An Overview of Financial Markets - II

(Recap: In part I, the motivation for the series had been laid out. In part II, we had discussed a bit about stock markets, what are their objectives, why liquidity is important etc. The previous article had been concluded with the point that to understand stock markets (which is the secondary market) better, it is important to understand the primary market. In this part we look at the primary markets.

Acknowledgments are also due here to Shyam Sundar (Peter to IITM guys :)) as some of the ideas came in our conversation.)

III

Primary Markets

As a definition, we can use the wikipedia definition that primary markets is that part of the capital markets that deals with the issuance of new securities. Hence, the term primary. It is like this is where there instruments originate, then they are traded on the secondary markets.

But what are these instruments? The common term for them is securities. Again, the term is self-explanatory. A security has a commercial value and you can use it in a commercial transaction as a security of some kind.

But why do these securities originate? Who originates them? Why do they come into existence?

For that consider the following scenario. You have a business idea, say, something related to setting up a website for something. You do some estimation and find that 40 lakhs is needed to get the project off the ground. You may have savings of 10 lakhs and can maybe borrow 10 lakhs from family and friends. So what has to be done for the 20 lakhs?

You can approach a bank. But a bank may not like the risk they are seeing. Like most dotcom financial projections, your projections promise the moon and sky, if you reach a certain critical traffic. And honestly, that is a big "if". Even if a bank were to fund it, it would require something as collateral and you may not have that.

Another alternative would be to approach an investor who has the stomach to take the kind of risk you are looking at. But before that, you need to write a business plan. Too much hype is made of business plans mainly due to the proliferation of business plan competitions. A B-plan (I hate that term!) is simply a checklist of items to make sure you have thought things through. Therefore, any business owner needs to think about:

• What is it exactly he/she is selling
• How to get the information across to the public that they exist - there is an art in this. The look and feel of the communication exercise matters as much to the public's perception as is the actual look and feel. Ok, not as much, because even the best marketer can't sell a bad product, but between two almost equal products, marketing can make a huge difference.
  
• How much money would be needed to finance the funding – how long would funding be required, when can the venture be expected to break even
• Operational issues – what sort of office do you want, where should your office be, how many people to hire, where to get them etc.
  

It is just an organized way of thinking about a business. At the starting time, only a few things would be clear, the rest of the picture emerges as you go along. But atleast, when you have a plan, you know what you know and what you don’t know!

Therefore, before going and meeting the investor you draw up financial projections. According to your projections, subject to certain assumptions, you don’t make money for the first two years but after that you really start raking it in. After the initial two years, you expect to make upwards of 2 crores a year say.

The investor looks at the plan and he likes it. He likes your business model and the idea but he is not sure if you have the maturity to execute it. Imagine the following conversation:

Investor (I): I like the business model. In fact, I think you are being conservative. This business can really grow exponentially once we take the hit for the first two years.

Entrepreneur (E): (Smiling) That’s encouraging…

I: But, I have my doubts on how you would implement it. I think you need to come back to me with some more details on the team. Fine, how much money are you looking at?

E: I have 20 lakhs, I estimate I need 30 more to get the process started.

I: Hmm… I really like your business. Subject to a better team, I am interested in taking equity stake. I could give you 30 lakhs for majority stake in your company.

E: How much?

I: I would own around 60% since I am giving that much money. But don’t worry I will be a dormant partner. Think about this. The other option is that I give you money in return for an interest payment. The interest payment can really screw you, this way I swim and sink with you.

E:(To himself) I am not comfortable with that at all. What if he is not dormant? What if he gets edgy after one year?

(To the investor) What happens if I borrow for an interest payment?

I: Hmmm… In that case, I am ready to invest 30 for 5 years at an annual rate of 20%.

E:(To himself) Wait… that means I need to pay you 6 lakhs a year as interest! And in the final year I have to return the principal and interest at 36! That is nonsense! This guy is sitting on his ass, doing nothing and I have to pay 6 a year in interest!

(To the investor) This is too high. In the first two years, I am anyway making a loss, this just adds to it.

I: (Persuasively) Look, I think you can reduce the operating costs. The interest payment would not pinch so much and…

E: If it is 20%, then you must give me a two year interest holiday? I can pay the corresponding interest at a later date…

I: You are not getting my side of the deal. If I charge 20% and say the company goes bankrupt in 2 years, I atleast get back 12 lakhs…

E: if the company goes bankrupt, you will get a claim on whatever I get by selling the assets of my company like the servers and stuff…

I: Haha… how much will that be! If I give you a 2 year holiday, I could earn much more by just putting my money in a fixed deposit. That is why I offered equity stake as an option. Think about these things and get back to me.

E: My problem with equity stake is this. You are a nice guy, I like you. Suppose, for some reason, you sell the stake to someone and exit and that person does not work with me, what happens.

I: If you have a problem with majority stake, we can work on a combination of debt and equity. Think about it.

E: Ok, I will do that. Thanks for your time.

I: Thanks for yours!
____________________________________________________________________

This is a stylized example. An example is an isolation of reality, isolated by the author with an intention in mind. Please do not think this to be how actual negotiations get conducted. I don’t know how they happen, maybe it is like this, maybe it is not.

But the example brings out points I would like to illustrate.

• The entrepreneur needs money and the investor, unhappy with returns from other sources, is looking to increase his/her returns. It is basically an opportunistic union and while it would be great to have a human touch in the process, the priorities of each party are clear. The entrepreneur does what is best for his baby, the investor does what is best for himself or his shareholders. Having said that, if either one gets over smart, both tend to lose.

• There were two structures discussed here. One was an equity investment and the other was a debt investment. If the business goes according to plan and it really works out, the equity investment makes more money. How? Say, the investor took a 50% stake and the company grew to having profits of 2 crores. This 2 crores is the earnings for the shareholders in the company. Therefore, the investor gets 1 crore, the entrepreneur and his family gets the rest. However, there are two options. The shareholders can take back the money i.e the 2 crores, but in that case, the company will not have any cash reserves to begin the year. Or they could reinvest it back into the company to make more money (hopefully) the next year.

In the debt structure, the investor gets 20% in good times. But in the bad times he gets the first claim on the proceeds from the liquidation. At the time of bankruptcy, the equity holder gets whatever is remaining after the creditors have been paid off. That makes sense, if the equity holder could have the first claim in good times and bad, then even when the going gets slightly tough, he may be tempted to run the company into the ground! Therefore, the debt structure is a less risky structure; both the loss and gains are capped. The equity structure is riskier. The moral from this is that in a good deal, the reward must be commensurate with the risk taken.

In the above example, the entrepreneur was a small guy and the investor was also a relatively small guy. It need not be. A big company like Reliance can approach investors for money for a new plant they are putting up. A bigger company could approach investors for funding for a takeover. These investors could be a bank, could be a private equity fund, could be a hedge fund etc. The actual structure of the deal would depend on the risk appetite of the investor and their commitments to their shareholders.

This "structure" that we spoke about is essentially a contract. That piece of paper now has some value, hence it becomes a security. Depending on the nature of the contract, this can either be made into a mass product and sold to everyone. Or you can make specialized, newer contracts from this and sell it to specific institutions. Either way, these agreements, if they have a value, can be traded. Where would they be traded? In the secondary markets.In the next part, we would take a closer look and begin to look at how to apply these ideas to real world situations.

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!

These Are a Few of My Favorite Things

(Yes, yes,this is nowhere near the poetry of the original. But to be really honest, raindrops on roses and whiskers on kittens are not my favourite things, though, potentially I suppose there is no reason to dislike them. The actual lyrics can be found here.)

The youtube video of the original song.

Feluda’s exploits and Bertie’s adventures,

Old rock music and classic war movies,

Smell of newspapers fresh in the morning,

These are a few of my favourite things

Sandwich from Cool Joint and breakfast at Woody’s,

Spicy hot gravies and white sevai* noodles,

Open Butter- Masal-Dosa from Adiga’s,

These are a few of my favourite things

Lazing on Elliot’s beach and dinner at Pupil,

Lots of cold beer on a hot afternoon,

Side dishes served in the bars of Chennai,

These are a few of my favourite things

IPL cheerleaders and CSK victories,

Ample Mallu girls in off-white dresses,

Robin Scherbatsky in any episode,

These are a few of my favourite things

When an exam cups, When the beer is flat,

When I lose money on F&O Nifty,

I simply remember my favorite things,

And then I don’t feel so baaaaad.

(P to the S:

1. Sevai refers to a noodle like dish made in Tamil Nadu. I am not going into those restaurant type descriptions - "a scrumptuous lentil based blah blah". I have never benefited from those descriptions. Has anyone ever?

2. Cool Joint is in Jayanagar 4th Block and Woody's is in JP Nagar. Funnily, I went to Woody's only once while at IIM. But I went there almost every time I went to Bangalore before that.

3. The Adiga's I am referring to is in Bannarghatta Road, near IIM. There is supposed to be different Adiga'ses (?) run by different brothers, but I have never noticed what this one is. (!)

4. Pupil is near the Besant Nagar Beach. You will find it, IF you don't know of it.

5. There is a really cool bar near Pavithra's in Jayanagar 4th Block. It is called B-15. Slightly hard to find. There is a staircase near Pavithra's which looks slisha shady, but it leads to B-15 on the 2nd floor. Fantastic music systems but the music gets kind of loud and is not a place to go to if you want to talk.

5. Almost every bar in Chennai serves free side dishes. This is for the gloating Bangaloreans who are like "Oh, Oh, Bangalore is the pub city." Yes, you may have pseud non-TASMAC-like shops where one can go buy alcohol without feeling pained at the dirty surroundings, maybe you can get all new beers and Smirnoff with ease. But we have free and unlimited side dishes in our bars. Yes, free and unlimited. So ha and haha :P

Vacation Stupor

‘Nother Dawn, ‘nother dusk,

‘Nother breakfast, ‘nother lunch’,

Before you can even know,

“How did all that time go?!”

The day begins late for the

Night ended early,

Everyone else in a hurry,

Pfft… why ever this melee

It is the vacation stupor,

The best type of stupor,

She is the mistress of time,

The vacation stupor

So much happenin’ around,

You check the news, too many views,

Really, don’t these people all over,

Ever get the beautiful vacation blues

You could travel,

You could laze by a pool,

You could surf the net,

Or curl with a book

It really doesn’t matter,

What you do,

As you long as you have

Nothing useful to do

An idle mind is a devil’s shop,

Continue this, you can’t,

But before it all comes to a stop,

Have as much as fun as you want