Capital Market Constituents and Instruments

Constituents of the Capital Market

• The capital market is composed of three distinct markets:
  • Industrial Securities Market (Corporate Securities)
  • Government Securities Market (Gilt-edged Securities)
  • Long-Term Loan Market (Mortgage & Term-Loan Finance)

Industrial Securities Market

• Purpose: Channel for non-government business organizations to raise long-term funds via issue of corporate securities.
• Typical instruments: Equity shares, preference shares, debentures, bonds.

(a) Primary Market / New Issue Market

• Handles fresh securities—financial claims not traded previously.
• Companies mobilize capital here through: Initial Public Offerings (IPOs), rights issues, private placements, preferential allotments, etc.
• Offers investors the first-time access to ownership or creditor status in the issuing firm.

(b) Secondary Market / Stock Exchange

• Organized marketplace for buying & selling “second-hand” listed securities.
• Trades a wide spectrum of instruments: Government bonds, municipal bonds, corporate shares & debentures, units of mutual funds.
• Transactions executed through licensed stock-brokers at prevailing market prices.
• Key roles:
  • Provides liquidity & marketability to outstanding securities.
  • Aids price discovery and continuous valuation of corporate performance.

Government Securities Market (Gilt-Edged Market)

• Definition: Market where tradable debt issued by Central/State Governments & semi-government bodies is bought and sold.
• Security characteristics:
  • Denominations: $100$ & $1000$ (common face values).
  • Fixed maturity, half-yearly interest (coupon) payments.
  • Considered risk-free: interest & principal repayment are sovereign-guaranteed.
  • Offer wide-ranging tax incentives.
• RBI’s role: Acts as banker to Government, conducts purchase/sale through the Public Debt Office (PDO) as part of monetary management. No underwriting needed.

Forms of Government Securities

• Stock Certificates / Inscribed Stock: Name of holder written on certificate & registered in Public Debt Office.
• Promissory Notes: Written promise to pay a definite sum on demand / future date.
• Bearer Bonds: Ownership vested in the physical holder; freely transferable.

RBI Trading Techniques

1. Grooming – Gradual acquisition of securities nearing maturity to facilitate smooth redemption.
2. Switching – Purchase of one issue against sale of another as a part of open-market operations.
3. Auctioning – Sale of securities to highest bidder (price- or yield-based auctions).

Long-Term Loan Market

• Provides long-term credit (beyond $1$ year) principally to corporate borrowers.
• Major intermediaries: Development banks & commercial banks.

Sub-segments

(a) Term-Loan Market

• Supplies medium- & long-term loans directly to industry.
• Key Indian institutions: IDBI, IFCI, ICICI, State Financial Corporations (SFCs).
• Services include project appraisal, identifying investment opportunities, fostering new entrepreneurs, modernization financing.

(b) Mortgage Market

• Grants loans secured against immovable property (real estate).
• Mortgage = Transfer of interest in specific immovable property to secure a debt.
  • Equitable mortgage: Security created through mere deposit of title deeds.
  • Legal mortgage: Legal transfer of property title to lender until repayment.

(c) Financial Guarantee Market

• Finance extended against third-party guarantee.
• Guarantee ensures creditor is repaid even if borrower defaults.
• Indian context covers:
  1. Deferred payments for imports & exports.
  2. Medium/long-term foreign loans.
  3. Domestic bank & institutional advances.

Capital-Market Instruments (Overview)

• Classified into:
  1. Debt Instruments – Debentures & Bonds.
  2. Equity Shares.
  3. Preference Shares.
  4. Derivatives – Secondary securities (forwards, futures, options, swaps).

I. Debt Instruments

1. Debentures

• Written acknowledgement of debt under company seal.
• Promise of repayment of principal + fixed interest at stated intervals.
• Usually secured by fixed or floating charge on assets.
• Holder = creditor, no ownership rights.

2. Bonds

• Signed promise to pay specified sum on set date / condition.
• Bearer instrument (transferable without deed); carries stamp duty.
• Issuer spectrum: Government (risk-free gilt) & private corporates (subject to default risk – must obtain SEBI-recognized credit rating).

II. Equity Shares

• Residual ownership; rank after preference shares for dividend & capital on winding-up.
• Variable dividend: depends on available profits & directors’ policy.
• Voting rights proportional to shareholding.
• High upside in prosperity, high risk in adversity.

Sweat Equity Shares

• Issued to employees/directors at discount for non-cash consideration (know-how, intellectual property, etc.).
• Preconditions: Authorized by special resolution; at least $1$ year elapsed since company entitled to commence business.

III. Preference Shares

• Carry two preferential rights:
  1. Dividend at fixed rate before equity shares during company’s life.
  2. Return of capital before equity shares on winding-up.
• Hybrid: combines features of equity (ownership) & debt (fixed return).

IV. Derivatives (Secondary Securities)

• Issued by financial intermediaries; claims ultimately backed by primary securities (shares, debentures).
• Core types: Forward Contracts, Futures, Options, Swaps.
• Used for hedging, speculation, arbitrage, and risk transfer.

Depository Receipts (DRs)

• Negotiable instruments allowing investors in one country to own shares issued in another while receiving dividends/capital gains.

A. Indian Depository Receipt (IDR)

• Rupee-denominated DR enabling foreign companies to raise Indian funds.
• Structure: Foreign issuer ➔ issues shares to an Indian Depository ➔ Depository issues IDRs to Indian investors; underlying shares = “Deposited Shares.”
• First IDR: Standard Chartered Bank ( $2010$ ).

Regulatory Milestones

• Companies (Issue of IDRs) Rules $2004$.
• SEBI operational guidelines $2006$; amendments thereafter.
• RBI FEMA instructions $22\,July\,2009$.

Key Elements

1. Overseas Custodian Bank – Foreign bank (with Indian branch) holding underlying shares; Finance Ministry approval required.
2. SEBI Approval – Application at least $90$ days before opening.
3. Listing – IDRs must be freely transferable & listed on Indian exchanges.
4. Dividend Flow – Declared dividends apportioned pro-rata & paid to IDR holders via Domestic Depository.
5. Taxation – Dividend taxed at $30\%$ + surcharge $10\%$ (current provision puts IDRs at disadvantage).

Advantages

• Wider access to liquid Indian markets.
• Indian residents gain exposure to foreign equity.
• Expands issuer’s investor base & enhances global brand.
• Eliminates forex risk for Indian investors (dividends paid in rupees).
• Facilitates portfolio diversification & wealth protection.

B. American Depositary Receipt (ADR)

• USD-denominated negotiable certificate issued by a US depository bank representing specified number of shares of a non-US company.
• Listed on NYSE, NASDAQ, AMEX etc.; dividends & prices quoted in $USD$.

Categories

1. Sponsored ADR
   • Formal agreement between foreign company & US depository bank.
   • Bank handles record-keeping, dividend distribution, Regulatory (SEC) compliance.
   • Eligible for listing on US stock exchanges.
2. Non-Sponsored ADR
   • Created by brokers/dealers without issuer’s involvement.
   • Traded over-the-counter (OTC); post-$2008$ SEC amendment, certain regulatory exemptions apply.

Advantages to Stakeholders

1. US investors access high-return foreign stocks.
2. Foreign company attains dual-country trading & enhanced visibility.
3. Potential currency arbitrage gains.
4. Simplified investment process & US-based taxation.
5. Often lower share price entry point for US investors.

Disadvantages

1. Exposure to forex fluctuations despite USD pricing.
2. Limited investment universe (only firms opting for ADRs).
3. Lower liquidity relative to domestic blue-chips; long-term holding may be needed.
4. Higher administrative costs (often passed to investors).
5. Strict SEC compliance – severe penalties for violations.

C. Global Depository Receipt (GDR)

• Dollar-denominated DR traded on European/US exchanges; underlying shares remain rupee-denominated (for Indian issuers).
• Issuing company allots shares to a foreign Depository which then issues GDRs to international investors.

Advantages

1. High Liquidity – Continuous trading on international bourses.
2. Access to Foreign Capital – Streamlined fundraising mechanism.
3. Easy Transferability – Minimal documentation; attractive to non-residents.
4. Potential forex gains on dividend & capital returns.
5. Shares can trade in multiple currencies.
6. Enhanced global coverage & reputation.
7. Domestic valuation uplift after international listing.
8. Opens door for FII & non-resident investment even where direct foreign share purchase is restricted.
9. Possible tax savings for investors compared with direct foreign shareholding.

Disadvantages

1. Multi-jurisdictional regulation – High compliance burden.
2. Exposure to foreign exchange risk (dividends/principal in foreign currency).
3. Unsuitable for small investors owing to large ticket size.
4. No voting rights for GDR holders (held by intermediary/depository).

Ethical, Practical & Policy Implications

• Investor Protection: Need for clear disclosure, rating requirements (for bonds), and regulatory oversight (SEBI, RBI, SEC, EU regulators).
• Monetary Policy Lever: RBI open-market operations (grooming, switching, auctioning) use G-secs market to manage liquidity.
• Globalization of Finance: Instruments like IDR/ADR/GDR integrate domestic markets with global capital flows, prompting harmonization of accounting & governance standards.
• Risk Management: Derivatives & DRs introduce currency, regulatory & market risks—necessitate robust risk-assessment frameworks for issuers & investors.

Quick Reference (Key Numericals & Statutory Points)

• Government security denominations: $100$, $1000$.
• Dividend tax on IDR: $30\%$ + surcharge $10\%$.
• SEBI application window for IDR: $90$ days pre-issue.
• Minimum operating period before issuing sweat equity: $1$ year.
• Landmark IDR issue: Standard Chartered Bank, $2010$.
• Key regulatory years: IDR Rules $2004$, SEBI guidelines $2006$, RBI FEMA instruction $2009$, SEC ADR amendment $2008$.

Concept Map (Inter-connections)

• Primary → Secondary market: Securities born in primary market attain liquidity/value in secondary market.
• Corporate → Term-loan/Mortgage finance: Where equity/debt issuance insufficient or unsuitable, firms tap long-term loan market.
• Domestic securities → DRs: Underlying shares parked with custodian/depository, fractional ownership marketed abroad (GDR/ADR) or in India (IDR).
• Debt vs Equity vs Derivative: Distinct risk/return profiles; derivatives often super-imposed on primary instruments for hedging/speculation.