market. Fraudulent promoters may try to dupe
the investors who opt to invest in a new issue. Investors in the primary market
need protection from such fraudulent operators.

 Successful floatation of a new issue in the primary market requires careful

planning, proper timing and comprehensive marketing efforts. The services of
specialised institutions such as merchant bankers, registrars to the issue,
underwriters, etc. are available to the issuer company to handle the task. There
is effective regulation of SEC at every stage of a public issue. There are also
regulations to ensure fair practice by the intermediaries in the market.

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Activity 6:

Part I. Indicate whether the following characteristics refer to the primary or secondary
market. Write PM for Primary Market and SM for Secondary Market.

1. The market place for new shares.

2. Also known as After Market.
3. Purchasing of the security is indirect.
4. It helps to supply funds to budding enterprises and also to existing
companies for expansion and diversification.
5. The security can be sold many times.
6. The buying and selling happens between company and investors.
7. The intermediaries are underwriters.
8. The price in this market fluctuates, depends on the demand and
supply force.
9. The security can be sold only once.
10. The intermediary is a stock broker.

Part II. True or False. Write True if the statement is correct, otherwise, write False.

1. Brokers are the buyers of securities.

2. The investors who are the primary lenders in the financial system
would prefer to „lend long‟, that is, invest their surplus for short
durations as they generally have a preference for liquidity.
3. The issuers of securities who are the ultimate borrowers would
prefer to „borrow long‟,
4. Intermediaries act as agents for the primary lenders or the
ultimate borrowers in the purchase or sale of securities.
5. In the primary market, the price of the security is determined by
the demand and supply.
6. The underwriter‟s job is to ensure that all agreed shares shall be
sold to investors.
7. In the book building process, the price of the share may not be
indicated in the prospectus.
8. The Secondary Market is the medium for raising fresh capital in the
form of equity and debt.
9. Operations in the secondary market DO NOT RESULT in the
appreciation of capital resources of the country.
10. The deficit generators are usually the units in the industrial,
commercial and government sectors.

Part III. Identification.

1. Refers to the ability to buy or sell an asset quickly and at a known
price—that is, a price not substantially different from the prices for
prior transactions, assuming no new information is available.
2. It is where outstanding securities are sold and bought
3. It is the market for short-term financial assets with maturities of
one year or less.
4. It is the market segment where securities with maturities of more
than one year are bought and sold.
5. It refers to a person or firm in the business of buying and

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selling securities for its own account or on behalf of its customers.

6. It is the function performed by the New Issue Market in which they
ensure or provide guarantee to the issuer to ensure successful
marketing of the issue.

7.It involves sale of securities to members of the public. The issuing

company makes an offer for sale to the public directly of a fixed
number of shares at a specific price.
8. It involves selling of securities to the existing shareholders in
proportion to their current holding.
9. It is a sale of securities privately by a company to a selected group
of investors.
10. It is any person or institution which is engaged in the business of
issue management either as manager, consultant, adviser, or by
rendering corporate advisory service in relation to such issue
management.

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