Definition of Stock Exchanges

Primary market is the market in which new issues of securities are sold by the issuing companies directly to the investors. Secondary market is the market in which securities already issued by companies are subsequently traded among investors. A person with funds for investment in securities may purchase the securities either in the primary market (from the issuing company at the time of a new issue of securities) or from the secondary market (from other investors holding the desired securities). Securities can be purchased in the primary market only at the time of issue of the security by the company, whereas in the secondary market securities can be purchased throughout the year. As a result, trading in a particular security in the primary market is an intermittent event depending upon the frequency of new issues of the security by the company, but trading in that security in the secondary market is continuous. The secondary market where continuous trading in securities takes place is the stock exchange. In this chapter we shall examine the functioning of stock exchanges in the country

What is a Stock Exchange

The stock exchanges were once physical market places where the agents of buyers and sellers operated through the auction process. These are being replaced with electronic exchanges where buyers and sellers are connected only by computers over a telecommunications network. Auction trading is giving way to “screen-based” trading, where bid prices and offer prices (or ask prices) are displayed on the computer screen. Bid price refers to the price at which an investor is willing to buy the security and offer price refers to the price at which an investor is willing to sell the security. Alternatively, a dealer in securities may declare the bid price and the offer price of a security, suggesting the price at which he is prepared to buy the security (bid price) and also the price at which he is prepared to sell the security (offer price). The bid-offer spread, the difference between the bid price and the offer price constitutes his margin or profit.

Securities of a company first become available on an exchange after the company conducts its Initial Public Offering (IPO). During the IPO, a company sells it securities to an initial set of investors in the primary market. These securities can then be sold and purchased in the stock exchanges. The exchange tracks the flow of orders for each security, and this flow of supply and demand for the security sets the price of the security.

A stock exchange may be defined or described in different ways. A simple description of a stock exchange is as follows: “A centralised market for buying and selling stocks where the price is determined through supply-demand mechanisms”.

A somewhat similar description of a stock exchange is the following: “An organisation that provides a facility for buyers and sellers of listed securities to come together to make trades in these securities”.

In a stock exchange, the trading in listed securities is carried out by qualified members who may act either as agents for customers or as principals for their own accounts.

A more descriptive definition of a stock exchange is: “An organised market place for securities featured by the centralisation of supply and demand for the transaction of orders by member brokers for institutional and individual investors”.

According to the Securities Contracts (Regulation) Act, 1956, which is the main law governing stock exchanges in India, “stock exchange means any body of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities”.

Functions of Stock Exchanges

A stock exchange has an important role to fulfil in the economic development of a country. It is essential for the smooth functioning of the private sector corporate economy. In the process of capital formation and in’raising resources for the corporate sector, the stock exchange performs four essential functions.

Firstly, it provides a market place for purchase and sale of securities such as shares, bonds, debentures, etc. Investors desirous of buying securities would be able to buy securities in the primary market only occasionally, that is, at the time of issue of such securities by the company, whereas they would be able to buy securities in the stock exchanges at any time, as trading in stock exchanges is continuous. Similarly, holders of securities who are desirous of selling the securities would be able to sell them only in the stock exchanges, as the issuing companies do not ordinarily buy back the shares. Thus, stock exchanges provide the facility for continuous trading in securities.

Secondly, stock exchanges provide liquidity to the investments in securities, that is, it gives the investors a place to liquidate their holdings. This is essentially the basis for the joint stock enterprise system. Investors would not be interested to invest in corporate securities without the assurance provided by the stock exchanges to the owners of corporate securities that these securities can be sold in the stock exchanges at any time.

Thirdly, the stock exchanges help in the valuation of securities by providing the market quotations of the prices of securities. The market quotations represent the collective judgement on the value of the securities arrived at simultaneously by many sellers and buyers in the market. The value of shares is influenced by macro economic factors as well as micro economic factors, long-term economic trends as well as short-term fluctuations in economic variables. Speculative forces in the securities market also influence share valuations. Market quotations of share prices provide valuable information to prospective investors as well as shareholders regarding the value of shares traded in the stock exchanges.

Fourthly, stock exchanges play the role of a barometer, namely, an indicator of the state of health of the nation’s economy as a whole. The shares of a large number of companies are listed for trading in the important stock exchanges of the country. The market quotations of individual shares represent their current valuation. The trend of price movements in the market is indicated by calculating stock market indices which represent the weighted average of prices of selected shares representing all the important industries. These stock market indices are used to represent the share market as a whole. Their movements and levels are indicative of the economic health of the nation to a great extent because movements of prices of shares are influenced by macro economic factors such as growth of GDP, financial and monetary policies, tax changes, political environment, etc.

The stock exchanges provide the linkage between the savings in the household sector and the investments in the corporate sector. They indirectly help in mobilising savings and channelising them into the corporate sector as securities.

Stock Market in India

The Indian securities market has become one of the most dynamic and efficient securities market in Asia today. The Indian market now conforms to international standards in terms of operating efficiency. In this context, it would be informative to understand the origin and growth of the Indian stock market.

During the latter half of the 19th century, shares of companies used to be floated in India occasionally. There were share brokers in Bombay who assisted in the floatation of shares of companies. A small group of stock brokers in Bombay joined together in 1875 to form an association called Native Share and Stockbrokers Association. The association drew up codes of conduct for brokerage business and mobilised private funds for investment in the corporate sector. It was this association which later became the Bombay Stock Exchange, which is the oldest stock exchange in Asia. This exchange is now known as The Stock Exchange, Mumbai, or BSE.

Ahmedabad was a major centre of cotton textile industry. After 1880, many new cotton textile mills were started in and around Ahmedabad. As new cotton textile enterprises were floated, the need for a stock exchange at Ahmedabad was strongly felt. Accordingly, in 1894, the brokers of Ahmedabad formed The Ahmedabad Share and Stockbrokers Association, which later became the Ahmedabad Stock Exchange, the second stock exchange of the country.

During the 1900s Kolkata became another major centre of share trading on account of the starting of several indigenous industrial enterprises. As a result, the third stock exchange of the country was started by the Kolkata stockbrokers at Kolkata in 1908. As industrial activity in the country gained momentum, existing enterprises in cotton textiles, woollen textiles, tea, sugar, paper, steel, engineering goods, etc. began to undertake expansion activities and new ventures were also floated. Yet another stock exchange was started in 1920 at Chennai. However, by 1923, it ceased to exist. Later, in 1937, the Madras Stock Exchange was revived as many new cotton textile mills and plantation companies were floated in South India. Three more stock exchanges were established before independence, at Indore in Madhya Pradesh in 1930, at Hyderabad in 1943 and at Delhi in 1947. Thus, at the time of independence, seven stock exchanges were functioning in the major cities of the country.

The number of stock exchanges virtually remained unchanged for nearly three decades from 1947 to 1977, except for the establishment of the Bangalore Stock Exchange in 1957. During the 1980s, however, many stock exchanges were established.

Some of them were:

Cochin Stock Exchange (1978)

Uttar Pradesh Stock Exchange (at Kanpur, 1982)

Pune Stock Exchange (1982)

Ludhiana Stock Exchange (1983)

Gauhati Stock Exchange (1984)

Kanara Stock Exchange (at Mangalore, 1985)

Magadh Stock Exchange (at Patna, 1986)

Jaipur Stock Exchange (1989)

Bhubaneswar Stock Exchange (1989)

Saurashtra Kutch Stock Exchange (at Rajkot, 1989)

Vadodara Stock Exchange (at Baroda, 1990).

Thus, from seven stock exchanges in 1947, the number of stock exchanges in the country increased to eighteen by 1990. Along with the increase in the number of stock exchanges, the number of listed companies and the capital of the listed companies has also grown, especially after 1985. Two more stock exchanges were set up at Coimbatore and Meerut during the 1990s, taking the total to twenty.

Over the Counter Exchange of India (OTCEI)

The traditional trading mechanism (floor trading using open outcry system), which prevailed in the Indian stock exchanges, resulted in much functional inefficiency such as absence of liquidity, lack of transparency, undue delay in settlement of transactions, fraudulent practices, etc. With the objective of providing more efficient services to investors, the country’s first electronic stock exchange which facilitates ringless, scripless trading was set up in 1992 with the name Over the Counter Exchange of India (OTCEI). It was sponsored by the country’s premier financial institutions such as UTI, ICICI, IDBI, SBI Capital Markets, IFCI, GIC and its subsidiaries and Canbank Financial services.

The exchange was set up to aid enterprising promoters in raising finance for new projects in a cost effective manner and to provide investors with a transparent and efficient model of trading. The OTCEI had many novel features. It introduced screen based trading for the first time in the Indian stock market. Trading takes place through a network of computers of over the counter (OTC) dealers located at several places, linked to a central OTC computer using telecommunication links. All the activities of the OTC trading process are fully computerised.

Moreover, OTCEI is a national exchange having a country-wide reach. OTCEI has an exclusive listing of companies, that is, it does not ordinarily list and trade in companies listed in any other stock exchanges. For being listed in OTCEI the companies have to be sponsored by members of OTCEI. It was the first exchange in the country to introduce the practice of market making, that is, dealers in securities providing two-way quotes (bid prices and offer prices of securities).

National Stock Exchange of India (NSE)

With the liberalisation of the Indian economy during the 1990s, it was inevitable that the Indian stock market trading system be raised to the level of international standards. The high powered committee on stock exchanges known as Pherwani Committee recommended, in 1991, the setting up of a new stock exchange as a model exchange and to function as a national stock exchange. It was envisaged that the new exchange should be completely automated in terms of both trading and settlement procedures.

On the basis of the recommendations of the Pherwani committee, a new stock exchange was promoted by the premier financial institutions of the country, namely 1DB!, ICICI, IFCI, all insurance corporations, selected commercial banks and others. The new exchange was incorporated in 1992 as the National Stock Exchange (NSE). It started functioning in June 1994.

The purpose of setting up the new exchange was to create a world-class exchange and use it as an instrument of change in the Indian stock market through competitive pressure. Technology has been the backbone of NSE. It chose to harness technology in creating a new market design. Its trading system, called National Exchange for Automated Trading (NEAT), is a state-of-the-art client-server based application. The NSE also uses satellite communication technology for trading. Its trading system has shifted the trading platform from the trading hall in the premises of the exchange to the computer terminals at the premises of the trading members located at different geographical locations in the country. It has been instrumental in bringing about many changes in the trading system such as reduction of settlement cycle, dematerialisation and electronic transfer of securities, establishment of clearing corporations, professionalisation of trading members, etc.

All the stock exchanges in the country, starting with the Bombay Stock Exchange, have shifted to the new computerised trading system which facilitates screen-based trading. As a consequence, the stock market today uses the state-of-the-art information technology tools to provide an efficient and transparent trading, clearing and settlement mechanism at par with international standards. The National Stock Exchange has played a leading role as a change agent in transforming the Indian stock market to its present form. Since its inception, the NSE has been playing the role of a catalytic agent in reforming the stock market and evolving the best market practices. The NSE has brought about unparalleled transparency, speed and efficiency, safety and market integrity. In this process the NSE has become the largest stock exchange in the country, relegating the Bombay Stock Exchange to the second place.

Inter-Connected Stock Exchange of India (ISE)

With the setting up of the National Stock Exchange in 1994, a transformation of the Indian stock market was initiated. Automated screen-based trading, rolling settlement on T + 2 cycle, dematerialisation of securities with electronic transfer of securities, etc. completely transformed the market structures and procedures. Gradually, the two national stock exchanges, BSE and NSE dominated the scene with practically all trading being routed through either of these exchanges. The regional stock exchanges became irrelevant as they could not compete with the breadth and depth of these two stock exchanges, and there was virtually no trading at any of the nineteen regional centres.

The members of the regional stock exchanges of the country started investing large amounts of money in automating their trading, clearing and settlement systems on account of regulatory compulsions. This situation prompted the regional stock exchanges to devise some way of reviving their fortunes. It was decided to evolve an ipter-connected market system by pooling the resources of the regional stock exchanges. Fourteen regional stock exchanges (excluding Calcutta, Delhi, Ahmedabad, Ludhiana and Pune stock exchanges) joined together and promoted a new organisation called Inter-connected Stock Exchange of India Ltd. (ISE) in 1998. The ISE was recognised as a stock exchange by SEBI and it commenced trading in February, 1999. It then began to function as a national level stock exchange.

The objective of setting up ISE was to optimally utilise the existing infrastructure and other resources of participating stock exchanges which were until now underutilised. The ISE aims to provide cost-effective trading linkage/ connectivity to all the members of the participating exchanges on a national level. This will help to widen the market for the securities listed on the regional stock exchanges.

Through ISE an attempt is made to make the regional markets vibrant and liquid through the use of the state of the art technology and networking. The trading settlement and funds transfer operations of the ISE are completely automated. However, ISE has not succeeded in becoming a competitive market force to BSE and NSE. This is mainly because the participating regional stock exchanges did not close down their regional segments.

At present there are twenty-three stock exchanges in the country. Four of them can be considered as national level exchanges, namely, NSE, BSE, OTCEI and ISE; the remaining nineteen are regional stock exchanges (RSEs) located in important cities of the country. But it may be noted that most of the trading in securities in the country are transacted through the two largest stock exchanges, namely the National Stock Exchange (NSE) and the Stock Exchange, Mumbai (BSE) which have trading terminals all over the country. Even in these exchanges, even though there are a large number of companies listed, active daily trading takes place only in the securities of a limited number of companies. The large volume of trading is accounted for by limited number of securities. For the vast majority of securities of listed companies, the stock exchanges fail to provide liquidity.

Organisation, Membership and Management of Stock Exchanges

Basically, a stock exchange is an organised market for trading securities. It is also called a bourse. It is an association or organisation of individuals which is governed by certain rules and regulations. The manner of organisation and the rules of membership are important features of stock exchanges as also the governance system of the organisation.

Over the years, stock exchanges in the country have been organised in various forms such as voluntary non-profit making association, public limited company and company limited by guarantee. In India, the earliest stock exchanges were organised as voluntary non-profit making associations of persons. Later on, stock exchanges began to be organised as companies.

The membership of stock exchanges initially comprised of individuals and partnership firms. It was the stock brokers who became members of stock exchanges either in their individual capacity or by forming partnership firms. Later on companies were also allowed to become members of stock exchanges. Thus, stock exchanges now have both individual and institutional membership. Membership in stock exchanges is restricted and limited. It is acquired by paying the prescribed entrance fee/share value. Members are also supposed to make security deposit and pay annual subscription to the exchange. The quantum of entrance fee/share value, security deposit and annual subscription vary from exchange to exchange.

The management of each stock exchange is vested in a Governing Board which is the apex body deciding the policies of the exchange as also regulating the affairs of the exchange. The composition of the governing board is of a heterogeneous nature. It usually consists of elected directors (mostly from the broking community), SEBI nominees and public representatives. The governing board is usually presided over by an executive director or president. The executive director/ president as the Chief Executive Officer (CEO) of the exchange is responsible for the day-to-day administration of the exchange. The governing board may constitute executive committees of its members to supervise and monitor specific functions.

The BSE governing board has twenty members consisting of nine elected directors, three SEBI nominees, six public representatives, an executive director (CEO), and a non-executive chairman. The governing board of the National Stock Exchange comprises senior executives from promoter institutions, eminent professionals in the fields of law, economics, accountancy, finance, taxation, etc., public representatives, nominees of SEBI and one full-time executive of the exchange.

The governing board of an exchange has wide powers for the management and administration of the stock exchange concerned. These powers include wide ranging discretionary powers also.

The important powers of the governing body are:

Manage and control the functioning of the exchange.

Regulate trading in securities.

Admit, fine, suspend or expel members and take such disciplinary action as it deems fit.

Settle disputes, if any, amongst the members and between members and nonmembers.

Make or amend any rules, by-laws or regulations or suspend their operations with the approval of the government.

Interpret the rules, by-laws and regulations. The stock exchanges have to comply with the directions of the SEBI.

Listing of Securities

For the securities of a company to be traded on a stock exchange, they have to be listed in that stock exchange. Listing is the process of including the securities of a company in the official list of the stock exchange for the purpose of trading.

At the time of issue of securities, a company has to apply for listing the securities in a recognised stock exchange. The Securities Contracts Regulation Act and rules, SERI guidelines, and the rules and regulations of the exchange prescribe the statutory requirements to be fulfilled by a company for getting its shares listed in a stock exchange. Important documents such as memorandum of association, articles of association, prospectus, directors’ report, annual accounts, agreement with underwriters, etc. and detailed information about the company’s activities, its capital structure, distribution of shares, dividends and bonus shares issued, etc. have to be submitted to the stock exchange along with the application for listing.

The stock exchange examines whether the company satisfies the criteria prescribed for listing. When the stock exchange finds that a company is eligible for listing its securities at the exchange, the company would be required to execute a listing agreement with the stock exchange. This listing agreement contains the obligations and restrictions imposed on the company as a result of listing. The company is also required to pay the annual listing fees every year.

The purpose of the listing agreement is to compel the company to keep the shareholders and investors informed about the various activities which are likely to affect the share prices of the company. A company whose securities are listed in a stock exchange is obliged to keep the stock exchange fully informed about all matters affecting the company. Moreover, the company has to forward copies of its audited annual accounts to the stock exchange as soon-as they are issued.

The securities of companies listed on a stock exchange may be classified into different groups. For instance, the securities listed on the Bombay Stock Exchange (BSE) have been classified into A, B1, B2, F, G and Z groups. The equity shares listed in the exchange have been grouped under three groups, namely A, BI and B2, based on certain qualitative and quantitative parameters which include number of trades, value traded, etc. The F group represents the fixed income securities. The G group includes Government securities for retail investors. The Z group includes companies which have failed to comply with the listing requirements of the exchange or have failed to resolve investor complaints or have not made arrangements with the depositories for dematerialisation of their securities.

Permitted Securities

The securities of companies which have signed listing agreement with an exchange are traded at the exchange as listed securities. A stock exchange sometimes permits trading in certain securities which are not listed at the exchange but are actively traded in other stock exchanges. Such securities are known as permitted securities. This facility is provided to help market participants to trade in certain actively traded securities even though they are not formally listed at the exchange. Thus, a stock exchange may have certain listed securities and certain permitted securities, and trading may take place in these securities regularly.

Regulation of Stock Exchanges

The stock exchanges play a very vital and sensitive role in the functioning of the economy, especially the private sector of the economy. The functioning of the exchanges, therefore, needs to be transparent, fair and efficient. This is ensured through proper regulation of the working of stock exchanges. There are Acts, rules, regulations, by-laws and guidelines governing the functioning of secondary markets or stock exchanges in the country. There is also a regulator in the form of the Securities and Exchange Board of India (SEBI) to oversee and monitor the functioning of both the primary and secondary securities markets in India.

The Securities Contracts (Regulation) Act, 1956, and the rules made under the Act, namely the Securities Contracts (Regulation) Rules, 1957, constitute the main laws governing stock exchanges in India. The preamble to the Act states that it is “an act to prevent undesirable transactions in securities by regulating the business of dealing therein”. This Act provides for the direct and indirect control of virtually all aspects of securities trading and the functioning of stock exchanges.

The provisions of the Securities Contracts (Regulation) Act, 1956, were formerly administered by the Central Government. However, since the enactment of the Securities and Exchange Board of India Act, 1992, the Board established under this Act has been authorised to administer almost all the provisions of the Securities Contracts (Regulation) Act. The various provisions of the Act deal with recognition of stock exchanges, submission of relevant documents, approval of by-laws and rules made by stock exchanges, listing of securities in stock exchanges and such other matters relating to the trading of securities and the functioning of stock exchanges.

Taking into consideration the fact that the securities market in India had shown tremendous growth, the government decided to set up a separate board for the regulation and orderly functioning of the securities market in the country, in the model of the Securities and Investment Board (SIB) of UK and the Securities and Exchange Commission (SEC) of USA.

Initially, the Securities and Exchange Board of India was constituted as an interim administrative body in 1988. SEBI was given a statutory status on 30th January 1992 by an ordinance to provide for the establishment of SEBI. Later, in April 1992, the Securities and Exchange Board of India Act was passed. In this Act it is stipulated that it shall be the duty of the Board to protect the interests of investors in the securities market and to promote the development of and to regulate the securities market.

Thus, the SEBI has been constituted to promote orderly and healthy development of the securities market and to ensure adequate protection to the investors in the securities market. The Board plays a dual role, namely a regulatory role and a developmental role.

The SEBI is constituted with six members, including the chairman of the Board. Two members are officials of the central government ministries of Finance and Law, one member is an official of the Reserve Bank of India and two members are professionals having experience or special knowledge relating to securities markets and are appointed by the central government. The Board is empowered to regulate the business in stock exchanges, to register and regulate the working of stock market intermediaries such as stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, etc.

The Board is also authorised to prevent and prohibit fraudulent and unfair trade practices in the market. It makes regulations and issues guidelines regarding the various aspects of the working of stock exchanges, and constantly monitors the activities in the securities market to ensure just and fair dealings. Transparency and equal opportunity to all market participants have been the goals of all developmental and regulatory activities of SEBI.

A stock exchange has the power to make by-laws for the regulation and control of contracts entered into by members and also for the regulation of trading in the exchange. However, these by-laws have to be approved by SEBI before implementation. Amendments to the by-laws should also be similarly approved.

The Depositories Act, 1996, is another important legislation affecting the functioning of stock exchanges. This Act provides for the setting up of depositories for electronic recording and transfer of securities. The paper-based securities and their transfer often resulted in delay in the settlement and transfer of securities and also led to bad delivery, theft, forgery, etc. The Depositories Act, 1996, was passed to change over to the electronic mode of security transfer through security depositories so as to improve the efficiency of the system.

The securities market in India is properly regulated to ensure that it functions efficiently and effectively. There are strict laws governing the functioning of stock exchanges; there is a vigilant regulator who oversees the implementation of these laws. As a result, investors now have confidence in the efficiency and robustness of the Indian stock market.

Trading System in Stock Exchange

A stock exchange is a market for trading in securities. But it is not an ordinary market; it is a market with several peculiar features. In a stock exchange, buyers and sellers do not directly meet and interact with each other for making their trades. The investors (buyers and sellers of securities) trade through brokers who are members of a stock exchange. In stock exchanges, trading procedures are fully automated and member brokers interact and trade through a networked computer system. Trading in a stock exchange takes place in two phases; in the first phase, the member brokers execute their buy or sell orders on behalf of their clients (or investors) and, in the second phase, the securities and cash are exchanged.

For the exchange of securities and cash between the traders, the services of two other agencies are required, namely the clearing house (corporation) of the stock exchange and the depositories. Further, unlike other ordinary markets, stock exchanges are markets where the prices of the items traded (namely, securities) fluctuate constantly. This fluctuation in security prices leads to speculative activities in the stock exchanges.

We need to understand clearly the trading system in stockexchanges, how the trades are settled through exchange of securities and cash, the role of the clearing corporation and the depositories, etc. We also need to understand the different types of speculative activities taking place in a stock exchange. The information about the prices of securities traded in a stock exchange is useful in understanding the behaviour of the stock markets.

Trading System

The system of trading prevailing in stock exchanges for many years was known as floor trading. In this system, trading took place through an open outcry system on the trading floor or ring of the exchange during official trading hours.

In floor trading, buyers and sellers transact business face to face using a varietyof signals. Under this system, an investor desirous of buying a security gets in touch with a broker and places a buy order along with the money to buy the security. Similarly, an investor intending to sell a security gets in touch with a broker, places a sell order and hands over the share certificate to be sold.

After the completion of a transaction at the trading floor between the brokers acting on behalf of the investors, the buyer investor would receive the share certificate and the seller investor would receive the cash through their respective brokers.

In the new electronic stock exchanges, which have a fully automated computerised mode of trading, floor trading is replaced with a new system of trading known as screen-based trading. In this new system, the trading ring is replaced by the computer screen and distant participants can trade with each other through the computer network. The member brokers can install trading terminals at any place in the country. A large number of participants, geographically separated from each other, can trade simultaneously at high speeds from their respective locations. The screen-based trading systems are of two types

Quote driven system

Order driven system.

Under the quote driven system, the market-maker, who is the dealer in a particular security, inputs two-way quotes into the system, that is, his bid price (buying price) and offer price (selling price). The market participants then place their orders based on the bid-offer quotes. These are then automatically matched by the system according to certain rules.

Under the order driven system, clients place their buy and sell orders with the brokers. These are then fed into the system. The buy and sell orders are automatically matched by the system according to predetermined rules.

Types of Orders

An investor can have his buy or sell orders executed either at the best price prevailing on the exchange or at a price that he determines. Accordingly, an investor may place two types of orders, namely, market order or limit order.

Market Orders

In a market order, the broker is instructed by the investor to buy or sell a stated number of shares immediately at the best prevailing price in the market. In the case of a buy order, the best price is the lowest price obtainable; in the case of a sell order, it is the highest price obtainable. When placing a market order, the investor can be fairly certain that the order will be executed, but he will be uncertain of the price until after the order is executed.

Limit Orders

While placing a limit order, the investor specifies in advance the limit price at which he wants the transaction to be carried out. In the case of a limit order to buy, the investor specifies the maximum price that he will pay for the share; the order has to be executed only at the limit price or a lower price. In the case of a limit order to sell shares, the investor specifies the minimum price he will accept for the share and hence, the order has to be executed only at the limit price or a price higher to it. Thus for limit orders to purchase shares the investor specifies a ceiling on the price, and for limit orders to sell shares the investor specifies a floor price.

Limit orders are generally placed “away from the market” which means that the limit price is somewhat removed from the prevailing market price. In the case of a limit order to buy, the limit price would be below the prevailing price and in the case of a limit order to sell, the limit price would be above the prevailing market price. The investor placing limit orders believes that his limit price will be reached and the order executed within a reasonable period of time. But the limit order may remain unexecuted.

There are certain special types of orders which may be used by investors to protect their profits or limit their losses. Two such special kinds of orders are stop orders (also known as stop loss orders) and stop limit orders.

Stop Orders

A stop order may be used by an investor to protect a profit or limit a loss. For a stop order, the investor must specify what is known as a stop price. If it is a sell order, the stop price must be below the market price prevailing at the time the order is placed. If it is a buy order, the stop price must be above the market price prevailing at the time of placing the order. If, subsequently, the market price reaches or passes the stop price, the stop order will be executed at the best available price. Thus, a stop order can be viewed as a conditional market order, because it becomes a market order when the market price reaches or passes the stop price.

Examples will help to clarify the working of stop orders. Suppose an investor has 100 shares of a company which were purchased at ` 35 per share. The current market price of the share is ` 75. The investor thus has earned a profit of ` 40 per share on his share holdings. He would very much like to protect this profit without foregoing the opportunity of earning more profit if the price moves still upwards. This can be achieved by placing a stop sell order at a price below the, current market price of ` 75, for example at ` 70. Now, if the price subsequently falls to ` 70 or below, the stop sell order becomes a market order and it will be executed at the best price prevailing in the market. Thus, the investor will be able to protect the profit of around ` 35 per share. On the contrary, if the market price of the share moves upwards, the stop sell order will not be executed and the investor retains the opportunity of earning higher profits on his holding.

Stop orders can also be used to minimise loss in trading. Suppose that a share is currently selling for ` 125 and an investor expects a fall in the price of the share. He may place an order for sale of the share at the current market price of ` 125 hoping to cover up his position by purchasing the share at a lower price and thus make a profit on the deal. This type of a transaction is known as a short sale. If price of the share falls as anticipated by the investor, he would make a profit. There is a possibility that the price may move upwards and in that case the investor has to purchase the share at a higher price to cover up his position and meet his sales commitment. This will result in a loss to the investor. This loss can be minimised by placing a stop buy order at a price above the current price of ` 125, for example at ` 130.

Now, if the price of the share rises to ` 130 or above, the stop buy order will become a market order and will be executed at the best price available in the market. Suppose that the stop buy order was executed at ` 131, then the loss of the investor is limited to ` 6 per share, that is, the difference between the selling price of ` 125 and the buying price of ` 131 per share.

One disadvantage of the stop orders is that the actual price at which the order is executed is uncertain and may be some distance away from the stop price.

Stop Limit Orders

The stop limit order is a special type of order designed to overcome the uncertainty of the execution price associated with a stop order. The stop limit order gives the investor the opportunity of specifying a limit price for executing the stop orders: the maximum price for a stop buy order and the minimum price for a stop sell order. With a stop limit order, the investor specifies two prices, a stop price and a limit price. When the market price reaches or passes the stop price, the stop limit order becomes a limit order to be executed within the limit price. Hence, a stop limit order can be viewed as a conditional limit order.

Let us consider two examples. Consider a share that is currently selling at ` 60. An investor who holds the share may place a stop limit order to sell with stop price of ` 55 and limit price of ` 52. If the market price declines to ` 55 or lower, a limit order to sell the share at the limit price of ` 52 or higher would be activated. Here the order will be executed only if the share is available at ` 52 or above. Thus a stop limit order may remain unexecuted.

Consider an investor who desires to make a short sale of a particular share at its current market price of ` 85. That is, he intends to sell the share without owning it but hoping to buy it later from the market at a lower price. He may also place a stop limit order to buy the share to minimise his loss in case the share price moves upwards contrary to his expectations. He may specify a stop price of ` 90 and a limit price of ` 93 for his stop limit order to buy. If the price moves up to ` 90 or above, then a limit order to buy the share with limit price of ` 93 would be activated. The order would be executed at a price of ` 93 or lower, if such price is available in the market.

The disadvantage of a stop limit order is that it may remain unexecuted. The stop order results in certain execution at an uncertain price, while a stop limit order results in uncertain execution within a specified price limit.

Trading in stock exchanges takes place continuously during the official trading hours. Stock exchanges are open five days a week, from Monday through Friday. An investor may place orders for trade through his broker at any time during the official trading hours, but he needs to specify the time limit for the validity of the order. The time limit on an order is essentially an instruction to the broker about the time within which he should attempt to execute the order.

Day Orders A day order is an order that is valid only for the trading day on which theorder is placed. If the order is not executed by the end of the day, it is treated as cancelled. All orders are ordinarily treated as day orders unless specified as other types of orders.

Week Orders These are orders that are valid till the end of the week during whichthe orders are placed. They expire at the close of the trading session on Friday of the week, unless they are executed by then.

Month Orders These are orders that are valid till the end of the month during whichthe orders are placed. Month orders expire at the close of the trading session on the last working day of the month.

Open Orders Open orders are orders that remain valid till they are executed by thebrokers or specifically cancelled by the investor. They are also known as good till cancelled orders or GTC orders. However, brokers generally seek periodic confirmation of open orders from the investors.

Fill or Kill Orders These orders are also known as FoK orders. These orders aremeant to be executed immediately. If not executed immediately, they are to be treated as cancelled.

Settlement

Trading in stock exchanges is carried out in two phases. In the first phase, the execution of the orders submitted by clients takes place between brokers acting on behalf of the clients or investors. Buy orders are matched with sell orders. In the automated system, trading is carried out in an anonymous environment and the orders are matched by the computer system.

The buyer now has to hand over the money and receive the security; the seller on the other hand has to hand over the security and receive money on account of the sale of the security. This process of transfer of security and cash is done in the second phase which is known as the settlement of the trade. The settlement process involving delivery of securities and payment of cash is carried out through a separate agency known as the clearing house which functions in each stock exchange. The clearing house acts as the counter party for each trade. Member-brokers who sell securities have to deliver the securities to the clearing house and will receive cash from the clearing house. Similarly, the member- brokers who buy securities will have to pay cash to the clearing house and receive the securities from the clearing house. The stock exchanges now follow a settlement procedure known as Compulsory Rolling Settlement (CRS) as mandated by SEBI. The earlier procedure of settlement was “account period settlement” wherein all trades carried out or executed during an account period of a week or fortnight were settled on the last day of the account period. The account period used to vary from exchange to exchange.

Under the rolling settlement system, the trades executed on a particular day are settled after a specified number of business days or working days. Initially, a T + 5 settle-ment cycle was introduced, which was subsequently reduced to a T + 3 cycle. Currently, a T + 2 settlement cycle is adopted by the stock exchanges. This means that the settlement of transactions done on T, that is, the trade day, has to be done on the second business day after the trade day. The pay-in and pay-out of funds and securities has to take place on the second business day after the day of trade. For example, for an order executed on Tuesday of a week, the settlement (delivery of security and payment of cash) has to be done on Thurs-day. The pay-in and pay-out of funds and securities are marked through the clearing house.

On the first business day (T + 1) after the trade day (T), the exchange generates delivery and receive orders for transactions done by member-brokers. These provide the relevant information regarding the securities to be delivered /received by the member-brokers through the clearing house. Similarly, a money statement showing the details of payments/ receipts of monies by the member-brokers is also prepared by the exchange. The Delivery/ Receive orders and the Money Statement can be downloaded by the member-brokers.

On the second business day (T + 2) after the day of trade, the member-brokers are required to submit the pay-in instructions to the depositories for transfer of securities to the clearing house in the case of demat securities. In the case of securities in physical form, the certificates have to be delivered to the clearing house. For pay-in of funds by member-brokers, the bank accounts of member-brokers maintained with the authorised clearing banks are directly debited through the computerised system.

For pay-out of securities by the stock exchange, the member-brokers are required to collect them from the clearing house on the pay-out day, in case of physical securities. The clearing house arranges for crediting the securities to the demat accounts of member-brokers; in the case of demat securities. There is a facility for direct transfer of securities to the investors’ accounts also.

For pay-out of funds by the stock exchange, the bank accounts of member-brokers with the authorised clearing banks are credited by the clearing house. In the rolling settlement system, pay-in and pay-out of both funds and securities are completed on the same day.

The member-brokers are required to make payment to clients for securities sold and deliver securities purchased by clients within one working day. This is the time frame permitted to member-brokers to settle their obligations with the clients as per the by-laws of the exchange

Speculation

People who buy and sell securities in the stock exchanges may have different motivations for doing so. A person may be interested in getting a good rate of return, earned on a rather consistent basis, for a relatively long period of time. For this he will choose the shares of a company which is fundamentally strong and has the potential for growth in the future.

Such a person is a genuine investor who invests his money in securities for long-term returns. There may be other persons who have a short-term perspective on their trading activities on the stock exchanges. A person may be interested in making a quick short-term profit from the fluctuations in the prices of securities in the stock market. Such a person is known as a speculator. Speculators are traders who intend to make high returns within a short span of time, making use of the short-term fluctuations in security prices.

Speculators constantly monitor the movement of share prices in the market. On the basis of their analysis of share price movements and on the basis of the evaluation of various information regarding the performance of companies, the speculative traders speculate on the future course of prices. They believe that mispricing of securities occurs periodically in the market. Sometimes, some securities may be overpriced (that is, their price may be higher than their intrinsic value) and at other times some securities may be underpriced. Speculators attempt to exploit such mispricing of securities, because it is presumed that the mispricing would be corrected by the market eventually.

Long Buy

If a speculator feels that a security is underpriced or that a security which is correctly priced at the moment is likely to show a rising trend, then he would like, to buy the security for the purpose of selling it at a higher price when the price rises as anticipated. The speculator in this case is said to take a long position with respect to that security. He is not interested in taking delivery of the security, but intends to sell it off as quickly as possible to gain some profit. Hence, he would not like to hold his long position for an extended period. He would like the mispricing to be corrected at the earliest, preferably, on the same day. Such kind of a speculative activity is known as long buy.

Short Sale

On the contrary, if a speculator estimates that a security is overpriced and its price is likely to decline shortly, he would like to sell the security at the current price and buy it sometime later when the price declines so as to deliver the security sold at the time of settlement of the trade. Ordinarily, a person sells securities which he owns. Here, the speculator is selling a security which he does not own or possess in the hope that he would be able to deliver the security on the due date ‘by buying it at a lower price within a short period of time. He hopes to gain some profit in the transaction. The speculator in this case is taking a “short position” with respect to the security by engaging in a ‘short sale’.

Fundamentally, a short sale is the sale of a security that is not owned by the seller at the time of the transaction. A short seller has to cover up his position or eliminate the deficiency by buying the security sometime in the near future. He will be able to make a profit out of the short sale transaction only if he is able to buy the security at a lower price. If the price of a security moves up against his anticipations, he will suffer a loss.

Speculation involves high amount of risk. The speculators take long or short positions on the basis of their estimation or speculation about the future movement of prices. If the prices of securities do not move in the expected directions within a short time, the speculators suffer losses.

Types of Speculators

Traders engaged in speculative activity in the stock market are described by different names based on the type of activity they generally engage in. The prominent among them are hulls, bears, stag and lame duck.

Bull

A trader who expects a rise in prices of securities is known as a bull. He, therefore, takes a long position with respect to securities. He engages in long buy anticipating a rise in prices of securities. The bulls will be able to make profit only if the prices rise as anticipated; otherwise they will suffer losses. When there is an overbought condition in the market, that is, the purchases made by speculators exceed the sales made by them; the bulls begin to spread good rumours about companies so as to raise the price of their shares. This activity is called a bull campaign.

When the prices of securities are generally rising in the market, resulting in buoyancy and optimism in the stock market, the market is said to be in a bullish phase.

Bear

A bear is a pessimist who expects a decline in the prices of securities. He, therefore, takes a ‘short position’ on securities by engaging in short sales. He attempts to cover up his short position by buying the securities at lower prices when prices decline. He may engage in a bear raid so as to bring down the prices of securities. Spreading unfavourablerumours about companies with the intention of creating a decline in their share prices is known as a bear raid. The bear will suffer a loss if the prices of securities rise after he takes a short position on securities. When there is a general decline in prices of securities in the stock market, the market is said to be bearish.

Lame Duck

A lame duck is a bear who has made a short sale but is unable to meet his commitment to deliver the securities sold by him on account of rise in prices of securities subsequent to the short sale. He is said to be struggling like a lame duck.

Stag

A stag is a trader who applies for shares in the new issues market just like a genuine investor. A stag is an optimist like the bull and expects a rise in the prices of securities that he has applied for. He anticipates that when the new shares are listed in the stock exchange for trading, they would be quoted at a premium, that is, above their issue price. As soon as the stag receives the allotment of shares, he would sell them at the stock exchange at the higher price and make a profit. A stag is said to be a premium hunter. The stag will, however, suffer a loss if prices of the new shares do not rise as anticipated when they are listed for trading.

Margin Trading

Investors may purchase securities in the stock exchanges either using their own funds or funds borrowed from banks, brokers, etc. Conservative investors would prefer to use own funds for trading in securities. Other investors may use borrowed funds for buying securities when there is a good opportunity to buy some securities but ready cash may not be available.

Borrowing money from the bank or the broker for purchasing securities is known as margin trading. The investor pays a part of the value of the securities to be purchased; the balance is provided by the broker or the banker. The cash paid by the investor is the margin. For example, if an investor places buy orders for purchase of securities worth ` 50,000 and pays as cash ` 30,000 to the broker, the investor’s margin is 60 per cent of the value of the securities. The balance amount is supplied by the broker.

In margin trading, the investor has to pay interest on the money borrowed to finance the securities transaction. Thus profit or gain from the transaction would be reduced to that extent. Even if there is no gain from the securities transaction, interest on the borrowed funds has to be paid. Margin trading is thus a risky venture.

Depositories

Financial securities such as equity shares, bonds and debentures are issued by companies to the investors who purchase them. They used to be issued in the form of certificates specifying the name of the holder, the number of securities comprised in each certificate, the face value of the security, etc. When the securities are subsequently traded between investors, the seller of the security hands over the certificate to the buyer through the stock exchange clearing house. The buyer then forwards the certificate to the issuing company or its authorised transfer agents to get his name entered in the certificate as the holder of the security. In this practice, the security has a physical form, namely that of a paper certificate.

The physical form of securities is giving way to electronic form of securities wherein a security is represented by an entry in a depository account opened by the investor for the purpose. The transfer of securities on sale of a security is effected through a debit entry in the depository account of the seller and a credit entry in the depository account of the buyer. The securities are issued, held and transferred in dematerialised form or ‘demat mode’. For the demat mode of shareholding, depositories play the most important role. Let us understand what depositories are and how they function.

A depository can be compared to a bank. A bank holds cash for customers and provides services related to transactions of cash. For this a customer opens an account in any of the branches of the bank. A depository holds securities for investors in electronic form and provides services related to transactions of securities. A depository interacts with clients through depository participants (DPs) which are organisations affiliated to a depository. An investor has to open a demat account with a depository participant to avail depository services of holding securities and transferring securities. There are two depositories in India namely:

National Securities Depository Limited (NSDL)

Central Depositories Services (of India) Limited (CDSL)

NSDL was India’s first depository which started functioning on November 6, 1996. CDSL was inaugurated on July 15, 1999. The functioning of these depositories is supervised and regulated by SEBI. Each depository has several depository participants affiliated to it.

SEBI has now made it compulsory for trades in almost all listed securities to be settled in demat mode. For this purpose, registered members of stock exchanges open clearing member accounts or pool accounts with depositories. These pool accounts are used by member-brokers to hold securities from clients and deliver them to the clearing corporation. These accounts are also similarly used to receive securities from the clearing corporation for onward distribution to clients.

The demat accounts opened by investors with depository participants are known as beneficiary accounts. When an investor has sold a security through a member-broker, he has to deliver the security to the member-broker who, in turn, has to deliver it to the clearing corporation. The investor has to authorise his DP to transfer the security from his beneficiary account to the clearing member’s pool account. Accordingly, the beneficiary account of the investor would be debited and the pool account of the clearing member would be credited. The clearing member gives authorisation to his DP to deliver the securities to the clearing corporation.

When an investor has purchased securities through member-brokers he has to receive the securities from the member-brokers. In the first instance, the clearing corporation will instruct its depository to credit the securities to the pool accounts of member-brokers who are entitled to receive them on pay-out day. The member-broker then instructs his DP to debit his pool account and credit the beneficiary account of the client with the securities to be transferred to the client.

An investor holding securities in the physical form, that is, in the form of certificates, has the facility to transfer it to the electronic form through the process of dematerialisation. The process of converting securities held in physical form (certificates) to an equivalent number of securities in electronic form and crediting the same to the investor’s demat account is known as dematerialisation. This is done by the DP on a request from the investor. Securities in demat form (or electronic form) may again be converted back to the physical form (certificates), if desired. This process is known as rematerialisation. At the time of issue of new securities by a company, the securities allotted to an investor can be directly credited to his demat account.

According to the Depositories Act, 1996, an investor has the option to hold securities either in physical form or in dematerialised form. But holding securities in demat form has several advantages. It is safe and also convenient to hold securities in demat form. Transfer of securities in physical form involves despatching of certificates through the postal service. This may result in delay, loss of certificate in transit, theft of certificate, damage to the certificate, etc. In dematform, transfer of securities is instantaneous and effortless. Much paper work is done away with in demat mode.

Stock Market Quotations and Indices

In stock exchanges, continuous trading in securities takes place and these trades occur at different prices. As a result, even on a single day, prices of securities may fluctuate. On any trading day, four prices can be easily identified, namely, opening price, closing price, the highest price of the day and the lowest price of the day. Apart from these short-term intra-day fluctuations, prices of securities exhibit certain secular trends when considered over a fairly long period of time. Prices may gradually increase over a long-term period; or they may decline over the long-term period. Ordinarily, prices move in a cyclical fashion, alternatively showing increasing and declining tendencies.

The short-term as well as long-term fluctuations in prices of securities are indicators of the variations in the underlying economic variables. Hence, it is necessary to closely observe and monitor the movement of prices in the securities market. Price information becomes quite valuable for this purpose. Price quotations of traded securities are available from the stock exchanges and are being published daily by most of the newspapers. Financial dailies give very detailed price quotations (opening and closing prices, highest and lowest prices, 52-week high and low prices, etc.), including the data on volume of daily trading.

In addition to the price quotations of individual ‘securities, stock exchanges make available stock market indices, which are useful in understanding the level of prices and the trend of price movements of the market as a whole. Stock market indices are meant to capture the overall behaviour of equity markets.

A stock market index is created by selecting a group of stocks that are capable of representing the whole market or a specified sector or segment of the market. The change in the prices of this basket of securities is measured with reference to a base period. There is usually a provision for giving proper weights to different stocks on the basis of their importance in the economy. A stock market index acts as the indicator of the performance of the overall economy or a sector of the economy.

The Stock Exchange, Mumbai (BSE) came out with a stock index in 1986, which is known as BSE SENSEX. It is an index composed with 30 stocks representing a sample of large, well-established and financially sound companies selected from different industry groups. The base year of BSE SENSEX is 1978-79 and the base value is 100.

The launch of BSE SENSEX in 1986 was followed up in January 1989 by another broader index, namely BSE National Index, comprising 100 stocks listed at five major stock exchanges in India at Mumbai, Kolkata, Delhi, Ahmedabad and Chennai. The base year of the BSE National Index was selected as 1983-84, and the base value was taken as 100. This index was renamed in October 1996 as BSE-100 index and is now calculated by taking the prices of 100 stocks listed at BSE only.

In 1994, two new index series, namely the BSE-200 and the Dollex-200 indices were launched by BSE. Meanwhile, there has been a steady increase in the number of listed companies and the market capitalisation of companies. New industry groups were also emerging.

The Stock Exchange, Mumbai, has been increasing the range of its indices with segment specific and sector specific indices such as BSE-PSU index to meet the requirements of market participants for more specific information on the market activities.

The major stock market indices available at the National Stock Exchange (NSE) are:

S and P CNX Nifty

CNX Nifty Junior

S and P CNX 500

CNX Midcap 200

5 and P CNX Defty.

S and P CNX NIFTY

It is an index calculated with a well-diversified sample of fifty stocks representing 23 sectors of the economy. The base period selected for Nifty is the close of prices on November 3, 1995, which marks the completion of one year of operations of NSE’s capital market segment. The base value of the index has been set at 1000.

Nifty is managed by India Index Services and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. The index is known as S and P index because IISL has consulting and licensing agreement with Standard and Poor’s (S and P), who are world leaders in index services.

CNX NIFTY Junior

It is composed of the next most liquid fifty securities so much so S and P CNX Nifty and CNX Nifty Junior together account for the hundred most liquid securities traded at NSE. The two indices are constituted in such a way as to be disjoint sets, that is, a stock will never appear in both the indices at the same time.

CNX MIDCAP 200

It is designed to capture the movement of the mid cap segment or medium-sized capitalisation companies. The medium capitalisation segment of the stock market is being perceived increasingly as an attractive investment segment with high growth potential.

The regional stock exchanges also bring out stock indices calculated from stocks listed and traded at those exchanges. Many prominent financial dailies also bring out their own stock market indices.

The price quotations and market index values are useful to investors and market analysts to understand the mood of the market and to take appropriate investment decisions.

Summary

Financial investment is the allocation of funds to assets and securities after considering their return and risk features.

Investor plans for a long horizon after considering the fundamental factors and assumes moderate risk. Speculators are interested in short term gains and their buying and selling are based on the market price movement.

Investor plans for a long horizon after considering the fundamental factors and assumes moderate risk. Speculators are interested in short term gains and their buying and selling are based on the market price movement.

The investor should have knowledge about the economy, the company and the market structure. Equity shares have the right to receive dividend and residual claim.

Sweat equity is issued to employees or directors at a discount for their contributions in technical knowhow or other specified area.

Right shares are issued to the existing shareholders at a price, on the pro-rata basis.

Bonus shares are issued to the existing shareholders freely in addition to the dividend from the company’s reserves.

Preference stocks have fixed dividends but have a perpetual liability on the companies)

Investment alternatives are many in number. They are negotiable financial securities and non-negotiable financial investments. Equity offers high return with high risk. Bonds provide steady and fixed flow of income. The securities issued by government are secured investments. Treasury bills carry a very low rate of interest.

Commercial paper has short-term maturity and is favoured by companies and institutional investors.

Certificate of deposit’s denomination is high and the interest rate is also high.

Banks’ deposits are safe form of investment. At present accounts like maxi cash saving, quantum optima, in 1 accounts and cluster accounts are offered.

The age-old post office deposits pay high interest rate. Post office monthly income scheme’s annualised yield is higher.

NBFC deposits offer high rates of interest. The risk associated with them is also high. RBI has laid down several rules to regulate them.

Public provident fund scheme is the post office scheme with the early withdrawal facilities. In NSS, the main advantage is the deferred tax payment. Withdrawal of entire amount in a single period results in heavy taxation.

Investment in National Savings Certificates provides tax exemption under Sec 80L.\

Life insurance provides wide variety life and accent cover. Deductions are allowed under U/S 80 DD.

Mutual funds collect funds from investors and invest in equities or money market instruments as specified by the schemes.

Gold and silver are the real asset form of investment. The appreciation of gold prices is rather very low in the past few years.

Real estate is a lucrative form of investment with high capital appreciation.