Table of Contents
1. Introduction to Equity.................................................................................................. 4
1.1 Equity as a source of ownership capital for a company............................................ 4
1.2 Debt vs. Equity.......................................................................................................... 5
1.3 Rewards associated with equity................................................................................ 6
1.4 Risks associated with Equity .................................................................................... 7
1.5 Different Classes of Stock ........................................................................................ 8
1.6 Share Capital as shown in Balance Sheet of the company ....................................... 8
2. Primary Market for Equities ..................................................................................... 10
2.1 Issue of Equity – Primary Market ........................................................................... 10
2.2 Why companies issue equity? ................................................................................. 10
2.3 Types of Public Offerings....................................................................................... 11
2.4 Parties involved in an equity issue.......................................................................... 12
2.5 Functions of Investment Bankers............................................................................ 13
2.6 Book Building and Fixed Price issue...................................................................... 15
2.7 Prospectus ............................................................................................................... 16
2.8 Description of entire IPO process ........................................................................... 17
2.9 Public offers, Rights offers and Private Placement of equity. ................................ 20
2.10 Stock Dividends and Stock Splits ......................................................................... 22
3. Secondary Markets for Equities................................................................................ 25
3.1 Introduction............................................................................................................. 25
3.2 Role of secondary market ....................................................................................... 26
3.3 Stock Exchange – A platform for equity trading .................................................... 26
3.4 Listing of securities on stock exchanges................................................................. 27
3.5 Delisting.................................................................................................................. 27
3.6 Open Outcry System ............................................................................................... 28
3.7 Screen Based Trading ............................................................................................. 33
3.8 Life Cycle of a Trade .............................................................................................. 40
3.9 Types of orders and their uses ................................................................................ 42
3.10 Volatility in the prices of stocks ........................................................................... 44
3.11 Market Capitalization............................................................................................ 46
4. Post – Trade Processing ............................................................................................. 51
4.1 Client Side & Street Side of Trade ......................................................................... 54
4.2 Trade Matching....................................................................................................... 55
4.3 Trade Confirmation................................................................................................. 56
4.4 Confirmation for institutional clients...................................................................... 57
4.5 Trade Affirmation ................................................................................................... 59
4.6 Settlement Matching ............................................................................................... 60
4.7 Reconciliations........................................................................................................ 61
5. Clearing and Settlement............................................................................................. 62
5.1 Clearing................................................................................................................... 62
5.2 Settlement ............................................................................................................... 64
5.3 A typical Settlement Cycle ..................................................................................... 67
Equity Markets 2
5.4 Institutional Block Trades....................................................................................... 69
5.5 Trade Allocation ..................................................................................................... 70
5.6 Post Trade Processing in Japanese Equity markets ................................................ 76
5.7 Post Trade Processing in European markets........................................................... 79
6. Stock Exchange Indices .............................................................................................. 83
6.1 Types of indices ...................................................................................................... 83
6.2 Price Weighted........................................................................................................ 84
6.3 Value Weighted ...................................................................................................... 85
6.4 Total Return Index .................................................................................................. 86
6.5 Important stock exchange indices ........................................................................... 86
7. International Equity Markets.................................................................................... 94
7.1 American Depository Receipts ............................................................................... 94
7.2 Global Depository Receipts (GDRs) ...................................................................... 95
7.3 Advantages of ADRs .............................................................................................. 96
7.4 Process of creation of ADRs................................................................................... 97
7.5 Participants in ADR issue process .......................................................................... 97
7.6 Trading in ADRs..................................................................................................... 99
8. Basic Mathematics of stocks .................................................................................... 101
8.1 Total Return from a stock ..................................................................................... 101
8.2 Dividend Yield...................................................................................................... 103
8.3 Capital gains / losses............................................................................................. 103
8.4 Market Capitalization & Enterprise Value ........................................................... 103
8.5 Price / Earnings and other multiples ..................................................................... 104
9. Sample Questions...................................................................................................... 106
10. Glossary ................................................................................................................... 108
Equity Markets 3
1. Introduction to Equity
Stock is a share in the ownership of a company. Stock represents a claim on the
company's assets and earnings. As one acquires more stock, the person’s ownership
stake in the company becomes greater. Share, equity, or stock all means the same thing.
As an owner, the shareholder is entitled to the company's earnings as well as any voting
rights attached to the stock. As the equity capital is not redeemed i.e. not returned back
to the shareholders, it becomes the permanent source of capital for the company1.
When stocks were in physical form they used to be represented by stock certificates. A
stock certificate is a piece of paper that is proof of the ownership. In today's computer
age, these records are kept electronically or in dematerialized form.
1.1 Equity as a source of ownership capital for a company
• There are principally two sources of capital : Equity capital and debt capital.
Equity represents the ownership capital. A common stock or an equity share is
the primary source of capital for the business without which business can not
exist. Debt capital comes from non-owners or outsiders. It is like a loan given to
the company by outsiders.
Sources of Capital
Equity – Owner’s Debt – Outside
except in case of share repurchase in which case the company buys back the shares and returns a part of
capital to the shareholders
Equity Markets 4
1.2 Debt vs. Equity
At some point every company needs to raise capital to fund its business. In fact
companies may have to raise capital quite regularly. To do this, companies can either
borrow or issue stock. A company can borrow by taking a loan from a bank or by
issuing bonds. This is called debt financing. On the other hand, if the company raises
capital by issuing stock, it is called equity financing. Some important differences
between debt and equity capital are as follows.
Debt capital is outside capital. Hence debt holders do not enjoy the rights of
equity holders, especially the voting rights.
Equity being ownership capital takes all the risks associated with ownership.
That means equity owners have no priority on claims of the assets of the company.
Equity capital is not required to be returned to the shareholders. On the other
hand, debt capital whether in the form of loan or bonds, has to be returned to the
Interest which is a reward to be paid to debt holders is a charge against profit
and has to be paid whether profits are adequate or not. Dividends, reward for
shareholders, may or may not be paid. It is not mandatory to pay dividends.
For the security of bond holders, a charge on company’s assets may be created.
Thus in case of non payment of interest or principle by the company, these assets can
be sold off to clear the dues of the debt holders. Even if a charge is not created on
assets, debt holders have a priority on company’s assets.
As far as return potential is concerned, there is no upside potential for debt
capital. For example, if the company does very well, it still pays the same rate of
interest applicable on the loan. Equity holders benefit in terms of higher dividend or
higher capital appreciation in case the company does well. Upside potential for
equity is unlimited.
Investors who want fixed return invest in debt securities. It is a low risk low
return product compared to equity. Investors who desire high return and are
prepared to take higher risk go for equity investment.
Equity Markets 5
Considering the fact that equity is a risky capital, the return expectations from
investors are also high. Compared to this the return expectations are low from fixed
income investors. That is why over the long term equity markets have outperformed
debt markets i.e. they have given better returns than the debt markets.
1.3 Rewards associated with equity
Dividends - The importance of being a shareholder is that the shareholders are
entitled to a portion of the company’s profits and have a residual claim on assets.
Dividends are of following types.
» Cash Dividends – Dividends are generally paid in cash. A part of profits are
paid out in the form of cash dividends.
» Stock Dividends – Dividends are given in the form of shares. This means
shareholders are given additional shares in certain proportion to their holdings,
free of cost.
Share repurchase – This involves buying back equity shares from shareholders
in certain proportion. Thus instead of using cash to pay dividends, cash is utilized by
the company to repurchase the shares. The price at which the shares are bought back
is generally higher than the current market price resulting in a gain for shareholders.
Capital Gains – Capital gains refer to the increase in prices of shares of a
company. In fact this is the reason why most of the investors hold equity shares. In
most of the cases, a large part of total return which a shareholder gets for investing
in equity comes from capital appreciation.
• Right to subscribe to new shares – A company may come out with a rights
offering. That is, it may offer additional shares at a certain price to its existing
Equity Markets 6
shareholders. This is the privilege that the shareholders enjoy. Many times rights
may be offered at a significantly discounted price compared to the current
market price, as a reward to shareholders.
Right to Vote – Being the owners of the company, shareholders can vote in
Annual General Meetings and other shareholder meetings on important matters
which affect the company’s businesses. These matters include increasing capital of
the company, auditors’ appointments, directors’ appointments etc.
Right to information – Shareholders have right to get timely information about
the company’s operations. They receive on a regular basis, annual reports, quarterly
reports and other corporate information.
1.4 Risks associated with Equity
Residual Capital – Equity is a residual capital. That means claims of equity
holders can be satisfied, after claims of all others such as lenders, creditors etc. are
satisfied. Hence equity holders take maximum amount of risk. However an
important point in this case is that differentiates between the liability of shareholders
and liability of owners of partnership etc. is that shareholders have a Limited
Liability. This means that, the owner of a stock is not personally liable if the
company is not able to pay its debts. In case of partnerships, on the other hand, if the
partnership goes bankrupt the creditors can hold the partners (shareholders)
personally liable and sell off their house, car, furniture, etc. to realize their dues.
Owning stock means that, no matter what, the maximum value a shareholder can
lose is the value of his investment. Even if a company goes bankrupt, the
shareholder can never lose his personal assets.
Capital Losses – Share prices are highly volatile. They keep changing as per
market’s perception about a particular company. Just as there is no upward limit to
which share prices can go, there is no downside limit as well. Hence shareholders
may loose substantial or entire part of their investments if share prices go down.
Equity Markets 7
Liquidity risk – Sometimes shares may suffer from poor liquidity. This means
that shares are not traded regularly or even if they are traded the trading volumes
are low. This is called the liquidity risk. If the shares become illiquid, shareholders
find it difficult to sell them off at current market prices.
1.5 Different Classes of Stock
Companies may issue different classes of common stock. This is because the company
may want a particular group of shareholders to have voting rights. Hence, different
classes of shares are given different voting rights provided the law of country allows the
same. For example, one class of shares would be held by a select group who are given
ten votes per share while a second class would be issued to the majority of investors
who are given one vote per share.
When there is more than one class of stock, the classes are traditionally designated as
Class A and Class B. The different classes of shares trade at different prices and they are
given different identification symbols.
1.6 Share Capital as shown in Balance Sheet of the company
Capital is the money that any company needs to run its business. Equity capital is
shown in following classes in Balance Sheet of a company.
Authorized capital is the maximum number of shares that a company is allowed to
issue for raising capital as per the Memorandum of Association (charter) of that
company. If authorized capital needs to be changed, shareholders’ approval is to be
obtained and Memorandum of Associated needs to be altered.
Issued capital is that part of the Authorized capital that has been issued by a company.
Companies generally do not issue their entire Authorized capital to the public and
withhold part of it for future issues.
Called up capital is that part of issued capital for which the company has called up
Equity Markets 8
Paid up capital is also called Subscribed capital and is that part of the Called up capital
for which the payment has been received from the investors. If the entire Issued capital
has been paid for by the investors it is said to be fully-paid up and if the entire issued
capital has not been paid for by the investor then it is called partly-paid up capital.
Par Value Shares – Par value of a share is the face value of the share. It is of little
economic significance. It may be mandatory to have par value or shares without par
value can also be issued. Country regulations may differ. In the US, par value is not
The shareholders equity of BOEING Company is shown below. This extract is from its
annual report for the year 2004.
In $ millions
Shareholders’ equity: 2004 2003
Common shares, par value $5.00 – 1,200,000,000 shares authorized;
Shares issued – 1,011,870,159 and 1,011,870,159 5,059 5,059
Additional paid-in capital 3,420 2,880
Treasury shares, at cost – 179,686,231 and 170,388,053 (8,810) (8,322)
Retained earnings 15,565 14,407
Accumulated other comprehensive income/(loss) (1,925) (4,145)
ShareValue Trust Shares – 38,982,205 and 41,203,694 (2,023) (1,740)
Total shareholders’ equity 11,286 8,139
Treasury Shares are shares repurchased by the company, which are not yet
Equity Markets 9
2. Primary Market for Equities
2.1 Issue of Equity – Primary Market
The primary market plays an important role in development of equity markets. If
primary market is healthy following benefits become available.
If increasing number of companies issue securities through primary market and
get the shares listed, investors have a lot of choice for investments.
The market capitalization2 of all listed securities goes up, as large number of
securities gets listed. Increased market capitalization of attracts more investors,
domestically as well as internationally.
If primary market is in good shape, the companies which raise capital through
sell of shares, may be able to do so at lesser cost. This is because as mentioned above,
more investors are attracted as market capitalization improves. Thus companies can
reduce their cost of funds.
2.2 Why companies issue equity?
There are reasons why the company may want to raise capital through equity or issue
equity shares. Some of the reasons can be as follows.
Company wants to become a public company from a private firm – In this case,
the company will have to issue fresh equity or the existing shareholders have to offer
their shares to the investors at large.
The company is planning a new project or expansion / diversification projects
requiring significant capital expenditure – If the company wants to incur substantial
capital expenditure, then increase in debt may not be sufficient and it will have to
raise equity capital.
Market capitalization refers to a product of number of outstanding shares a company has and market price
Equity Markets 10
Domestic or Overseas Listing – Companies may want to get its shares listed on
domestic or overseas stock exchanges, this gives the company wide publicity and
adds to its goodwill. For this it may have to issue equity.
2.3 Types of Public Offerings
Initial Public Offerings (IPO)
This offer is made when the company issues shares to the investors at large for the first
time. Prior to an IPO, a company is not a listed company. It becomes a listed company
subsequent to an IPO.
Advantages of listing shares on stock exchange
Increase in the capital – When the company lists its shares on stock exchanges, it
issues shares to the public. This leads to the increase in company’s capital. With the
increased capital, company can finance its growth.
Liquidity – Stock exchanges offer an opportunity for the investors to buy the
shares and exit whenever they want. This is possible only after the company lists its
shares. Thus increased liquidity in company’s shares attracts more investors making
the company popular.
Publicity – A listed company is generally widely publicized compared to an
unlisted one. Not only that even when lenders think of giving loans to companies
they find it more comfortable to lend to a listed company.
Valuation – Before the company is listed, market participants have no idea about
its valuation since the share prices are not available. But once the shares get listed, it
helps in price discovery process as market participants start trading in shares at
Follow on or Secondary Offerings
A follow on or secondary offer is an offer made by an already listed company. These
offers are generally made to raise capital required to fund the capital expenditure.
Equity Markets 11
Shelf registration is a registration of securities that are not to be offered for sale
immediately. This is because the company may want to come out with public issue but
market conditions are not favorable. Hence the company may want to register the issue
and offer the same after some time. Another reason for shelf registration is to minimize
underwriting costs. Any type of public offering involves significant amount of costs.
Especially the underwriting expenses are substantial. Suppose the company expects that
it will need additional capital in the near future, then it can minimize its underwriting
expenses by the process of shelf registration. This registration of securities, as per the
SEC rule 415, can be done upto two years in advance. The securities can be issued when
required or when market conditions are favorable. That is why these issues are called
shelf registrations because after they are registered, the issues lie on shelf and can be
sold with short notice.
It may be advantageous for the investment banker3, who is the lead manager for the
issue. This is because each time only relatively a small number of shares are issued,
hence lead manager may be able to manage the issue with one or two other
underwriters4 instead of having a big syndicate. This allows the issuers to invite
competitive bids from investment bankers and thus helps reduce the cost of issue.
2.4 Parties involved in an equity issue
Issuing Company – Issuer has to decide the quantum of securities to be sold based on
the requirements, the proposed utilization of proceeds etc. All the information regarding
the business and its operations which is an integral part of registration statement and
prospectus needs to be accurately provided by the issuer. Any misleading information
may result in the issue getting suspended by the SEC.
The role of investment banker is explained in the section of Parties involved in an equity issue.
The role of underwriter is explained in the section of Parties involved in an equity issue.
Equity Markets 12
Investment Banker – This is the key participant in the entire issue process. The role of
investment banker starts from the very beginning where an advice needs to be given to
the issuer on the type of security that will best meet the his requirement. Investment
banker, being a market expert, can gauge the market potential for various types of
securities, response to issues of companies belonging to certain sectors etc. and hence is
in a better position to advise the companies.
The role of investment bankers is very important in the entire primary issue
management. The most important role that they play is underwriting the issue.
Underwriting means the investment banker along with other syndicate members
guarantees to subscribe to any unsubscribed portion of the issue. Once the issue is
underwritten, it guarantees the issuer of the proceeds from the issue. Thus it relieves
him form the pressure of getting subscriptions.
2.5 Functions of Investment Bankers
Underwriters perform a variety of functions. That is why they are very important
participants in the entire issue process.
Help in issue design
- As Principal
- As Agent
Equity Markets 13
Helping the issuer design the issue – This is the initial help that is provided by
the underwriters. The advice is given on aspects such as restructuring of the issuers’
existing capital structure, suitability of a new issue, the type of securities etc. Once
these details are finalized, the underwriters may help in registering with the SEC.
Deciding the pricing of the issue – Pricing of the issue needs to be decided
carefully after going through the initial market response to the issue. The
underwriting syndicate is in a better position to understand the market response.
Operational Procedures – A number of operational tasks need to be completed.
For example each security needs to be given a security identification number (in the
US, a CUSIP number needs to be given to each security). Similarly as all the issues
are now in dematerialized form, the securities need to be lodged with the
depository. A corporate trust agent needs to be informed so that they help in actual
issuance of securities.
Underwriting – The actual underwriting function can take the following two
forms. That is, the investment banker may commit to purchase the shares as
principal or act as an agent.
Distribution – This involves distribution of shares to the ultimate investors. This
is generally done with the help of a selling group who are the investment or broking
firms. The brokers are compensated depending upon the number of shares sold by
Equity Markets 14
Brokers / Dealers – They help in distribution of the issue to the investors. They form the
L Underwriting Selling group
U Inv. Bank A Broker A V
I N E
N D S
G E T
R Inv. Bank B Broker B O
R T Inv. Bank C Broker C
Stock Exchanges – Companies propose to get their shares listed on stock exchanges after
the issue. Hence they have to seek approval for listing their securities. If the listing
criteria specified by the exchange are met, companies are given the approval for listing.
Depository – For securities to be depository eligible, the criteria laid down by
depository such as Depository Trust and Clearing Corporation must be met. Once
approved investors can settle their trades through depositories.
2.6 Book Building and Fixed Price issue
In book building process, when the issue is sold, price at which it is sold is not fixed.
Investors know only a price range. They can submit the bids at various prices given in
the price range. The book running lead manager runs the book and the book is open for
inspection to the investors. It means that investors know the response for the issue on a
daily basis till the issue is open. Depending upon the response, the final price of the
issue is determined. This helps in the price discovery process unlike the fixed price issue
in which case, issue is sold at a fixed price.
Equity Markets 15
When a company wants to come out with an IPO or follow on offer, it has to approach a
number of investors who need to make an investment decision. To help them make this
decision, the company needs to prepare what is known as prospectus. It is a legal
document which provides details about the company proposing to make a public offer.
The prospectus is a very important document. Its contents need to be carefully drafted.
Generally companies give a very detailed disclosures of all the aspects related to its
business and management. There are two types of prospectuses which are prepared.
Initial / Preliminary Prospectus – This has to be filed for approval with the capital
market regulators. Thus in the US, the initial prospectus is to be filed with Securities and
Exchange Commission. Since this prospectus is yet to be approved by the SEC, a
disclaimer needs to be printed in red ink on the cover page stating that the issue has not
yet been approved. That is why this is called a Red Herring prospectus. The price at
which the issue is sold is determined after SEC’s approval, hence no price mentioned in
Final Prospectus – The approval of SEC comes after examining that the registration
form and preliminary prospectus are complete and do not appear to contain any
misleading information. After receiving the approval, the company can go ahead with its
issue process. At this time it comes out with the Final Prospectus which is distributed to
the investors. The price at which the issue going to be sold, is indicated in final
Equity Markets 16
Details mentioned in the prospectus
Use of issue proceeds
Capitalization & distribution
Management’s Discussion of Finances and Operations
Prior Year Results
Description of business
Description of Capital Stock
Report of Independent Public Accountants
2.8 Description of entire IPO process
IPO has to be a well planned activity. There are a number of steps involved in IPO.
1) IPO Idea Generation – The starting step is that the company thinks about
offering shares to the public. This may be because it wants to list its shares or to
raise capital or any other reasons.
2) Selection of Investment Banker – We have already seen that the investment
banker plays an extremely important role. Hence the selection of investment
banker assumes great importance.
3) Preparation of Registration Statements - These statements consist of important
information such as
- Business descriptions and properties held,
- shares held by directors, officers, underwriters,
- details of investors holding more than 10% shares,
- certified financial statements,
Equity Markets 17
- description of security being offered etc.
SEC examines these statements and ensures that they fulfill the regulatory
4) Filing of registration statements and Red Herring Prospectus - Red herring
prospectus is the preliminary prospectus. These documents are filed with SEC.
5) Cooling off period - After filing these documents, a 20 day cooling off period
begins. This is the period in which discussions are held with the potential buyers.
Preliminary prospectuses are sent by the brokers to potential clients so that the
clients give indications of interest in the issue. This is important because this
gives the issuer and investment banker an idea about clients willingness to
subscribe to the shares in a given price range. However, this is just indication of
interest and the client is not bound to purchase as indicated. No sale of securities
can take place till registration of securities is complete.
6) Establishment of syndicate – This takes place in the cooling off period. In
consultation, with the lead underwriter, other members of underwriting
syndicate are determined.
7) Registration of Securities with states – Here the registration of securities is done
with different states in the US.
8) Assessing investor interest - This is an ongoing process. A number of investors
are approached with the help of underwriting syndicate and response to the
issue is gauged.
9) Approval from SEC – Once the issue is approved by the SEC, formal marketing
for the issue can start. Road shows, investor / analyst conferences are held where
company officials and underwriters meet and discuss about the issue related
10) Tombstone Advertisement – This gives details of actual issue and underwriters
to general public. This is placed in a newspaper so that the investment
community knows about the issue.
11) Final Prospectus Preparation - After the SEC’s approval, final prospectus is
prepared which mentions the price range and issue date.
Equity Markets 18
12) Issue Opens – Subscriptions to the issue are collected.
(Steps involved in entire IPO process – This is just an indicative flow. Actually steps
may be taken simultaneously. For example, after the syndicate has been established,
soliciting investor interest and registration of securities in various states etc. may be
IPO idea Selection of Preparation of
generation investment Registration Statement
banker and Prospectus
Establishment Cooling off Filing of Registration
of syndicate period Statement and
Prospectus with SEC
Registration of Assessing
securities in investor Approval from SEC
various states interest for the issue
Issue opens Preparation of
Equity Markets 19
2.9 Public offers, Rights offers and Private Placement of equity.
Public Issue – A public issue in one when the shares are issued to the general public i.e.
it is free for subscription to all investors. A public issue is one that is most challenging,
time consuming and costly process. This is because to make a public issue a success, lot
of planning and coordination of various activities is required. The advantages of raising
capital by public issue are
Wide publicity – The company which is going public for the first time or with
subsequent offer, gets a wide publicity. It advertises heavily for the issue and in the
process its management, operations and other relevant things automatically get
known to the public.
Huge capital raising possibilities – Since public issue is open to all investors, the
possibility of raising a huge amount of capital exists. This is particularly suitable if
the company is planning a major project involving substantial capital expenditure. In
such cases, public issue may be the only option to raise the required amount of
However public issues have some disadvantages also.
High Cost – The cost of public issue is very high. The number of agencies,
including the lead manager, who take responsibility of public issue management,
obviously charge fat fees. Even internally, a number of employees may have to be
devoted to the issue management, which involves substantial cost. Apart from this,
the cost of publicity is also on the higher side. Considering the cost involved, it
makes sense to go for public issue only when the capital requirements are huge.
Time Consuming – A public issue process is time consuming. While it is difficult
to put exact time line, a successful public issue can be concluded in more than an
year’s time. During this time period, substantial part of the company’s resources,
energies are diverted towards making the issue sail through smoothly.
Equity Markets 20
Rights Issue – A rights issue is one in which the shares are offered to the existing
shareholders only. If any of the existing shareholders is not interested in subscribing to
the rights shares, he can renounce the rights in favor of any other interested investor.
These rights are even traded on the stoke exchanges. Compared to the public issue,
rights issues can be concluded in shorter time, are not costlier since wide publicity is not
required. However as far as capital raising is concerned, there are limitations since the
company approaches only its existing shareholders. Hence when the capital
requirements are not high, then rights issue may make sense. However if the company is
private company and wants to become public by listing its shares on stock exchanges,
then a rights issue will not help.
Underwriting of rights issue may be required if the issuer feels that market conditions
are not favorable or the issue may not have sufficient demand. In this case a stand by
underwriting may be done which ensures that in absence of enough demand, the
underwriters pick up the shares and make the issue fully subscribed.
Private Placement – A very popular way to raise capital is private placement. In this
case, unlike the public or rights issue, the number of investors approached for capital
raising are few. Mostly these are institutional investors who subscribe to such issues.
Since the issue is not open to all investors, but to a few of them, it is called an offer on
private placement basis. This offer can not be made to more than 35 investors in a 12
month period. These institutional investors have access to the kind of information that
will generally be contained in a prospectus. Hence a separate prospectus is not prepared
unlike the public issue, only the offer is described in offering memorandum.
Private placements, which are regulated under Regulation D, require registration with
SEC. The offer may not be advertised publicly by the issuer or the investment banker.
There is a criteria laid down for investors who can invest through such private
placements. This requires investors to have a net worth of at least $ 1 million or gross
income of at least $ 200000 per year for last two years.
Equity Markets 21
2.10 Stock Dividends and Stock Splits
Bonus Issue or Stock Dividend – In this case the company creates new shares by
distributing free shares to its shareholders. This does not result into additional capital
Stock Split – Even in stock splits, new capital is not raised. In this case, the face value of
existing shares is split into smaller lots so that the number of shares goes up.
The intention in both the above cases is to reduce the market price so that it trades in
particular trading range.
Cover Page of Prospectus of IKANOS COMMINICATIONS INC
IKANOS COMMUNICATIONS INC
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Filed Pursuant to Rule 424(b)(4)
Registration No. 333-132067
We are selling 2,500,000 shares of our common stock and the selling
stockholders named in this prospectus, including members of our senior
management, are selling 3,250,000 shares. We will not receive any proceeds from
the sale of shares by the selling stockholders.
Our common stock is quoted on the Nasdaq National Market under the symbol
"IKAN." On March 16, 2006, the last sale price for our common stock as reported
on the Nasdaq National Market was $20.92 per share.
Investing in our common stock involves risks. See "Risk Factors" beginning on
Per Share Total
Public offering price $ 20.7500 $ 119,312,500
Underwriting discount $ 1.0375 $ 5,965,625
Proceeds to Ikanos (before expenses) $ 19.7125 $ 49,281,250
Proceeds to the selling stockholders (before expenses) $ 19.7125 $ 64,065,625
The selling stockholders have granted the underwriters a 30-day option to
purchase up to 862,500 additional shares of common stock to cover
over-allotments, if any.
Equity Markets 22
Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if
this prospectus is truthful or complete. Any representation to the contrary is
a criminal offense.
The underwriters expect to deliver the shares to purchasers on or about March
Citigroup Lehman Brothers
Deutsche Bank Securities
Thomas Weisel Partners LLC
Needham & Company, LLC
March 16, 2006
Underwriting Terms of Issue of IKANOS COMMINICATIONS INC
Citigroup Global Markets Inc. and Lehman Brothers Inc. are acting as
joint book running managers and are acting as representatives of the
underwriters named below. Subject to the terms and conditions stated in the
underwriting agreement dated the date of this prospectus, each underwriter
named below has severally agreed to purchase, and we have agreed to sell to
that underwriter, the number of shares set forth opposite the underwriter's
Citigroup Global Markets Inc. 2,012,500
Lehman Brothers Inc. 2,012,500
Deutsche Bank Securities Inc. 747,500
Thomas Weisel Partners LLC 546,250
Needham & Company, LLC 431,250
The underwriting agreement provides that the obligations of the
underwriters to purchase the shares included in this offering are subject to
approval of legal matters by counsel and to other conditions. The underwriters
are obligated to purchase all the shares (other than those covered by the
over-allotment option described below) if they purchase any of the shares.
The underwriters propose to offer some of the shares directly to the
public at the public offering price set forth on the cover page of this
prospectus and some of the shares to dealers at the public offering price less
a concession not to exceed $0.6225 per share. If all of the shares are not sold
at the initial offering price, the representatives may change the public
offering price and the other selling terms.
The selling stockholders have granted to the underwriters an option,
Equity Markets 23
exercisable for 30 days from the date of this prospectus, to purchase up to
862,500 additional shares of common stock at the public offering price less the
underwriting discount. The underwriters may exercise the option solely for the
purpose of covering over-allotments, if any, in connection with the offering.
To the extent the option is exercised, each underwriter must purchase a number
of additional shares approximately proportionate to that underwriter's initial
We, our directors, executive officers and certain of our stockholders,
including the selling stockholders, have agreed that, for a period of 90 days
(subject to an extension of up to 18 days) from the date of this prospectus, we
and they will not, without the prior written consent of Citigroup and Lehman
Brothers, dispose of or hedge any shares of our common stock or any securities
convertible into or exchangeable for our common stock, provided that, we will
be permitted to issue shares of our common stock with a market value of up to
$25.0 million on the date of issuance in connection with bona fide acquisitions
we might make. Citigroup and Lehman Brothers may release any of the securities
subject to these lock-up agreements at any time without notice.
In connection with our initial public offering, the underwriters of
such offering obtained lock-up agreements from all of our officers and
directors, certain of our employees and each stockholder of at least 1% of our
capital stock, under which they agreed not to transfer or dispose of, directly
or indirectly, any shares of our common stock until March 21, 2006. The
representatives of such underwriters have agreed to release the selling
stockholders from their lock-up agreements to the extent they are participating
in the offering.
Equity Markets 24
3. Secondary Markets for Equities
Secondary market for equities, or for any other financial security, is a market where
outstanding securities i.e. securities which have been issued by the issuer are traded.
Thus when a corporation issues new shares, it does so through primary market. Once
these shares are issued to the investors, a mechanism is established so that shares can be
exchanged between the interested parties. This is called the secondary market.
Primary Market Investors
Issues shares to investors
A Investors transfer funds to the issuer
Listing of shares on stock exchange
Investor A Trading of shares and transfer of funds Investor B
between the investors
Equity Markets 25
3.2 Role of secondary market
The main function of secondary market is to create the liquidity in financial instruments.
In simple words, it provides entry point to those investors who want to buy the
securities and exit point to those who want to sell them. Thus a vibrant secondary
market increases the market size, attracts more participation from investors and leads to
the development of sound financial markets. In fact, a healthy secondary market will
also give a boost to primary market.
3.3 Stock Exchange – A platform for equity trading
Equity shares are exchange traded products. That is, once issued, the issuer gets them
listed on a recognized stock exchange which facilitates trading in shares. In many
countries, there are a number of stock exchanges, but usually one or two dominate in
terms of trading volumes, listing of shares of highly valued companies etc.
The role of stock exchange is very important in conduct of trading in equity shares. The
major functions of stock exchanges are as follows.
establishing rules for allowing membership to the firms,
facilitating listing of securities,
framing rules for trading of securities,
establishing proper risk management framework for smooth conduct of trading
ensuring the dissemination of information to all market participants
Organization and governance of Stock Exchanges
Stock exchanges are bodies established as per the provisions of law of that country.
Traditionally stock exchanges were owned and managed by brokers, dealers. While this
had advantage of domain expertise, several issues relating to conflict of interest arose.
Hence a need was felt to demutualize the stock exchanges. Demutualization means that
the ownership, management and trading rights are not linked to each other.
Equity Markets 26
Membership of stock exchanges
The trading platform of exchanges is accessible to investors only through the trading
members who are subject to its regulatory discipline. Any entity can become a member
of a stock exchange by complying with the prescribed eligibility criteria. A stock
exchange membership is an important position. This is because by becoming a member
of stock exchange, one is allowed to trade on his account as well as on behalf of its
clients. Since this gives rise to obligations, in terms of payment of funds for the buyers or
delivery of securities for the sellers, the members should be capable of fulfilling these
The rules for membership of stock exchanges are framed by the respective stock
3.4 Listing of securities on stock exchanges
Listing means admission of securities of an issuer to trading privileges on a stock
exchange through a formal agreement. The prime objective is to provide liquidity and
control over trading while facilitating disclosure of important information to the
investors. It is possible to “Permit” trading by a stock exchange for a company not listed
on it, provided the company is listed on another recognised stock exchange. This is
facilitated through Over The Counter exchange.
Companies may be delisted from the stock exchanges due to the following reasons.
Voluntarily by the controlling group – This is because the controlling group
becomes the shareholder for most of the stock and there in very little public holding
left. Hence they may want to delist the shares so that they are not required to comply
with the regulations of stock exchange.
Due to acquisition by another company – Company A acquires company B, by
paying cash or shares to shareholders of company B which is delisted.
Equity Markets 27
Compulsorily by the stock exchanges for non compliance with listing agreement
– If a company fails to comply with regulations of stock exchange, it may delist the
shares of the company.
In each of the above cases, there is a detailed regulatory process which has to be
followed before delisting can be done.
How share prices are quoted? What are bid–ask prices?
Stock prices are quoted in decimal forms. Bid price is the price the buyer is willing to
pay for an asset. Ask price is the price the seller is willing to receive for an asset. When
bid and ask prices match, transaction takes place.
The trading platform is provided by the exchanges. All members of the exchange
(brokers) are given access to the trading platform. Investors have to route their orders
through the members. Trading can be done by Open Outcry system or can take a form of
Screen Based Trading.
3.6 Open Outcry System
In an Open Outcry system the dealers/brokers meet in a specified area (called the
“Ring”) and trades are entered manually. For Example, NYSE follows the system of
Open Outcry for stock trading as described below.
NYSE – Floor Trading
Market professionals gather on Trading Floor, which consists of trading rooms
occupying 48000 square feet. Trading starts with the ringing of opening bell in the main
trading room. The trading floor is made up of various trading posts. In each trading
post, particular stocks are traded between specialists and brokers.
Parties involved in trading of equities
Equity Markets 28
These are the Brokers i.e. intermediaries who receive orders from the public to buy or
sell shares. There are two main types of floor brokers who work on the Trading Floor:
• House Brokers - Employed by brokerage houses that are members of the NYSE.
They are highly trained market professionals and operate for their institutional
• Independent Brokers - The majority of independent brokers are “direct access”
brokers who deal with the institutional public at low commission rates.
Specialist – Each stock has a specialist whose main function is to provide buy and sell
quotes to floor brokers. Thus he helps in making the market liquid. He is ready to buy
that particular stock at a price and ready to sell at a particular price. His bid and ask
quotes keep changing depending upon market demand and supply.
Investors Broking Firms
Communicate orders telephonically A B
or by filling orders online
Post 1 Post 2
Trading Floor Post 3
Post 5 Post 4
Once the orders are received by the broking houses from their investor clients, these are
either automatically, through electronic means, transmitted to the trading posts or to
the floor brokers who openly meet at the trading post to execute the orders. Small orders
Equity Markets 29
are generally sent to the specialists’ workstations at the trading posts through SuperDOT
system, while others can be transmitted through Broker Booth Support System (BBSS) to
the brokers’ wireless handheld computers. (It is estimated that 95% of the orders,
representing 65% of share volume are delivered directly to trading posts through
electronic means. Remaining 5%, accounting for 35% of share volumes are represented
by floor brokers.) The trading crowd which gathers around the trading posts announces
their bids and offers loudly so that anyone present can do the deal with them. A trade is
executed when best bid (highest bid) meets best offer (lowest offer).
Thus the orders are executed by the specialists who handle a particular stock or by floor
brokers competing against each other for the best price for their customers.
After the trade is executed – The information is sent through the specialist’s workstation
to the concerned brokering house which in turn intimates its client. At the same time the
information is sent to Consolidated Tape, known as Ticker, so that it can be
disseminated to all the market participants.
Workstation of Specialist Broker Investor
NASDAQ 2249.72 -17.74 -0.78% | DJIA 10972.28 -33.46 -0.3% | S&P 1272.23 -6.24 -0.49%
This is followed by post trade processing, clearing and settlement.
Source : Website of New York Stock Exchange
Role of a Specialist
A specialist performs very important functions in the entire trading process.
Auctioneer – In this role, a specialist announces a fair market price at the start of each
trading session everyday. This price is arrived at by taking into account demand and
supply for the stock. Throughout the day specialists keep quoting bid and offer quotes
Equity Markets 30
to facilitate trading.
Agent – He acts as an agent for all orders transmitted electronically through SuperDOT
or specifically requested by floor brokers to be executed on their behalf.
Catalyst – Orderly market needs to be maintained by the specialists for their assigned
stocks. This requires minimal price fluctuations so that investors are protected.
Dealer – During the times of heavy selling pressure or high demand for the stock, the
specialist tries to absorb the stock to kerb the selling pressure or creates supply of the
stock from his own reserves. Thus he helps market price stabilize during these volatile
Source : Website of New York Stock Exchange
NYSE Trading Floor Technology
As mentioned above, at NYSE orders are routed to trading posts, booths or floor traders’
handheld computers by the systems SuperDOT and Broker Booth Support System
(BBSS). A brief description of these systems is as follows.
SuperDOT – This system caters to smaller orders. This Super Designated Order
Turnaround System enables routing of both market and limit orders5. These orders are
transmitted directly to the trading post and reach the specialist for that stock. This
results into faster trading since orders reach electronically rather than reaching through
phone to floor traders who execute it manually.
BBSS – The Broker Booth Support System provides two alternatives to the member
firms. First one is that the orders can be routed electronically through BBSS directly to
the trading post. Alternately, orders can be sent to the handheld computers of floor
brokers who then execute the same. Hardware such as 18-inch, high-resolution, flat
panel display; software; support and connectivity and options make BBSS a turnkey
Consolidated Tape System (Ticker) – Whenever the trades are executed, the
dissemination of information of prices at which the trades are done and the volume of
These orders are explained in the section Types of Orders
Equity Markets 31
trade need to be disclosed continuously. A Consolidated Tape System, popularly
known as Ticker, is an integrated, worldwide reporting system of price and volume data
for trades in listed securities in all markets. Some other pieces of information such as
market open / close announcements, market summary reports etc. may also be
provided through this.
Source : Website of New York Stock Exchange
Equity Markets 32
3.7 Screen Based Trading
In a screen based trading system the orders are punched into an electronic trading
system which does the matching on a price time priority. Screen Based Trading is
Fast – It is faster than open outcry because as soon as the orders are input in the
brokers’ systems, they are ready for the execution if suitable match is found. In open
outcry system, after the order reaches a floor broker, he has to go to the concerned
trading post for execution of orders. Hence screen based trading can be considered
to be faster.
Cheaper – Since market information is available to all the market professionals at
the same time, it may help in narrowing down the spread between bid and ask rates,
making it cheaper compared to the open outcry system.
Anonymous – In an open outcry system, when a broker approaches a trading
post, the identity of the broker becomes known to the specialist or other brokers. In
screen based trading, however, this possibility does not exist as all the orders are
routed through the systems and it is difficult to know the counterparty.
Transparent – It is transparent because the information is available to all market
professionals at one time.
Less error prone – Once two floor brokers strike a deal, they have to input the
details manually. This may leave a scope for errors and disputes. However, in screen
based trading the deal is automatically done once the order details are input in the
system thereby reducing the possibility of errors and disputes.
Unlimited in geographical reach – In screen based trading, all the systems of
brokers are linked to the systems of exchanges through satellites, hence sitting in any
corner of the country or across continents for that matter, wherever broker terminals
exist, trading can be done.
It is important to note that most of the exchanges have turned towards screen based
trading. Even those like the NYSE, where open outcry system continues, systems have
been developed to route the orders electronically to the trading posts for direct
execution, as we have already seen.
Equity Markets 33
Screen Based Trading in US
In the US, one of the platforms for screen based trading is National Association of
Securities Dealers Automated Quotations (NASDAQ). It is a wholly owned subsidiary
of National Association of Securities Dealers (NASD) and provides largest electronic
screed based equity securities trading facility. It is largest in the US, both in terms of
number of listed companies and traded share volume. The listed companies
predominantly are from emerging industries such as technology, retail,
communications, financial services, transportation, media and biotech.
Equity Markets 34
As mentioned above, NASDAQ is owned by NASD. It is a registered national securities
exchange and recently got its approval from SEC regarding this. The main intention for
registering as a separate exchange is that it can operate without being controlled by
NASD. As a stand alone exchange, it can frame its own rules and regulations. The
services provided by NASDAQ are similar to the ones provided by the other stock
exchanges and primarily include
Issuer Services – NASDAQ provides for listing of securities
Market Services – It allows to execute buy and sell orders for the listed
Thus NASDAQ competes actively for the business with NYSE, other American Stock
Exchanges and Electronic Communication Networks (ECNs). It also has a system of
market makers who make the stocks as liquid as possible by continuously providing
buy / sell quotes. However, unlike the NYSE it is a fully computerized, screen based
system. The average NASDAQ listed stock has over 20 market makers. NASDAQ links
over 250 of competing market makers.
Source: The website of NASDAQ
Equity Markets 35
Electronic Communications Networks (ECNs)
Investors worldwide use the platform provided by various stock exchanges for trading
in stocks. However, with the advent of technology, a new platform called Electronic
Communications Networks provides investors with new execution choices. These are
alternate trading systems and they have witnessed good growth in recent past. The
following discussion pertains to how ECNs work?, types of ECNs, benefits to users etc.
ECNs started off as providers of after-hours (post trading hours) services to clients. In
fact, Instinet, one of the largest ECNs, started offering after hours services to
institutional and professional traders since 1970s. Since then ECNs have become an
important part of securities industry and have provided competition to the existing
established stock exchanges. In simple words, ECNs bring buyers and sellers together
electronically for trading purposes. One of the most important features of ECNs is that
they provide greater flexibility and reduce costs for its subscribers. As per the report of
Securities Exchange Commission, ECNs today account for approximately 30% of total
share volume and 40% of dollar volume traded in NASDAQ securities and 3% of total
share and dollar volume in listed securities. Prior to 1996, the quotes provided by
market makers on ECNs, at times used to be better, compared to that provided by them
on other stock exchanges or national securities association. This resulted in investors,
especially retail investors, getting inferior deals on national stock exchanges. Hence in
1996, Order Handling Rules were established by the Securities Exchange Commission, to
address this. As per the rules, the specialists or market makers were required to
communicate their ECN quotes, if they were better than those offered on stock
exchanges, directly or through ECNs to stock exchanges or securities associations. This
made two important gains. The spreads on stock exchanges narrowed down and the
ECNs were brought under national market system.
ECNs are nothing but electronic systems that provide the following services :
Equity Markets 36
Dissemination of the information about the orders entered into ECNs by the
market professionals such as an exchange market makers or OTC market makers.
Execution of such orders by the subscribers.
Let us see how these services are provided by a typical ECN.
Subscriber (Broker – Dealer) E C N
Sends a display limit order Order details are checked
and transmitted to all other clients of
Order is executed.
If matching order exists
If matching order does not exist, order is
placed in limit order book.
The subscribers to the ECNs include retail investors, institutional investors, market
makers, broker–dealers etc. The most important advantage of ECNs is that not only
information of prices quoted on various exchanges is available, ECNs allow access to the
information about liquidity of institutional clients which are linked to the ECNs. Thus
OTC trades, i.e. Institution to Institution trades become possible. Some of the ECNs
Equity Markets 37
currently operating in the US securities industry are Instinet, Island, Bloomberg
Tradebook, Archipelago, REDIBook etc.
A global agency broker, Instinet provides access to clients to more than 40 equity
markets worldwide. Moreover, the information about liquidity of Instinet’s institutional
clients is also available through this linkage. Thus liquidity positions across the markets
are available. The clients can use these services in the following ways.
Agency Sales Trading – This service is offered by Instinet through its sales
traders in New York, London, Tokyo, Hong Kong and Toronto. It is called agency
sales trading since Instinet conducts sales activities only for its clients, there is no
proprietary trading that takes place. Thus there is no conflict of interest in executing
the trades. Moreover the orders which are put in by clients are exposed to not only
the exchanges such as NYSE or security associations like NASDAQ, but also to all
institutional clients of Instinet. This makes the transactions more cost effective.
Direct Trade between clients – Clients can trade directly with each other
without the involvement of any other party through Instinet.
Source : Website of Instinet
A global electronic agency brokerage, Bloomberg Tradebook provides agency broking
services to institutional investors and broker – dealers. Clients are provided with direct
connectivity to 36 markets and electronic trading capabilities in over 65 markets
spanning over 54 countries. Services also include global clearing and settlement
capabilities. Through its relationships with B-Trade Services and BNY Brokerage (both
affiliates of Bank of New York), the floor of New York stock exchange can be accessed
i.e. the quotes of NYSE are accessed.
Source : Website of Bloomberg Tradebook
Equity Markets 38
After Hour Trading in US markets
After hour trading is US market is facilitated by the ECNs. Though all the after hour
trading can not be attributed to the ECNs, they have a significant share in after hour
trading. The stock exchanges such as New York Stock exchange and American Stock
Exchange provide crossing sessions in which buy and sell orders which match can be
executed at 5.00 pm though actual trading hours end at 4.00 pm. These orders are to be
executed at the closing prices of 4.00 pm. NASDAQ securities also trade after hours for
which market professionals use NASDAQ trading and price reporting systems such as
SelectNet, Automated Confirmation Transaction Service and NASDAQ Trade
Institutional investors and market professionals send their after hour orders for
execution through ECNs to broker-dealers. A number of risks however are involved in
after hour trading. These are as follows.
Inability to See or Act Upon Quotes – Since it is not a regular hour trading, investors
may be allowed to view quotes from one trading system that the firm uses. Similarly,
even if investors can see the quotes on other ECNs, order execution may not be possible.
Lack of Liquidity – The number of buyers and sellers who wish to trade after regular
trading hours can not match to that of in the regular trading hours. Obviously, this leads
to lack of liquidity. Some stocks may witness reduced activity or some stocks may not
trade at all after hours.
Larger Quote Spreads – This results form the point mentioned above i.e. lack of
liquidity. Less trading activity generally leads to wider spreads between bid and ask
prices. Hence your order may not be executed at the best price.
Price Volatility – Stock prices may be more volatile after hours due to two reasons. One
is existence of small number of buyers and sellers which enables participants to offer
Equity Markets 39
wide quotes. Another reason is that, the news that comes after the trading hours are over,
has greater impact on the prices. Hence prices tend to be more volatile.
3.8 Life Cycle of a Trade
A typical equity trade goes through a number of stages. Typically a Life Cycle of Trade
will have three phases. They are i) Pre-trade phase ii) Trade Phase and iii) Post trade
Pre Client Investment
Post Pre – Clearing Settlement
Equity Markets 40
i) Pre Trade Phase
• Client Advice - This phase includes the advice which is provided by the brokers,
investment bankers to their clients. This advice is based on Equity Research
which is done by the brokers and investment bankers. Equity research basically
involves studying various companies from the point of view of making
investments in shares of those companies. It is also possible that a firm conducts
research in-house. But before investment decision is taken, doing proper research
• Investment decision - This involves actual decision of buying or selling shares of
companies. Once taken, this decision is communicated to the broking firm that is
a member of stock exchange and which executes the transaction on clients’
ii) Trade Phase
• Trade Order & Trade Execution – Orders are communicated by the
institutional and retail investors to their brokers. Orders can be communicated
manually through telephones or through electronic means. These orders are then
entered into the trading systems for execution. When any order enters the
trading system it is an active order which tries to find a match on the other side.
If a match is found a trade is generated. If it does not find a match, it becomes a
passive order and sits in the order book. As and when valid orders are received
by the system they are first numbered, then time stamped and then scanned for a
potential match. They are executed as per Price Time priority.
» Price / Time Priority
If match is not found they are stored in price/time priority. Price priority means
that of any two orders, the order having the best price would get a higher
priority. Time priority means that for any two orders at the same price the order
that is entered first gets the higher priority.
Equity Markets 41
There are different types of orders, which serve different purposes as follows.
3.9 Types of orders and their uses
Stop loss orders or (Stop orders)
These orders are stored in a “Stop Loss Book” till the trigger price specified in the order
is reached or surpassed, after which the order is released into the normal book.
A sell order gets triggered when the last traded price reaches or falls below the trigger
price, while a buy order gets triggered when the last traded price reaches or goes above
the trigger price
Good Till Day or Immediate or Cancel Orders
A “Day” order is valid for the day on which it is entered. If the order is not executed
during the day, the system automatically cancels the order at the end of the day.
“Immediate or Cancel” order, if not filled immediately on release is automatically
cancelled. In both cases partial match is possible and the unmatched portion is cancelled.
Limit or Market order
If an order has a price specified it is called a limit order. It is possible to input an order
without a specified price – called market orders, in which the order would get matched
at the best available price. Thus if the investor specifies that a particular stock has to be
bought (or sold) at say $ 50, then it is a limit order. If no price is specified, the stock will
be bought or sold at existing best market price.
Minimum fill order
Allows the user to specify the minimum quantity for which the order should be traded
in each trade.
All or none order
Allows the user to specify a condition that only the full order quantity should be traded
against. For example, all or none order to sell 25000 shares will be executed only if entire
25000 shares are sold at a time otherwise order will not be executed.
A Disclosed Quantity Order
Equity Markets 42
This is an order which allows only a portion of the order to be disclosed to the market.
For example, an institutional client wants to buy 100000 shares of a particular company.
Once the order is put in the system, this information will be seen by all market
participants in screen based trading. Since this is a large order, it may cause market price
moving sharply in a particular direction (upward in this case). Hence a disclosed quantity
order discloses only a portion of order to be executed. In the above case, of the total order
size of 100000, only a portion say 10000 will be disclosed at a time. Once the first 10000
shares are bought, next 10000 will appear on the screen.
iii) Post Trade Phase
• After the trade is executed, the preparations for clearing and settlement start.
These stages are explained in detail in the sections of Post Trade Processing,
Clearing and Settlement.
How are stock prices determined in various stock exchanges?
Stock prices are basically a function of demand and supply. A large number of factors
create the demand and supply for a particular stock. Rules are framed by each stock
exchange to allow a minimum price fluctuation for each stock. This is called a tick size
which is explained below.
Tick size refers to the minimum price fluctuation allowed at every price change. That
means the prices can not change by less than the prescribed tick size. Tick sizes may very
depending upon the prices of the stocks.
Equity Markets 43
3.10 Volatility in the prices of stocks
The stock markets are characterized by volatility in stock prices. Market participants
may overreact to any information that comes to the market, making prices volatile. Stock
market history is full of evidence of panic selling or illogical buying that takes place
quite regularly. Especially panic selling is cause of concern as it may not only wipe out
investors’ wealth considerably but may result in stock market defaults and loss of
confidence by investors. Hence stock exchanges world over employ few measures to
control the changes in prices. Some of them are as follows.
The securities and futures markets have circuit breakers. The intention of imposing
circuit breakers is to reduce volatility in prices. Thus the trading comes to a halt
automatically if prices of individual stocks or stock exchange indices move up or down
beyond a particular level when compared to the earlier day’s price levels. Every stock
exchange decides its own rules regarding circuit breakers.
Circuit Breaker Levels at NYSE for first quarter 2006.
In the event of 10% decline (1100 points) in Dow Jones Industrial Average (DJIA),
trading comes to a 1 hour halt before 2.00 pm and to a 30 minute halt between 2.00 pm to
2.30 pm. There is no halt if this happens after 2.30 pm.
In the event of 20% decline (2150 points) in DJIA, trading comes to a 2 hour halt before
1.00 pm and to a 1 hour halt between 1.00 to 2.00 pm. The market closes if this happens
after 2.00 pm.
In case of 30% decline (3250 points) in DJIA, market closes no matter what is the time.
Equity Markets 44
Daily Price Limits
In order to ensure that prices do not jump or they do not become extremely volatile,
exchanges have established Daily Price limits on stocks. Because of daily price limits,
prices fluctuate in a price band and hence investors are protected from large fluctuations
or sudden jumps in prices. Daily price limits established by Tokyo Stock Exchange, for
stocks within some prices ranges is given below.
Previous day’s closing price in Yen Daily Price limit in Yen
Less than 100 30
100 to 200 50
200 to 500 80
500 to 1000 100
Concept of short selling
Short selling means selling the stock without possessing the same. The stock is sold
when the price is high and is expected to be bought back when the price comes down
resulting in a profit. However, if the stock price does not come down during the period,
the short seller incurs a loss. Short selling may not be allowed in certain markets or may
not be allowed for certain types of market participants as it is considered to be a risky
Equity Markets 45
One of the parameters, which are used to judge the efficiency of financial markets, is
liquidity offered in the trading of securities. Obviously, the more liquid the stock is, the
greater is its attractiveness. This is because investors are sure of being able to get in and
get out of that stock, whenever they want. That is why liquidity is considered to be an
important attribute, which makes the stock attractive or unattractive.
How does one measure the liquidity? Liquidity can be measured with the help of a
concept called impact cost. Impact cost measures the extent to which the price fluctuates
due to purchase or sell of a particular quantity of stock. If a particular quantity of stock
results into a significant change in the price, impact cost is considered to be high and the
stock is less liquid.
3.11 Market Capitalization
Market capitalization of a company is a product of the number of outstanding shares in
the company’s capital structure and its market price. It indicates the valuation of the
company at a particular point of time. The total market capitalization of an exchange is a
summation of valuations of all listed companies on it. The market capitalization of an
exchange measures the extent of coverage of companies achieved by that exchange. The
higher the market capitalization, the better coverage the exchange has in terms of quality
and / or quantity of companies listed on the same.
Depending upon the market capitalization, the stocks can be classified into segments
such as Large Cap stocks, Mid Cap stocks and Small Cap stocks. On most of the stock
exchanges different segments have been created for trading different capitalized stock.
Equity Markets 46
London Stock Exchange – Segments for trading different stocks
LSE offers following segments for trading different stocks.
The Main Market
As the name itself suggests this is the main market segment of LSE. In fact when LSE or
UK stock market is referred to, it is this segment which is referred. More than 2000
companies including over 500 overseas companies are listed and traded in this market.
There are special groupings made under Main Market. One such group is techMARKTM
that consists of technology companies. A segment for healthcare companies is called
techMARK mediscienceTM. For listing securities on the Main market, the securities need
to be admitted to the Official List by the UK Listing Authority, which is a division of UK
Capital Market Regulator, Financial Services Authority (FSA). Apart from this, approval
from LSE itself is required.
Alternative Investment Market (AIM)
Started in 1995, AIM trades more than 1200 companies representing a variety of
industries including sectors such as IT, leisure and hotels, healthcare, biotech etc. The
regulations are comparatively less stringent here compared to the Main market. This
segment has given investors an opportunity to trade in those stocks which can not be a
part of the Main market.
Called the ‘Off Exchange’ market, established in 1995, is a riskier segment of LSE as it is
not regulated. Securities that are traded on it are unlisted and unquoted. Some
companies before getting listed on AIM or the Main market may use this as a starting
point, some may prefer to be traded on OFEX permanently.
The broker may use any of the following trading platforms to execute the orders.
Equity Markets 47
SETS – This is LSE’s trading service for UK blue chip stocks. The companies listed are
large cap stocks, very liquid and popular amongst the investors.
SETSmm – This is LSE’s trading service for mid cap stocks and most liquid small cap
SEAQ – Even SEAQ is the trading service for mid cap stocks and some other securities.
Source : London Stock Exchange
Basket trading provides a facility to create offline order entry file for a selected portfolio.
On inputting the value, the orders are created for the selected portfolio of securities
according to their weightage in the basket. Basket Trading facilities are provided by the
stock exchanges themselves or the broking houses. The Basket of stocks can be made
i) the sectors – it can be a basket consisting stocks of pharmaceutical companies
or metal companies
ii) the market capitalization – can be a basket of large / mid or small capitalized
iii) the investment theme – basket of growth stocks, basket of high dividend yield
Once a basket buy order is placed, all the stocks in the basket will be bought (as market
order) in the same proportion in which they make the basket. This is done automatically,
so the investors don’t have to bother about purchasing each stock separately. Once the
basket is created, the investors are free to trade in any of the stocks separately or along
with the entire basket.
Equity Markets 48
Similar to basket trading, Index trading provides a facility of buying and selling of stock
exchange indices in terms of securities that comprise the index. The user provides the
value and other inputs to the system and the system generates the orders. Thus a buy
order for a Stock Exchange Index such as S & P 500 will result into buying all the stocks
forming part of S & P 500 stock index in the same proportion at it is in index.
Exchange Traded Funds (ETFs)
Exchange-traded fund is a mutual fund that trades like a stock. Like an index fund, an
ETF represents a basket of stocks that reflect an index such as the S&P 500. Unlike a
mutual fund that has its net-asset value (NAV) calculated at the end of each trading day,
an ETF's price changes throughout the day, fluctuating with supply and demand. While
ETFs should replicate the return on indexes, there is no guarantee that they will do so
exactly. It is not uncommon to see a 1% or more difference between the actual index's
year-end return and that of an ETF.
An ETF gives the diversification of an index fund with the flexibility of a stock. ETFs can
be short sold, bought on margin and purchased in as little as one unit. The expense
ratios of most ETFs are lower than that of the average mutual fund.
The first exchange-traded fund was the S&P 500 index fund (nicknamed spiders because
of their SPDR ticker symbol). Spiders began trading on the American Stock Exchange
(AMEX) in 1993. There are hundreds of ETFs trading on the open market now – for just
about any kind of sector of the market.
Some of the more popular ETFs have nicknames like cubes (QQQs), vipers (VIPERs) and
diamonds (DIAs). All ETFs are passively managed, meaning investors save big on
Equity Markets 49
Nasdaq-100 Index Tracking Stock(QQQ)
This ETF represents the Nasdaq-100 Index, which consists of the 100 largest and most
actively traded non-financial stocks on the Nasdaq. QQQ offers broad exposure to the
This investment instrument represents the benchmark S&P 500. Further the various
sectors of the S&P 500 stocks have been further divided and sold as separate ETF’s.
VIPERs are Vanguard’s brand of the financial instrument. Vipers, or Vanguard Index
Participation Receipts, are structured as share classes of open-end funds. Vanguard also
offers several ETFs for different areas of the market including the financial, healthcare
and utilities sectors.
Diamonds Trust Series I, track the Dow Jones Industrial Average.
Equity Markets 50
4. Post – Trade Processing
For a successful trade completion, a number of post trade functions are required to be
performed. These functions are generally performed by the participants in the securities
industry such as banks, brokers, investment managers and specialized institutions like
custodians and depositories. These participants play an important role in post trade
processing, clearing and settlement which starts with the preparation for clearing and
The systems, procedures for clearing and settlement have evolved over a number of
years as securities markets have changed. Some factors that have changed drastically
over the years are as follows.
Automated processing of trade from manual processing
Very high volumes compared to low volumes of securities
Changes in settlement cycles (for eg. Trade Cycle in US Securities industry is T+3
Increase in number and variety of securities, which need to be traded and settled
Significant increase in cross border trades
These changes have led to the development of new systems, which are still evolving to
incorporate the changes taking place in the securities industry.
Equity Markets 51
Post Trade Processing 6
In every country where the organized stock exchanges exist or the securities industry
functions, the regulatory framework for Clearing and Settlement is established by the
concerned authorities. For example in US, Section 17 A of the Securities Exchange Act of
1934 (Exchange Act) defines the establishment of a national clearing and settlement
system for securities transactions. The institution, Depository Trust & Clearing
Corporation (DTCC), through its subsidiaries provides clearing, settlement and
information services for all types of securities including equity instruments. (see the box
below for DTCC).
Depository Trust & Clearing Corporation
Established in 1999, The Depository Trust & Clearing Corporation (DTCC) through its
subsidiaries, provides clearing, settlement and information services for equities,
corporate and municipal bonds, government and mortgage-backed securities and over-
the-counter credit derivatives. It is owned by major banks, broker/dealers and other
companies within the financial service industry, including the National Association of
Securities Dealers (NASD) and the NYSE. DTCC has operating facilities in multiple
locations in the United States and overseas.
Some of the services provided by DTCC include
Clearing Services – Provided through National Securities Clearing Corporation
(NSCC), a subsidiary, to more than 2500 brokers, dealers, banks, mutual funds and
Settlement Services – Provided through NSCC as stated above
Fixed Income – Fixed Income Processing Services provided through Fixed
The discussions of Post Trade Processing refers to the US markets, unless otherwise specified
Equity Markets 52
Income Clearing Corporation (FICC).
Asset Services - Custody asset servicing provided for more than two million
securities issues from the US and 100 other countries. These are provided through
Depository Trust Company (DTC), a subsidiary.
Underwriting Services – Offered by DTC as stated above.
Global Corporate Actions – Offers Corporate Actions announcements
processing through a wholly owned subsidiary, Global Asset Solutions, LLC.
In 2004, the value of securities settled through DTCC subsidiaries exceeded $1.1
quadrillion. DTCC has emerged as the world’s largest financial post-trade infrastructure
organization. Source : DTCC website
Equity Markets 53
4.1 Client Side & Street Side of Trade
For every trade to be processed, there are two sides client side and street side. For a
successful trade processing, both the sides have to settle simultaneously.
Client Side Street Side
Client -- Counterparty
Retail Or Or
This side involves the broker and his This side involves the broker and his
Client. The settlement of trade is through counterparty. It clears through clearing-
Broker for Retail clients. house such as National Securities Clearing
For Institutional clients, the trades generally Corporation.
Settle through Depository Trust Company. However if the broker himself is the
counterparty i.e. he fills the client’s order
from his own inventory, there is no street
side clearing process.
After the trade takes place, and before the clearing process starts a number of processes
are required in order to ensure that the trades clear and settle without fail. These
processes are as follows.
Trade Trade Trade Settlement
Matching Confirmation Affirmation Matching
Equity Markets 54
4.2 Trade Matching
In order to ensure that trades settle without fail, trade matching is required. In this
process the counterparties to the trade match the details of completed trade. Thus both
sides agree on the details of the trade before settlement. The participants involved in
trade matching are exchanges, NASDAQ and brokers. The type of trade matching that
is required depends upon how the trades have taken place. Generally in following four
methods trades can take place.
Method 1 – Broker fills the order from his own inventory
In this case, there is no external matching required as counterparty
broker is not involved. Hence street side matching is not required.
Trade details are however reported to the exchange to disseminate
price information. This occurs when the broker acts as a market
maker for a particular stock in which the client wants to trade.
Method 2 -- Two brokers complete the trade on Stock Exchanges, NASDAQ
When the trade is done on the exchange, no further matching is
required. This is because the exchange records and reports the
event and trade details are automatically captured. Thus the trade
is locked in after completion by the two counterparties. Hence no
matching is required.
Method 3 - An over the counter trade or trades done off an exchange verbally
When the trade is done over the counter verbally or in case of
block trades executed off the exchange there are chances of
errors. These trades are generally done telephonically and hence
the need for matching is the greatest in these trades.
Confirmations sent to the counterparties reveal any problems
related to such kind of trades.
Equity Markets 55
Method 4 – Trade matching though Alternative Trading Systems
In this case, an OTC trade is done electronically through a
number of Alternative Trading Systems which offer such a
facility. These systems offer the facility of finding counterparties
and doing the trade electronically. This ensures that trades are
matched immediately after electronic execution.
4.3 Trade Confirmation
The next process prior to clearing and settlement is confirmation. This is required
because the clients need to know what brokers have done on their behalf and also to
bring out errors if any in trade execution.
Confirmation for retail clients
Retail clients receive paper confirmations in the mail. They match this against the
original order which they had placed and see if there are any mismatches which are
immediately reported to the broker.
Broker Retail Clients
Sends paper confirmation to clients.
Confirm or report errors, if any
Equity Markets 56
4.4 Confirmation for institutional clients
Institutional clients hold instruments such as equity shares with Depository Trust
Company. Hence they must receive an electronic confirmation for the trades done by
brokers on their behalf. For matching and verifying the trade details, institutional
clients often use automated matching mechanisms or reconciliation applications. For
example in the US, Omego TradeSuite is the primary institutional confirmation system.
These systems are used by investment managers, brokers and custodians to route
confirmations between them.
Through the electronic confirmation systems, trade messages are processed between all
trading and settlement counterparties. Some other Electronic Trade Confirmation (ETC)
systems are also available.
Equity Markets 57
Omgeo TradeSuite is a comprehensive trade processing solution that automates
messaging and settlement for equity and fixed income securities. TradeSuite is used by
Investment Managers, Broker/Dealers, Custodians and interested parties for post-trade
processing on domestic and cross-border trades of U.S. securities.
TradeSuite provides seamless connectivity from execution to settlement, utilizing fixed
formats and translation between message standards. Through the TradeSuite, real-time
notices of execution, allocations, confirmations, affirmations and affirmed confirmations
can be sent . This reduces the complexity of post trade processing considerably. This
also reduces the chances of trade failures and helps to settle the trades quickly.
Messages are generally sent in SWIFT or Omgeo formats.
Some benefits of the system includes
Streamlining of post trade process by electronically processing trade messages
between all trading and settlement counterparties
Improvement in operational efficiency and reduction in costs by eliminating
errors and delays associated with phone and fax
Control of settlement risk and complexity through real-time transaction
reporting and by processing all security types, settlement locations, and currencies
Integration of front and back office trade communications through flexible
message translation services and automation of notices of execution and allocations,
building an electronic bridge to trade agreement and settlement
Easy implementation and operations using Windows XP, Windows 2000, and
Windows 2003 Server software
Source : DTCC website
Equity Markets 58
4.5 Trade Affirmation
As already stated, institutional clients hold their shares with the custodians. Hence after
the trade is made these clients have to send their affirmations to the custodians so that
they can release funds or securities as the case may be. If no affirmations are received to
the brokers’ confirmations, the funds or securities may not be released resulting into a
Initiates the confirmation process Client
Confirm or report errors, if any Manager)
Releases funds or securities
The process of affirmation is done buy the investment manager since on his behalf the
broker has executed the trade. The actual process of sending affirmations can be through
DTC’s systems if the securities are eligible. Thus the investment managers receive
confirmations through the DTC’s systems and through the same systems the
affirmations are sent. It is extremely important that affirmations are sent without which
the trades will not settle.
For other securities, a SWIFT message or a fax can be used to communicate the
Equity Markets 59
4.6 Settlement Matching
This step is required in order to match the settlement details so that settlement takes
place smoothly. Some of the settlement details are as follows.
L A Price
E S Account
Place of settlement
The settlement matching can be done locally or centrally. Local matching involves two
counterparties matching their settlement details bilaterally. Central matching came into
picture because the securities industry was moving towards shortening of settlement
cycles. This necessitated faster processing of information with advanced systems. Thus
Central Matching Facility defined as Virtual Matching Utility (VMU) came into being.
DTC and Thomson Financial in the US, formed a joint venture called Omgeo which
developed a global VMU called Central Trade Matching (CTM). As it stands, some
vendors offer automated local matching applications while other are developing their
Equity Markets 60
Reconciliations are extremely important in trade processing. This is because in securities
transactions, there are a number of participants involved, who need to keep records of
balances of funds and securities. These records need to tally with each others, otherwise
it may lead to failure of trades i.e. trades will not settle.
In simple words, reconciliation involves comparing two different groups of information.
The kinds of reconciliations required are reconciliations of
• Cash balances and cash transactions
• Security holdings and security transactions
• Accounting entries
• Special / other reconciliations
If the records do not tally, i.e. reconciliation breaks exist, then they should be
immediately investigated and corrected. The reconciliations are required between
• Manager to Custodian – The securities records kept by investment managers
should match with that of the custodian. If records are not reconciled at regular
intervals then it may lead to incorrect positions balance in the books of one of
them. It may give rise to a situation that investment manager may end up selling
excess quantity of stocks because the records as per his books show a higher
balance of shares compared to the custodian’s records.
Other types of reconciliations done regularly are
• Broker to Manager
• Broker to Clearing Agency
• Broker to an Exchange
• Custodian to depository
Equity Markets 61
5. Clearing and Settlement
Clearing and settlement are the final two processes in trade processing cycle. Before
coming to clearing, all the participants must have agreed to the trade details going
through the above mentioned processes.
This is a process of exchange of money and securities between brokers using a form of
netting. The clearing system nets all the trades done by all the brokers throughout the
day. Thus the street side of a trade i.e. broker to broker portion of a trade is netted out.
Broker A Broker B
Trade details Trade details
Net position Net position
There are two forms of netting
• Bilateral Netting – This means arriving at net obligations (i.e. netting) of
securities and funds between two brokers / parties.
• Multilateral Netting – This means arriving at net obligations of securities and
funds between all the brokers. Thus at the end of the day, exchanges arrive at a
net position in securities or funds for each broker.
Broker also does netting between his different clients. In each stock the net position for
the day is arrived at as follows.
Equity Markets 62
Stock 1 Stock 2 Stock 3
Client 1 + 400 -- +300
Client 2 -- +500 -300
Client 3 -200 -800 --
Net Position +200 -300 0
+ means purchase of securities and – means sale of securities by clients
Thus Broker A’s net position is + 200 in stock 1 (he expects to receive 200 shares at the
time of settlement) and -300 in stock 2 (he should deliver 300 shares for settlement) and
zero in case of stock 3.
In a similar way, net cash position is worked out. If we take the same example as above,
there is a cash obligation for the broker A for buying stock 1 (200 units) while he expects
to receive cash for selling 300 shares of stock 2 on behalf of his clients. For stock 3, the
difference between buying price & selling price will determine when Broker A will have
an obligation to pay or right to receive,
The role of clearinghouse is important in the clearing process. Different securities are
cleared by different clearing houses. In the US, equities’ clearing is done by National
Securities Clearing Corporation (NSCC) which is the largest clearing house in the US. As
mentioned above, clearinghouse such as NSCC consolidates each brokers net obligations
into one net position for each stock. This is reported to DTC for net settlement. This
process is called Continuous Net Settlement. The daily net cash position arrived at is
called Daily Net Money Settlement. (See the box : NSCC)
Equity Markets 63
This is the last process in the Life Cycle of a Trade. In settlement all the counterparties
exchange securities and money as per their obligations.
Broker A Retail Clients
Trade by trade settlement by each client
Payment of money or transfer of securities
Payment of money or delivery of securities
For settlement between Broker A (say a buying broker) and Broker B (say a selling
broker), both NSCC and DTC play an important role.
Equity Markets 64
Sends instruction to buy securities Sends instruction to sell securities
Broker A (Buying Broker) Broker B (Selling Broker)
Buy order is sent to exchange Sell order is sent to exchange
Trade information is sent by the exchange to NSCC.
NSCC sends to Broker A details NSCC sends to Broker B details
of all trades and net cash position
NSCC of all trades and net cash position
and securities position to be settled and securities position to be settled
NSCC sends instructions to DTC with net securities position to be settled
DTC transfers ownership of securities DTC
electronically from selling broker’s
account to NSCC’s account and from Funds are sent or received by
there to buying broker’s account broker / dealer’s settling banks
from DTC to complete settlement.
Equity Markets 65
National Securities Clearing Corporation
A subsidiary of DTCC, National Securities Clearing Corporation (NSCC), provides a
number of clearing and settlement services. Some of the services offered are as follows.
Automated Customer Account Transfer Service (ACATS) - The Automated
Customer Account Transfer Service (ACATS) is a system that automates and
standardizes procedures for the transfer of assets in a customer account from one
brokerage firm and/or bank to another.
Continuous Net Settlement (CNS) System - The Continuous Net Settlement
(CNS) System is an automated book-entry accounting system that centralizes the
settlement of compared security transactions and maintains an orderly flow of
security and money balances.
Trade Capture and Reporting - These services provide validation, comparison,
and reporting for trades executed on major US exchanges, as well as regional and
Equity Markets 66
5.3 A typical Settlement Cycle
US securities settle on T + 3 basis. This means that the settlement i.e. exchange of
securities and funds take place within three days of the trade. For trades done on
Monday, settlement has to be completed by Thursday. The actual process follows the
steps as shown below.
Trade Date (T)
Real time, trade details
Trade electronic to participants
Executio transfer of by NSCC
trade details to
T+1 T+2 T+3
NSCC securities to net
assumes role buyers and
of CCP payments of money
to net sellers
For Institutional clients, the settlement takes place through a custodian bank which
releases funds / securities to DTC. (See the box: DTC)
Depository Trust Company
A member of US Federal Reserve System, Depository Trust Company retains custody of
2 million securities, most of them in dematerialized form. The depository also provides
the services necessary for the maintenance of the securities it has in custody.
Equity Markets 67
Broker executes the trade on exchange
Instructs broker to
buy or sell a large block of securities
Sending and receiving trade data and trade
enrichment with settlement instructions
is done by Omgeo’s systems.
Custodian Bank receives instructions from
investment manager or from Omgeo
on behalf of investment manager to
deliver or receive securities or payment
Omgeo instructs DTC, on behalf of
Investment manger or broker to settle
affirmed / confirmed trades between
the custodian and the broker
Settling banks are instructed Securities are electronically
by the custodians and brokers transferred to the buyer
to send or receive funds from DTC. This is done upon
DTC. authorization of DTC
Equity Markets 68
5.4 Institutional Block Trades
Institutional trades are different compared to the retail trades. In case of retail trades, the
securities are transferred to the broker’s account from the retail investor. However, in
case of institutions, securities are generally held by the bank custodian which takes the
necessary steps to complete the settlement.
Another difference is that institutions deal in large quantities. They acquire a large
quantity of a specific stock. This stock is allocated to different accounts. These types of
trades are called block trades. When a large quantity of stock is to be purchased, there
are two possibilities. The institution can buy this quantity by placing a single order
through a broker or can divide it in smaller lots. If it places the single order, the
possibility of purchase price going up is high. This is because the market understands
that there is a large buyer for that stock. However if the order is divided into smaller lots
and a broker acquires these lots from different brokers, the market in general will not
know the actual demand.
Thus, a significant number of deals which institutions do are block deals. An example is
as follows : Broker A, on behalf of Investment Manager Z, buys 12000 Microsoft shares
from Brokers B, C, D and E.
B C D E
2500 3000 4500 2000
shares shares shares shares
Equity Markets 69
5.5 Trade Allocation
The investment managers purchase a large quantity of shares for different portfolios that
they manage. Hence there is a need for allocating these shares to different portfolios. This
process is known as allocation of trades. Allocation may be decided at the time of placing
an order with the broker. Some portfolio managers on the other hand may wait till the
order gets executed and then allocate to different portfolios. For example, the 12000
Microsoft shares purchased above may be allocated between three portfolios as follows.
A Portfolio C
5000 B 4000
shares 3000 shares
Since allocations of trades have to be done to different accounts, the communications of
allocation becomes important. Especially considering the fact that the investment
managers may have a large number of accounts with many custodians, process of
allocation becomes complex. Hence a transition is required from manual to automated
allocations. One such communication network we have already seen that of Omgeo
products such as Omgeo TradeSuite, OASYS, CTM etc. In order to simplify this process,
the concept of Standing Settlement Instruction (SSI) database was developed. This does
not require resending the trade details every time the trade is done. This is because SSI
contains the details of an account which are required for settlement of trades. Omgeo has
incorporated SSI application called ALERT (developed by Thomson Financial) and SID
Equity Markets 70
(developed by DTC). The investment managers can use SSIs to communicate settlement
instructions or do it manually through fax or leased lines etc.
A typical block trade settlement is as follows.
Trade Execution - An investment manager places an order with Broker A. Since it is a
large order, broker A executes a deal with Brokers B, C and D. Broker A then informs
investment manager about the deal.
Investment Broker C
Trade Confirmation - Broker A also informs various prices at which shares are bought so
that the investment manager knows the average price. This is followed by confirmations
sent by Broker A to NSCC and street side confirmations sent to NSCC by brokers B, C and
Clearing - At the end of the trading day, NSCC performs netting of the trade and sends
DTC net obligations of each broker to prepare for the street side settlement. (As
mentioned earlier, NSCC is concerned with settlement of street side of trade and DTC
settles client side of the trade for institutional clients.)
Allocation and Affirmation – Based on the requirement to allocate the trade between
various portfolios, the investment manager informs the broker. This information is passed
Equity Markets 71
on to DTC, which has to allocate this trade between various portfolios. Hence DTC
generates four confirmations which have to be affirmed by the investment manager. If
investment manager fails to affirm any of the trades, settlement will fail. As mentioned
above the allocations and confirmations can be manual or electronic.
It is important that both the sides of the trade the client side, and the street side i.e. broker
to broker side need to be completed simultaneously. Thus in this case, broker A (assuming
it is a purchase transaction for institutional investor) receives shares from his
counterparties and delivers the same to the custodian. On the other hand, the custodian
sends broker A cash which he in turn sends it to his counterparties. In a sale transaction,
Investment managers and brokers / dealers need to communicate between them trade
and allocation details. This communication can be by manual processes such as phone
calls, faxes and e-mails. However manual processes are error prone and hence may
result into failed trades. Hence the need for automated trade processing. One such
service which has emerged as industry standard trade allocation and acceptance service
in the US is Omgeo OASYS.
The steps involved in using this service are as follows.
Allocations can be sent automatically by the investment managers to the brokers
/ dealers via OASYS. This happens after the trade execution.
The next step involves accepting or rejecting trade details and allocations by
brokers / dealers. This is done on the same business day. This ensures that all the
details are correct so that settlement can take place smoothly.
Another service which is available is OASYS – TradeMatch. This is a link
between Omgeo OASYS which is electronic trade allocation and acceptance service
and Omgeo TradeMatch, a central matching service for US trades. This service
enables real time central matching of trade messages. Thus the confirmations which
are input by the executing brokers / dealers are automatically matched and (or
affirmed) with the allocations fed into the system by the investment managers.
Equity Markets 72
Moreover for faster processing, the trade processing systems of a firm can be
linked on line to OASYS under its direct connectivity option. Due to the online
linkage, trade details and allocation are communicated immediately. The entire
process can be concluded with great speed even if volumes are high, improving
efficiency, cutting costs and reducing the risk of trade failure by providing
counterparties with accurate and complete trade information.
The overall Benefits for Investment Managers can be summed up as under.
For all counterparties, Omgeo OASYS and the other products mentioned above
become a single interface for US domestic trade allocations.
Trade communication is automatic.
Manual communications may cause costly errors in confirmations / affirmations
etc. This is avoided here resulting into lower costs. Similarly administration expenses
in the back office are reduced because of automated systems.
Omgeo OASYS TradeMatch can be used for matching trade allocations,
irrespective of whether all the counterparties are using OASYS or not. It enables real-
time central matching.
Omgeo OASYS can also be linked to Omgeo ALERT which enables enrichment
of trade with the settlement details so that settlement becomes faster.
Every settlement process has two legs – cash & security. The two legs can be combined
in a single legal action or treated separately. If both legs are combined in a single legal
action i.e. the transfer of ownership cannot be legally effective without the cash payment
and vice versa – the procedure is called “Delivery Vs. Payment” or “DvP”. When the
two legs are not linked legally, the technical term “free of payment” or “FoP” is used.
Equity Markets 73
The entity that maintains accounts with the settlement agent in order to settle
payment obligations arising from securities transfers, both on its own behalf and for
other market participants. These settling banks are generally specified by the
respective central banks or exchanges or regulators.
The date on which parties to a securities transaction agree that settlement is to take
Types of settlement - Account Period & Rolling Settlement
There are two type of settlement : One, Account Period Settlement and another
Rolling settlement. In former case, the settlement of trades take place after the
particular account period say a week or ten days are over. Thus if Monday to Friday
is the account period, all the trades during Monday to Friday will be considered for
settlement together. In case of rolling settlement, the settlement takes place a given
number of business days after the date of the trade. For example, if rolling settlement
is T + 3, all the trades, no matter whether they are done on any of the week days, will
be settled in three business days subsequent to the trading day.
This function comprises of customer account keeping and the administration of
securities on behalf of customers. The services include capital increases,
redemptions, collection of dividends & interest, reporting and value added services
such as collateral management, proxy voting, income processing, tax services,
translations, portfolio analysis etc.
Function of Safekeeping
Securities evidenced by physical certificates need to be stored in a safe place.
Traditionally banks have provided that facility. Securities in dematerialised forms
are kept in databases of depositories. There is no Physical Security. In some cases
Equity Markets 74
(like Eurobonds) securities are evidenced by a Global Certificate, and all securities of
one issue are stored by a single institution – a common depository. Immobilization
is the placement of physical certificates in a central vault to facilitate book-entry
Function of Notary
Whenever new securities are created authentication and registration of such new
issues is required. This function is performed by Notary. For this, a verification is
done to see whether securities fulfil certain technical & formal requirements to be
eligible for post trade services. Includes registering any change of the issued amount
e.g. in case of corporate actions like stock split.
Equity Markets 75
Post Trade Processing of Equity Trades in other markets
While the basic principles and activities of clearing and settlement systems are similar in
most of the markets, the intermediaries involved and the technology is different in
different markets. Moreover with advent of technology, newer practices of post trade
processing are being worked out. Let us look at clearing and settlement in other parts of
5.6 Post Trade Processing in Japanese Equity markets
There are six stock exchanges in Japan principle being Tokyo Stock Exchange. For the
listed equities on these bourses, Japan Securities Clearing Corporation (JSCC) conducts
the clearing operations. Not only the cash products, but JSCC also clears the derivatives
traded on Tokyo Stock Exchange.
Clearing of Trades
C Manager --
Broker A – Buying Broker Broker B – Selling Broker
After the trade has been entered into, JSCC performs Novation, which means that the
contract between buyer and seller is substituted by two contracts : Between the buyer and
JSCC as Central Counter Party and between the seller and JSCC as Central Counter Party.
This is required because JSCC guarantees settlement of trade irrespective of whether the
buyer or the seller fails to make the settlement. This function is commonly performed by
CCPs in all markets.
Subsequent to this, JSCC undertakes netting of positions created out of trading for the
day. As mentioned earlier netting essentially involves arriving at the net obligations of the
Equity Markets 76
counterparties. Thus multi-lateral netting is conducted so as to arrive at the net amount of
securities to be delivered and net amount of funds to be paid.
Settlement of trades
After netting out the obligations, the participants are informed about their obligations. The
securities are transferred between participants’ accounts at Japan Securities Depository
Center (JASDEC). These are of course in the form of book entries and a debit is given to
net seller’s account at JASDEC and a credit is given to JSCC’s settlement account. The
settlement can be said to be complete when a net debit is given to JSCC’s settlement
account and credit is given to net buyer’s account at JASDEC. The settlement cycle is for T
+ 3 days. The settlement of funds happen by account transfer between a participant
account and a JSCC account at either six settling banks designated by JSCC or Bank of
The settlement of these securities is done on Delivery vs Payment (DvP) basis. A typical
DvP schedule will be as follows.
The securities must be delivered to JSCC by 13.00 on settlement date by the
Similarly the payment of funds must be completed by 13.00 on settlement date.
Receipt of some securities is possible prior to the above deadline provided they
had completed their obligations to JSCC before the above deadline on the settlement
date. Receipt of such securities will be limited to the collateral deposited, securities
delivered to JSCC and cash paid to JSCC.
Multiple intra day batch process is used to transfer securities from JSCC’s
account to participants account.
If participants fail to deliver the securities they are supposed to deliver, then
value of failing securities is to be paid by them by 14.15 on the settlement day.
Equity Markets 77
If there is a failure on the part of participant to pay the funds for securities to be
received, the seller of those securities i.e. the receiver of funds will receive funds
from 14.45 on the settlement date.
The possibility of failure by the participants to pay in funds or securities may give rise to
an impression that a significant credit risk exists in securities transactions. However the
way in which these defaults are taken care of in Japan is as follows.
We have already seen that by the process of Novation JSCC enters into the contract with
both the sides of participants (i.e. buyers and sellers). Thus the CCP assumes the
obligations as well as the rights of settlement. In case of a loss due to defaults by any of
the participants, settlement guarantee is provided by the CCP as follows.
--- JSCC collects a clearing fund as a deposit from the participants. In case of a loss, this
fund is utilized for making good this loss.
--- All the participants provide a mutual guarantee. Hence if the clearing fund deposit is
insufficient, other participants compensate for it.
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Japan Securities Depository Center, Inc. (JASDEC)
JASDEC is the sole central securities depository in Japan. The services provided by
JASDEC are deposit of securities and book-entry transfer for domestic equities,
corporate bonds, preferred equity securities etc.
The participants in the market such as securities companies, banks, securities finance
companies, insurance companies etc. directly open accounts in JASDEC for doing
securities transactions. Investors such as individuals and corporates in turn open
accounts with participants and do the necessary transactions through these participants.
A part of its business is entrusted to Japan Securities & Custody (JSSC) by JASDEC.
Japan Securities Settlement & Custody (JSSC)
JSSC provides settlement and custody services for a broad range of securities including
foreign equities and publicly-issued bonds. It also undertakes deposit, delivery and
custody of domestic stocks as commissioned by JASDEC.
Source: Tokyo Stock Exchange
5.7 Post Trade Processing in European markets
In the European Post trade industry, a number of players such as International Central
Securities Depositories (ICSDs), Central Securities Depositories (CSDs), Global and Local
custodians and settlement banks operate and offer post trade services. Considering the
fact that a number of players exist in this industry, it has become competitive. The size of
the post trade industry is estimated to be close to €17 billion in revenues. Apart from the
five distinct functions of post trade processing, a number of ancillary banking services
Equity Markets 79
Europe being made up of different countries, cross border post trade processing
assumes importance. However considering that different players from different
countries play an important role in this industry, there is a need for joint efforts on the
part of the governments, regulators and market participants in order to improve the
efficiency of post trade processing.
Profile of services offered by different players
Clearing Settlement Custody Safekeeping Notary
ICSDs √ √ √ √
CSDs √ √ √ √ √
Common √ √
Custodians √ √ √ √
Some major Players in European markets
ICSDs – Clearstream Banking, Luxembourg, Euroclear Bank
CSDs – Clearstream Banking, Frankfurt, Euroclear, France, Monte Titoli etc.
Custodians (Global) – Citibank, J P Morgan Chase, BNP Paribus, Bank of New York
Custodians (Local) , (Common Depositories) – HSBC, Deutsche Bank
Equity Markets 80
Role of Central Counter parties in Post Trade Processing
As mentioned earlier, Central Counter Parties (CCPs) make the process of Trading on
exchanges default risk free by assuming the counterparty risk. Following is an example
of Eurex Clearing AG which is a wholly owned subsidiary of Eurex Frankfurt AG and
acts as a CCP for German markets.
Eurex – Central Counter Party
Eurex Clearing AG, acts as a CCP for the equity transactions executed on Frankfurt
Stock Exchange and for derivatives traded at Eurex Exchanges. It performs novation by
becoming a buyer for each seller and seller for each buyer. CCP also simplifies the
settlement process and guarantees anonymity from trading to settlement.
Some other advantages include efficient risk management where Euerx ensures that the
total risk exposure for each clearing member (margin), is covered by the deposit of
collateral in the form of cash or securities. It is directly connected with various
Equity Markets 81
Investment E Investment
Manager -- X Manager --
Buyer - Seller
Broker A – Buying Broker Broker B – Selling Broker
Equity Markets 82
6. Stock Exchange Indices
A large number of securities are traded in equity markets all over the world. The prices
of equity shares of various companies keep on fluctuating on a continuous basis. These
shares are issued by companies which operate in different lines of businesses or
industries. Some of the companies are established players some are start-ups. Some
companies are valued very high, indicated by their market capitalization while some
suffer from low valuation. Shares of some companies may go up during a particular day,
others may not change at all, some may witness a downfall. Thus trends in the equity
market are complex enough to confuse an investor. Hence at the end of the day an
investor would want to know the answers to the following questions.
how has the overall market performed? Or
how have the stocks belonging to a particular industry done? Or
has the valuation of medium capitalized companies changed during the day ?
These answers are provided by the stock exchange indices, hence there is a need for
them. These indices provide an overall picture of the trend in prices of stocks covered by
the index during a particular period. Looking at an index, one gets an idea of how stocks
have performed during that period. Index acts as a barometer of market activity.
6.1 Types of indices
Depending upon the stocks which form part of an index, they can be classified into
i) Broad based indices – In this case, the index covers the stocks in such a way that the
movement in those stocks gives an idea about how the entire market has behaved. For
this, either the index needs to cover a large number of stocks and / or the market
capitalization of stocks covered under the index should form a substantial part of total
market capitalization of all listed companies. If this happens, the index does capture
movement in overall market more accurately. In every market, broad market indices are
developed and used widely. For example, in US, S & P 500 index may be used widely
Equity Markets 83
which consists of 500 stocks or in Japan, Nikkei 225, can be considered as broad based
index covering 225 Japanese stocks.
ii) Sector / Industry Specific Indices – These indices are sector or industry specific. For
example, a Pharmaceuticals Index covers only pharmaceutical companies or a banking
index covers only banks. Indices can also cover a particular type of companies. For
example, a small cap index covers only low capitalized companies.
iii) Regional Market Indices - These cover one or more regional international markets.
For example, Morgan Stanley Capital International (MSCI) indices cover markets such as
Emerging Markets through Emerging Market indices or European market through MSCI
Europe index etc.
iv) Indices based on International equity instruments – These are developed by taking
ADR / GDR prices.
For arriving at an index, we need a base year average and current year (i.e. at present)
average. Index is just a ratio of Current year average to base year average. While
arriving at these averages, it has to be decided how will the weights be given to its
constituent stocks which make the index. There are a number of ways in which this is
done. Index can be i) Price Weighted, ii) market value or capitalization weighted (based
on full market capitalization or free float) iii) equal weighted
6.2 Price Weighted
As the name suggests, a price weighted index is simply the arithmetic average of current
prices. Only prices of shares influence the index. Thus if price change for a particular
stock is substantial, then it will have maximum influence on the index. The total
valuation of the company, i.e. market capitalization is ignored. Hence change in price is
important, whether that change is in low capitalized stock or high capitalized stock is
immaterial. Best example of price weighted index is Dow Jones Industrial Average, one
of the oldest indices.
Equity Markets 84
6.3 Value Weighted
Based on Full Market capitalization
In this case, it is not the price but the total value of the company which will have greater
influence on the index. Hence effect of a large price change in a low capitalized stock
may be completely nullified by a small change in opposite direction in a large
Assuming that the index consists of 5 stocks and there is no change in outstanding
shares, the calculation of price weighted and capitalization weighted index is shown
Price in the base year Price in the current year outstanding shares
A 80 220 100000
B 30 150 70000
C 20 120 50000
D 200 480 250000
E 170 350 200000
Price Weighted Index - A simple average of stock prices
Base Year Average Current year average Index
100 264 264
Value Weighted Index
Total 95100000 228500000 240
Value weighted index is arrived at by dividing the total market capitalization of all
stocks in the current year by the total market capitalization of all stocks in the base year.
The formula for calculating value weighted index is
Indext = Beginning Index Value * (∑ Pt * Qt / ∑ Pb * Qb)
Where Pt & Pb are prices of stocks in current and base year respectively and Qt & Qb are
number of outstanding shares in current and base year respectively
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The beginning index value is generally taken as 100.
Based on Free Float Market Capitalization
In case of value weighted index considered above, all outstanding shares were used to
arrive at market capitalization. However, in free float methodology, we use only those
shares which are freely available for trading. That is shares with promoters,
governments, strategic investors are ignored. For calculation of free float market
capitalization, shareholding pattern of the company is required, which is generally
provided by the company on regular basis.
Equal Weighted – In this case, all the stocks are given an equal weightage. That means
irrespective of their prices and market capitalization, it is assumed that an equal dollar
amount is invested in each stock that makes the index and then change in the total value
of these stocks gives an idea of how index has changed.
6.4 Total Return Index
The indices mentioned above take into account only the change in prices i.e. capital
appreciation. This ignores the dividend yield. Index can be calculated taking into
account dividend yield which is called a total return index. Thus the closing value of
total return index calculated at the end of every day,
= Previous day’s closing index * [(End of the day market Value + Cash Distributions
during the day)] ÷ Start of day market value
Total return can be calculated for any established index. For example, taking all stocks
belonging to S & P 500 or NASDAQ 100, a total return index can be calculated.
6.5 Important stock exchange indices
There are a large number of indices used in many markets. Let us look at some
important ones used widely in US and other markets.
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Dow Jones Industrial Average (DJIA)
One of the oldest stock market barometer, launched in 1896, DJAI is a price-weighted
average of 30 blue-chip stocks that are generally the leaders in their industries. The
companies which make this index are all large capitalized US companies including
Microsoft, Coca Cola, Citi group Inc, McDonald’s, General Electric, Wal Mart, 3M
The methodology of this index defers from other indices in the sense that no rules are
framed for inclusion of stocks in calculation of DJAI. This selection rests with the editors
of The Wall Street Journal.
The index is calculated as follows.
It = ∑ Pit / Dajd
where It = Index at time t, Pit = prices of different stocks at time t, Dajd = Divisor which
is adjusted for stock splits and changes in sample
The divisor needs to be adjusted to reflect the split as shown below. Divisor is adjusted
in such a way that the index remains same before and after the split.
Prices after split in A &
Price before split D*
A 220 110
B 150 150
C 120 120
D 480 120
E 350 350
Sum 1320 850
Divisor 5 3.22
Index 264 264
* One unit of Stock A is split in two units and one unit of Stock D is split into 4 units.
Equity Markets 87
Movement of DJIA in last five years
S & P 500 Index
A broad based index, Standard and Poor’s 500 index consists of 500 stocks. The index is
capitalization – weighted. Thus considering its broad coverage of stocks it gives a
picture of changes in US domestic economy through value of these stocks. The base year
for the index is 1941-43 and the base level for the index was 10. The index is maintained
by the S & P committee, made up of Standard and Poor’s economists and index analysts.
The index is used widely as a benchmark index to compare the performances of
portfolio managers. It is considered as ideal proxy for the total US markets.
Equity Markets 88
Movement of S & P 500 in last five years
NASDAQ 100 Index
Introduced in 1985, NASDAQ 100 is made of one hundred largest (in terms of market
capitalization), domestic and international non-financial securities listed on NASDAQ.
Major industries including computer hardware and software, telecom, retail/wholesale
trade, biotechnology etc. are represented in the index.
The methodology used for index calculation is a modified capitalization weighted. The
composition of the index is reviewed on a quarterly basis and is adjusted, if required,
using a proprietary algorithm if certain pre-established weight distribution
requirements are not met. This ensures that the index reflects enhanced diversification.
Some parameters considered while including the stock into the Index
Exclusive listing on Nasdaq National Market
The security must be of a non-financial company;
Minimum of average daily trading volume of 200,000 shares;
Equity Markets 89
Only one class of security per issuer is allowed;
The issuer of the security may not have annual financial statements with an audit
opinion that is currently withdrawn;
Even after inclusion, the company has to meet continuing eligibility parameters, such as
: An adjusted market capitalization of security must equal or exceed 0.10% of the
aggregate adjusted market capitalization of the Index at each month- end. If this
criterion is not met for two consecutive month-ends, the security is removed from the
Other Market Indices
FTSE 100 Index
Developed in 1984, The FTSE 100 Index is a capitalization-weighted index of the 100
most highly capitalized companies traded on the London Stock Exchange. These
companies represent approximately 80% of UK market. To qualify, companies must
have a full listing on the London Stock Exchange with a Sterling or Euro dominated
price on SETS, subject to eligibility screens.
This is a total return index. 30 blue chip German stocks trading on Frankfurt Stock
exchange are a part of this index. These stocks are large capitalized stocks on Deutsche
Börse which trade on Prime Standard segment of Official or Regulated market in
Germany. Started with the base value of 1000 as of December 1987, the index uses free
float shares in its calculation.
Equity Markets 90
Following Criteria is used for inclusion of stock in DAX.
Legal registered office in Germany
Admission to Prime Standard and fulfillment of all resulting international
transparency requirements such as Quarterly Reporting, Following International
Accounting Standards such as US GAAP or International Financial Reporting
Standards / International Accounting Standards etc.
Continuous trading on Xetra, which is the electronic trading platform of
Order book turnover on Xetra and on the floor of Frankfurt Stock Exchange of
the preceding 12 months
Market capitalization at the reporting date (last trading day of the month) based
on the free float
Nikkei – 225
Another example of price weighted index, Nikkei – 225 covers 225 top rated Japanese
companies. These companies are listed in the First Section of Tokyo Stock Exchange. The
methodology of calculation is same as that used for Dow Jones Industrial Average.
Started in 1949, the index had average price of 176.21 Japanese yens and a divisor of 225.
Equity Markets 91
Movement of Nikkei 225 in last five years
Hang Seng Index
33 companies that represent over 70% of total market capitalization of Stock Exchange of
Hong Kong make the Hang Seng Index. It is a capilalization weighted index. Developed
with base of 100 in 1964, the index has four sub-indices : Commerce and Industry,
Finance, Utilities and Properties.
30 blue chip stocks on Bombay Stock Exchange are a part of this value weighted index.
Sensex has a base year of 1978-79, when the base value was 100. For the selection of
companies in the index, factors such as liquidity, depth, floating stock, industry
representation etc. are considered. BSE uses free float for calculating the index.
Equity Markets 92
Products based on Indices
There are a number of products which are based on indices. The most important being the
derivatives. Index Futures and Index Options are very popular products which are used
widely for hedging and trading purposes. These products are based on a particular index.
For example, Chicago Board of Trade, trades options on DJIA, while Chicago Mercantile
Exchange has NASDAQ 100 futures which are traded.
Equity Markets 93
7. International Equity Markets
Companies can raise capital by issuing shares domestically in their respective countries.
As against this, they can also issue capital in the international market, outside their
countries, to raise capital. Foreign investors may invest in the domestic equity markets if
the law of the country permits it. Foreign investors may also invest in equities or similar
instruments issued by companies in international markets. Thus as we can see
international equity markets provide one more avenue for companies to raise funds and
investors to invest.
The instrument issued in US and European capital markets are American Depository
Receipts (ADRs) and Global Depository Receipts (GDRs). Let us see in detail what are
the features of these instruments, how are they issued and related aspects. Since both
ADRs and GDRs are similar, the discussion concentrates on ADRs.
7.1 American Depository Receipts
An ADR is a negotiable instrument that represents an ownership interest in securities of
a non-US company. This definition brings out the features of this instrument.
Negotiable Instrument - ADR is a negotiable instrument i.e. capable of being
transferred from one party to another, capable of being traded.
Represents ownership interest – It is a part of ownership capital. ADR holders
are entitles to certain rights such as common stockholders.
Securities of non-US company – The company which issues ADRs must be a
Apart from the above, some other features are
ADRs are quoted in US dollars - Since they are issued and traded in US, they
are quoted in US dollars. Thus the issuing company gets its capital in US dollars.
ADRs are listed on US exchanges – For trading in ADRs to take place, they are
listed on US stock exchanges. This allows any American investor to invest in non-US
Equity Markets 94
companies as if he is investing in any US company and saves him from cross border
ADRs are considered US securities – Since they are considered to be US
securities, issuing companies must satisfy all the norms laid down by Securities &
Exchange Commission in respect of ADRs.
American Depository Shares (ADS)
ADS is a share which is issued under deposit agreement representing an underlying
security in the issuer's home country. ADRs in fact can be though of as a bundle of
ADSs. Since the term ADR is more widely used, the same has been used throughout.
7.2 Global Depository Receipts (GDRs)
Very similar to ADRs in nature, these are the receipts evidencing underlying shares,
which are issued simultaneously in more than one country. That is why they are called
Global Depository Receipts. GDRs are listed on a number of stock exchanges such as
London Stock Exchange and Luxemburg Stock Exchange.
Equity Markets 95
7.3 Advantages of ADRs
Investors are happy because Issuers are happy because
» Diversification of portfolio by investing » Opportunity to increase capital in the US
in non-US companies. by attracting American investors
» Holding and trading of non-US securities » Listing ADRs on US stock exchanges
becomes very easy. gives a boost to the company’s prestige
» For publicly listed ADRs, issuers have to » Company may get research coverage in
give detailed information as laid down by US. This further attracts more investors
SEC, thus access to information improves towards the company.
which is presented in a form familiar to US
» Communication of corporate actions, » Availability of capital internationally
payment of dividends, sell of ADRs is may bring down cost of capital for the
greatly facilitated. company.
Equity Markets 96
7.4 Process of creation of ADRs
ADRs represent ownership interest in securities of non-US company. Hence ADRs
should be backed by equity shares i.e. for each ADR there should be number of equity
shares which deposited with local custodian.
Issuer Approaches depository for creating ADRs Depository
Requests the issuer to deposit shares with
Deposits shares Confirms the deposit
with custodian of shares
7.5 Participants in ADR issue process
Issue of ADRs is like issue of shares to the general public. Hence it required a detailed
planning and coordination efforts. The nature of ADR is in the form of depository
receipt which is issued by the depository. The underlying shares however are deposited
with the custodian. Hence Depository and Custodian play an important role right from
issue of ADRs to management of ADRs.
Depository – The depository plays an important role in the entire issue process. First of
all, the depository may guide the client on the Level of ADR it should go for. The three
Levels of ADRs are explained below in detail. The choice of stock exchange on which the
ADRs are to be listed is also important and depository may help in arriving at that. The
Equity Markets 97
ADR ratio also has to be worked out. Depository also helps in appointing custodians,
coordinating with legal counsel and announcing the ADR issue.
Custodians – The main job of a custodian is to receive and keep in safe custody the
shares which are deposited by the ADR issuing company. Once the shares are received,
confirmation of deposit of shares needs to be sent to the depository.
Investment Banks – Investment banks have the biggest role to play. The success of an
ADR issue depends upon them. The entire marketing for the issue is done by them.
They provide similar advice as provided by the depository in terms of Level of ADR,
choice of stock exchange etc. Apart from this, they advise on how to market the issue,
how to plan investors’ / analysts’ meets? Their role is equally important in making
roadshows with the management which is an advertising campaign for the issue. These
investment banks have close contacts with institutional investors, underwriters who
underwrite full or part of the issue.
Apart from the parties mentioned above, the company needs Legal Experts who take
care of regulatory aspects of the issue and Investor Relations Experts who help in
For registration of ADRs Form F – 6 , registration statement is required
Since ADRs are offered to the general public in US, a prospectus needs to be filed
which gives detailed information about the company containing business
information, risks inherent in business, offer price, plan of distributing ADRs etc. To
register securities underlying ADRs, Form F -1 needs to be filed.
Form 20 – F annual report and all interim financial statements and current
development need to be informed by filing Form 6 –K regularly.
Once the issue is concluded and ADRs are listed, trading starts. Trading in ADRs means
that investors keep on changing every day. Since ADR holders represent ownership
Equity Markets 98
capital, all corporate actions such as dividends or corporate announcement should reach
them. However issuer is not in touch with US investors and it would be operationally
very cumbersome to tackle with them. Hence all corporate actions and related
information needs to passed on by the Issuer to Custodian, Custodian to Depository and
Depository to the Investors as shown below.
7.6 Trading in ADRs
Once the ADRs are listed, they start trading. Institutional investors may prefer to hold
ADRs listed on US stock exchanges or since they have access to the domestic stock
markets of various countries, they may prefer to hold shares listed on respective stock
exchanges. This decision is based upon the number of factors; the most important being
liquidity. Since only a small part of the company’s total capital may be raised
internationally i.e. the number of shares represented by ADRs are smaller in proportion
to the total capital of the company, liquidity in ADRs may be lower compared to that of
in equity shares. Hence in case of many companies, ADRs may trade at premium
compared to equivalent price of the company’s shares. Taking the same example cited
above, if shares are trading at Rs 88, 10 shares make 1 ADR and Indian Rupee / US
Dollar exchange rate is Rs 44, then one ADR issued by Indian company should trade
around $ 20. However in reality it may happen that the ADRs trade at a significant
premium since the availability of ADRs is not adequate. Or sometimes due to some
reasons, the ADRs may trade at discount compared to the local shares. This creates
Can outstanding ADRs be cancelled, underlying shares sold and shares reconverted into
ADRs. If this happens the arbitrage will be corrected. This depends upon the country
regulations. For example, in India this process, which is called a two way fungibility was
allowed only in 2002. Not only this, it is a limited two way fungibility. It means
investors holding ADRs can cancel them with the depository and sell the underlying
Equity Markets 99
shares in the local market. Subsequently the company can issue ADRs upto cancelled
shares. If this process is allowed, then cancellation of ADRs, and conversion of shares
into ADRs becomes a regular process.
Equity Markets 100
8. Basic Mathematics of stocks
8.1 Total Return from a stock
The total return from stock consists of dividend and capital appreciation. The total
return may be calculated from a point of view of i) Holding period or Single period
return or ii) Multi period return
Holding Period Return
As per this return, dividend or capital appreciation during a particular period, say a
calendar year is considered. Let us take the following example,
Shares of ABC Inc. were purchased by an investor one year back at $ 78. The current
price of this share is $92. If the dividend paid during the year by the company was $ 2.5
per share, how much return the investor has got?
Rt = [Dt +( Pt – P t-1 )] / P t-1
where Rt is the return on stock during period t,
Dt is the dividend on stock during period t
P t-1 is the price at the beginning of the period, i.e. price at which shares were
Pt is price at the end of the period
Hence putting the relevant figures, return can be worked out.
Rt = [2.5 + (92-78)] / 78 = 21.15%
Post Tax return
The return calculated above is pre-tax return. If we are interested in post tax return, then
tax rates on dividends and capital gains (short term and lone term) have to be found out
Equity Markets 101
Suppose tax is paid on dividends at the rate of 30% and tax on capital gains is 10%, post
tax return will be as shown below.
Post tax dividend income = 2.5 (1-0.3) = 1.75
Capital Gains = 92-78 = 14, tax on capital gains = 14 * 0.10 = 1.4
Net of tax capital gains = (92 – 78) - 1.4 = 12.6
Hence total post tax return = (1.75 + 12.6) / 78 = 18.40%
Thus because of income tax, the return has come down from 21.15% to 18.40%.
Multi Period Return
This can be calculated in many ways. It can simply be an arithmetic average of annual
returns or it can be a geometric mean as shown below.
Years 2001 2002 2003 2004 2005 2006
Price at the beginning 78 92 88 120 144 160
of the year in $
Dividends during the 2.5 2.5 3.0 3.0 3.5 4.0
year in $
The wealth ratio for each year can be calculated as follows.
Wt = [Dt +Pt ] / P t-1
Years 2001 2002 2003 2004 2005
Wealth Ratio (2.5+ 92) (2.5 + 88) (3 + 120) (3 + 144) (4 + 160)
/78 / 92 /88 /120 /144
=1.21 =0.98 = 1.40 =1.225 =1.14
Realized return = (W1 * W2 * W3 …… Wn)1/n
Where W1 , W2, W3 are wealth ratios for particular years and n is number of years
= (1.21*0.98*1.40*1.225*1.14)1/5 = 18.31%
Equity Markets 102
8.2 Dividend Yield
As we have already seen, total return consists of two components: Dividends and
Capital Appreciation. While in most of the cases, equity investors look forward to capital
appreciation, dividend yields can present attractive investment opportunities at times.
In fact there are some investors who tract dividends yields closely and spot these
Dividend Yield = Dividend Per share / Market Price
If the market price of company’s shares is $ 90, and annual dividends declared are $ 4.5,
the yield works out to 4.5 / 90 = 5%.
Thus as share price goes on increasing dividend yields become unattractive.
8.3 Capital gains / losses
In absolute terms, this is simply the selling price less purchase price of shares. In
percentage terms, the above subtraction is to be divided by purchase price.
8.4 Market Capitalization & Enterprise Value
Market Capitalization refers to the valuation of a company taking into account the
market prices at a particular point of time. Market capitalization is arrived at by
multiplying number of share outstanding and market price. As market prices fluctuate,
market capitalization also fluctuates. It is an important measure in the sense that a large
market capitalization attracts more investors towards the company. This is because
large market capitalization is due to either capital base is large (which means more
number of shares available for trading) and / or share price is higher (which indicates
that the market is positive about such companies). The blue chips companies i.e.
companies which are successful over a number of years are all large market capitalized
Equity Markets 103
Market Capitalization takes into account the company’s equity capital. However, the
company also deploys debt capital for its business which is ignored by the market
capitalization. Enterprise value takes debt capital into account.
Enterprise Value = Market Capitalization + Value of debt (as its appears in Balance Sheet
of a company)
8.5 Price / Earnings and other multiples
While arriving at the valuation of equity shares a number of multiples are used. The
most popular and widely understood is Price / Earnings ratio.
P /E ratio = Price / Earnings Per Share
It indicates how many times of earning the market price is at present. Comparing these
ratios of various companies, one gets a broad idea of valuation. Of course this is a very
basic measure and many other tools are utilized to value companies.
Earnings per Share are the per share earnings which are meant for equity shareholders.
It is arrived at by deducting dividend on preference shares, if any, from the Net Income
earned during a particular period. Following example shows the calculation of P/E
Net Income for the year 2005 in $ 25,000,000
Preference Share Capital in $ 70,000,000
Preference Dividend in % 8.5
Equity Share Capital in $ 12,700,000
Par Value of Shares in $ 0.50
Market Price of shares in $ 17
Earnings for equity shareholders = Net Income - Preferred Dividend
= 25,000,000 – (70,000,000*8.5%) = 19,050,000
Number of outstanding shares = Equity Capital / Par Value
= 12,700,000 / 0.50 = 25,400,000
Earnings Per share = 19,050,000 / 25,400,000 = 0.75
Equity Markets 104
P/E ratio = 17/ 0.75 = 23 times
Some Other Multiples which are commonly used are
i) Market Capitalization to Sales ratio – This ratio gives an idea about how
much is the market capitalization compared to the sales generated by the
companies. If for any company this ratio is lower, compared to that of the
companies belonging to similar businesses, analysts may conclude that
shares are undervalued on this parameter.
ii) Price to Book Value – This is an accounting measure. This ratio is arrived at
by dividing market price by book value.
Book Value = Networth of the company / Number of shares outstanding
Networth of the company is Equity Capital plus the reserves i.e. the retained
earnings or the amount of profits ploughed back in the business by the
company over the years. This ratio indicates the how shares price priced in
relation to the book value.
iii) Enterprise Value to EBIDTA – We have already seen what is an enterprise
value. EBIDTA is an operating profit measure. In simple terms it is the profit
of the company before deducting expenses such as interest, depreciation, tax
and amortization. That is why it is called Earnings Before Interest
Depreciation Tax and Amortization. This ratio tells us how many times the
enterprise value of a company is of its EBIDTA. A higher value may indicate
that the company is highly valued on this parameter.
Equity Markets 105
9. Sample Questions
1. The client side of trade for Institutional Clients in the US, is settled through --
2. In case of Over The Counter trades, trade matching is done automatically.
3. Custodians do not release securities unless they receive ----- from investment
4. The counterparty risk is assumed by ---- in case of trading of equities.
b. Central Securities Depository
c. Central Counterparty
5. If in the settlement process, the transfer of ownership cannot be legally effective
without the cash payment and vice versa, the procedure is called ------
a. Free of Payment
b. Receipt vs Payment
c. Delivery vs Payment
6. Identify the correct sequence of following activities.
a. Trade Matching, Trade Affirmation, Trade Confirmation, Settlement
b. Trade Matching, Settlement Matching, Trade Affirmation, Trade
c. Trade Matching, Trade Confirmation, Trade Affirmation, Settlement
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7. Which of the following is not a corporate action?
a. Stock Dividend
b. Cash Dividend
c. Stock Split
d. None of the above
8.The settlement cycle for equities in Japan is ----
a. T + 1 day
b. T + 2 days
c. T + 3 days
d. T +5 days
9. Which of the following statements is true in case of ECNs?
a. ECNs are stock exchanges
b. ECNs provide only after trading hours services to clients
c. ECNs provide greater flexibility and reduced costs to its
10. An investor instructs his broker to sell a stock at $ 45. The price of the stock at
present is $ 42. This is a
a. Market order
b. Limit order
c. Stop loss order
11. A floor broker goes to a trading post and requests a market professional to
execute a buy order on his behalf. This market professional must be -----
a. House broker
12. ABC Inc.’s stock is trading at $30. The number of outstanding shares in the
company’s capital structure is 1,200,000. Hence market capitalization of ABC Inc. is
a. $ 1.2 million
b. $ 30 million
c. $ 36 million
Equity Markets 107
American Depository Receipts(ADR) is a negotiable instrument that represents an
ownership interest in securities of a non-US company.
Authorized capital is the maximum number of shares that a company is allowed to
issue for raising capital as per the Memorandum of Association (charter) of that
Basket Trading provides a facility to create offline order entry file for a selected
Bilateral Netting is arriving at net obligations (i.e. netting) of securities and funds
between two brokers / parties.
Bloomberg Tradebook is a global electronic agency brokerage. Bloomberg Tradebook
provides agency broking services to institutional investors and broker – dealers.
Bonus Issue or Stock Dividend – In this case the company creates new shares by
distributing free shares to its shareholders.
Brokers are the intermediaries in a transaction between buyers and sellers of securities.
Brokers are the intermediaries in a transaction between buyers and sellers of securities.
Capital is the money that any company needs to run its business.
Capital Gains refer to the increase in prices of shares of a company.
Called up capital is that part of issued capital for which the company has called up
Clearing is a process of exchange of money and securities between brokers using a
form of netting.
Dealers do not act as intermediaries, they take positions in securities on their own
Debt capital comes from non-owners or outsiders. It is like a loan given to the
company by outsiders.
Dividends are a part of the company’s profits paid to the share holders.
EBIDTA is an operating profit measure. It is the profit of the company before
deducting expenses such as interest, depreciation, tax and amortization.
Equity Markets 108
Electronic Communications Networks (ECNs) are alternate trading systems
which provide investors with new execution choices.
Equity represents the ownership capital. A common stock or an equity share is the
primary source of capital for the business without which business cannot exist.
Exchange-traded fund is a mutual fund that trades like a stock.
Floor Brokers are the brokers i.e. intermediaries who receive orders from the public
tobuy or sell shares.
Global Depository Receipts (GDRs) are the receipts evidencing underlying shares,
which are issued simultaneously in more than one country.
House Brokers are employed by brokerage houses that are members of the stock
exchanges like NYSE.
Index trading provides a facility of buying and selling of stock exchange indices in
terms of securities that comprise the index.
Independent Brokers: The majority of independent brokers are “direct access”
brokers who deal with the institutional public at low commission rates.
Initial Public Offerings (IPO) This offer is made when the company issues shares to
the investors at large for the first time.
Instinet is a global agency broker which provides access to clients to more than 40
equity markets worldwide.
Issued capital is that part of the Authorized capital that has been issued by a
Market Capitalization of a company indicates the valuation of the company taking
into account the market prices at a particular point of time.
Market Capitalization to Sales ratio gives an idea about how much is the market
capitalization compared to the sales generated by the companies.
Multilateral Netting is arriving at net obligations of securities and funds between all
Paid up capital is also called Subscribed capital and is that part of the Called up
capital for which the payment has been received from the investors.
Par Value Shares – Par value of a share is the face value of the share.
Equity Markets 109
Price to Book Value is an accounting measure. This ratio is arrived at by dividing
market price by book value.
Prospectus It is a legal document which provides details about the company proposing
to make a public offer.
Public Issue is when the shares are issued to the general public i.e. it is free for
subscription to all investors.
Residual Capital – Equity is a residual capital. That means claims of equity holders
can be satisfied, after claims of all others such as lenders, creditors etc. are satisfied.
Rights Issue is one in which the shares are offered to the existing shareholders only.
Secondary market is a market where outstanding securities i.e. securities which have
been issued by the issuer are traded.
Settlement is the last process in the Life Cycle of a Trade. In settlement all the
counterparties exchange securities and money as per their obligations.
Share repurchase involves buying back equity shares from shareholders in certain
Shelf registration is a registration of securities that are not to be offered for sale
immediately. The issue is spread over some time period.
Short selling is selling the stock without possessing the same.
Stock is a share in the ownership of a company. Stock represents a claim on the
company's assets and earnings.
Stock Split is when the face value of existing shares is split into smaller lots so that the
number of shares goes up.
Stock Exchange Indices provide an overall picture of the trend in prices of stocks
covered by the index during a particular period.
Specialist provides buy & sell quotes to floor brokers and makes a market in securities
which are assigned to him.
Tick Size refers to the minimum price fluctuation allowed at every price change.
Trade Allocation is allocating large quantity of shares for different portfolios
Equity Markets 110