Cm102   D&B   Equity Markets.20070118
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Cm102   D&B   Equity Markets.20070118 Cm102 D&B Equity Markets.20070118 Document Transcript

  • FDN-CM102-DB-Part 1 Equities Module Equity Markets 1
  • 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 Capital Capital 1 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 lenders. 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 subscription. 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 mandatory. 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 cancelled. 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. 2 Market capitalization refers to a product of number of outstanding shares a company has and market price of shares 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 different prices. 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 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. 3 The role of investment banker is explained in the section of Parties involved in an equity issue. 4 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. Issue Pricing Help in issue design Functions of investment bankers Operational procedures Distribution Underwriting - 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 them. Equity Markets 14
  • Brokers / Dealers – They help in distribution of the issue to the investors. They form the selling group. L Underwriting Selling group E Syndicate I A S I D S N U Inv. Bank A Broker A V U I N E N D S G E T R Inv. Bank B Broker B O W R F R S I I R T Inv. Bank C Broker C M E R 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
  • 2.7 Prospectus 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 this prospectus. 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 prospectus. Equity Markets 16
  • Details mentioned in the prospectus Risk factors Use of issue proceeds Dividend Policy Capitalization & distribution Financial Data Management’s Discussion of Finances and Operations Prior Year Results Description of business Management Principal Stockholders 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 requirements. 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 matters. 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 done simultaneously.) IPO idea Selection of Preparation of generation investment Registration Statement banker and Prospectus Establishment Cooling off Filing of Registration of syndicate period Statement and Preliminary Prospectus with SEC Registration of Assessing securities in investor Approval from SEC various states interest for the issue Tombstone Issue opens Preparation of Advertisement final prospectus 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 capital. 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 raising. 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 QuickLinks-- Click here to rapidly navigate through this document Filed Pursuant to Rule 424(b)(4) Registration No. 333-132067 PROSPECTUS 5,750,000 Shares Common Stock -------------------------------------------------------------------------------- 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 page 7. 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 22, 2006. -------------------------------------------------------------------------------- Citigroup Lehman Brothers -------------------------------------------------------------------------------- Deutsche Bank Securities Thomas Weisel Partners LLC Needham & Company, LLC March 16, 2006 Underwriting Terms of Issue of IKANOS COMMINICATIONS INC UNDERWRITING 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 name. Underwriters Number of shares ------------------------------------- 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 --------- Total 5,750,000 --------- 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 purchase commitment. 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 3.1 Introduction 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 Issuer : Corporation A Investors transfer funds to the issuer Secondary Market 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 obligations. The rules for membership of stock exchanges are framed by the respective stock exchanges. 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. 3.5 Delisting 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. Trading Mechanism 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 Floor Brokers 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 customers. • 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 C D Post 1 Post 2 Post 6 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 Ticker 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 periods. 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 solution. 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 5 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
  • NASDAQ 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 securities 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 ECNs 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. Instinet 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 Bloomberg Tradebook 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 Dissemination Service. 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 phase Pre Client Investment Advice Decision Trade Trade Trade Trade Order Execution Post Pre – Clearing Settlement Settlement, Post Trade Trade services 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 is essential. • 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’ behalf. 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 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. Circuit Breakers 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 activity. Equity Markets 45
  • Liquidity 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. OFEX 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 stocks. SEAQ – Even SEAQ is the trading service for mid cap stocks and some other securities. Source : London Stock Exchange Basket Trading 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 depending upon 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 stocks iii) the investment theme – basket of growth stocks, basket of high dividend yield stocks etc. 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
  • Index Trading 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 management fees. 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 tech sector. SPDRs (Spiders) 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 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 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 settlement. 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 days) 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 other participants. Settlement Services – Provided through NSCC as stated above Fixed Income – Fixed Income Processing Services provided through Fixed 6 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 Broker Client -- Counterparty Retail Or Or Institutional None 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. Investment Brokers Managers Custodians 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 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 failed trade. Broker Institutional Initiates the confirmation process Client (Investment Confirm or report errors, if any Manager) Custodian Releases funds or securities Affirmations 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 affirmations. 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. S E D T E Security T T L A Price E I Quantity M L E S Account N Place of settlement T 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 own VMUs. Equity Markets 60
  • 4.7 Reconciliations 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. 5.1 Clearing 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 Clearing System 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
  • Broker A 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
  • 5.2 Settlement 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
  • Retail Clients 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. Settling Bank 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 International trades. 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) Reporting of Real time, trade details Trade electronic to participants Executio transfer of by NSCC trade details to NSCC T+1 T+2 T+3 Delivery of NSCC informs NSCC securities to net brokers / assumes role buyers and dealers about of CCP payments of money net position 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
  • Institutional Trade Broker executes the trade on exchange Investment Manager 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 Custodian Bank Omgeo instructs DTC, on behalf of Investment manger or broker to settle affirmed / confirmed trades between the custodian and the broker DTC 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 Settling participant Bank 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 12000 shares of Microsoft Investment Manager 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. 12000 shares of Microsoft Portfolio Portfolio A Portfolio C 5000 B 4000 shares 3000 shares 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. Broker B Broker A Investment Broker C Manager Broker D DTC NSCC 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 D. 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, reverse happens. Omgeo OASYS 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. Settlement 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
  • Settlement Bank 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. Settlement Date The date on which parties to a securities transaction agree that settlement is to take place. 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. Custody function 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 transfer. 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 the world. 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 J S C Investment Investment C Manager -- Manager -- - Seller Buyer C C P 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 Japan. 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 participants. 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. Equity Markets 78
  • 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 exist. 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 √ √ Depositories 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 international CSDs. Equity Markets 81
  • E R Investment E Investment Manager -- X Manager -- Buyer - Seller C C P Broker A – Buying Broker Broker B – Selling Broker Settlement Instructions Clearstream Banking Euroclear 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 capitalized stock. 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 below. Number of Price in the base year Price in the current year outstanding shares Stocks 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 8000000 22000000 2100000 10500000 1000000 6000000 50000000 120000000 34000000 70000000 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 Equity Markets 85
  • 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. Equity Markets 86
  • US Indices 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 Corporation etc. 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* Stocks 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 Index. 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. DAX index 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 Deutsche Börse 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. BSE Sensex 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 non-US company. 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 trading. 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 investors. » 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 Custodian Deposits shares Confirms the deposit with custodian of shares Local Issues Custodian ADRs to US Investors 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 publicity process. Regulatory requirements 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 arbitrage opportunities. 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 purchased 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 and applied. 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 opportunities. 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 companies. 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 ratio. 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 Other Multiples 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 -- a. NSCC b. DTCC c. DTC d. Clearstream 2. In case of Over The Counter trades, trade matching is done automatically. a. True b. False 3. Custodians do not release securities unless they receive ----- from investment managers. a. Confirmations b. Affirmations 4. The counterparty risk is assumed by ---- in case of trading of equities. a. Custodian 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 Matching b. Trade Matching, Settlement Matching, Trade Affirmation, Trade Confirmation c. Trade Matching, Trade Confirmation, Trade Affirmation, Settlement Equity Markets 106
  • Matching 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 subscribers 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 b. Specialist c. Dealer 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
  • 10. Glossary 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 company. Basket Trading provides a facility to create offline order entry file for a selected portfolio. 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 subscription. 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 account. 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 company. 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 the brokers. 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 proportion. 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