An Overview of Financial Markets

(This is part I and II of an n part series on financial markets as I understand them. n part because even I don't know how many would be required. Not to fear, I will not leave it half baked, I have written parts III and IV and will put it up based on the response to this.)

I

In the recent past, there has been much focus on the functioning of capital markets. This set of blog articles is aimed at the layman who may be bewildered by the sudden assault of finance-related jargons everywhere. Turn on any TV channel and there are gurus and pundits each giving their own views sprinkled with newer and newer jargon. Now, in addition to TARP, there is TALF, TGLP yada yada and it gets too much for regular market watchers also. Funnily, two highly respected people, sometime from the same organization, hold different views on the same issue! And sometimes the confusion gets pretty serious, for instance, when President Obama recently blamed a set of “speculators” for their intransigent attitude that led to Chrysler filing for bankruptcy.

Just at the end of February, everyone had given up on the stock markets. Publishers were paying advances on books that were going to address the death of Capitalism. Now, a lot of the major indices have rallied 25-30% from the lows and suddenly, the world seems sunnier. And Economists are talking of U,V, W shaped recoveries?

What the hell is all this? Why do we need a stock market? What are these financial institutions? Who is the “Market” that everyone is talking about? On what basis is stock trading done? If it is indeed blind speculation, why doesn’t the government shut it down? If it is shut down will the world end as these guys claim? Is financial innovation good at all? If you look at the daily turnover of BSE and NSE, it has been varying between 80,000 crores and 1,00,000 crores. It may come as a surprise that around 70% of that is in the Futures and Options Segment of the NSE. If indeed financial innovation is bad, how has it withstood the test of time and in fact gained in importance?

As stated earlier, this is meant for the layman. However, I am still a student and just because I use the word layman it does not imply I am an expert. I have tried to keep it as accurate as possible but please feel free to point any flaws or confusions in the presentation.

Also, at first shot, I would not advise the reader to apply whatever has been written here to the real world. Some of the ideas will be “idealized” forms. We will see later how to apply it.

II

The Stock Markets

When I was in school, I used to think that the stock market was an entity run by the Government of India. This misconception arose due to the fact that the stock market position was telecast daily on the news. I figured if it is coming on a daily basis it must be something important to everyone and the Government usually controlled these institutions.

Of course, I later realized that it is a private entity and the stock market number quoted was that of the Bombay Stock Exchange. There were many stock exchanges once, almost all state capitals had one, but most went out of business. Interestingly, since the BSE and NSE are for-profit organizations, they could issue shares and get listed on their own exchanges! Now when people refer to stock market they could be referring to either the Bombay Stock Exchange or the National Stock Exchange in Delhi.

(Actually, I need more clarity on how the index numbers are calculated. I have heard that NSE is based on market capitalisation. So is the Nifty a weighted average of the market caps of the 50 companies? Fundaes needed please)

The stock exchange acts as a marketplace. What do exchange owners want? They want people to trade on it and they make their money by taking a part of the transaction fees. The transaction fee is very small in percentage terms but very profitable overall. As mentioned earlier, say, the overall turnover of NSE is 60,000-70,000 crores on an average per day. 0.01% of that translates to 6 crores a day. With 250 trading days on an average, we are talking of upwards of thousand crores a year of turnover.

For the exchanges, success begets more success. If there were two exchanges, similar in terms of what you can trade, one with 1000 players and another with 100,000 players, the second exchange is likely to have more “liquidity”. What does that mean? If you go to money.rediff.com, and look up the quotes for individual stocks, you will see various bits of information given about that stock. You will find information like Day’s High/Low or Year’s High/Low. In addition you would see something called Volume. That gives an indication of how easy it is to get into that stock or get out of it.

For example, according to some analysis, you may think a particular stock is a good investment. But for the past 6 months if it has traded only say 1000 shares a day and you want to buy 500 shares, then you could have a trouble exiting the position. When there are more buyers and sellers, the probability of getting the price you want gets higher. This attracts more people into that exchange which in turn increases the probability of getting the desired price and so on.

However, if the 1000 player exchange offered more innovative services and charged a higher fee, there may even be an “oomph” factor associated with it!

Exchanges take on significant operational headaches. With technology, it is not that apparent today. My father said it used to take more than a month in the 80s and 90s to get hold of the shares you bought. Errors were common and people made arrangements to counteract those problems which in turn created other problems. :P Today delivery happens at T+2 i.e you get hold of the shares you two days after you bought. In addition there are facilities like “Buy Today Sell Today”, “Buy Today Sell Tomorrow”. While these facilities increase the liquidity, they also require clear definitions of who is legally liable for what.

“All this is fine. But the basic question has not been answered. On 28^th April 2009, the BSE went down by 350 points and on 29^th April it went up by 400 points. The stock markets seem like a casino or a con game. What is going on?”

The stock markets are secondary markets. To understand the existence of stock markets it is important to understand primary markets.

“Hey, this is the problem with finance types. Everyone speaks very well but no one seems to give a one line answer. Is it a con game or not?”

Hmm… If I could, I would. The financial system that has evolved is not an Act of God. It is the result of evolution, conventions and practices. And sometimes the logic goes a bit backward and forward, wish I could help it!