[Economy 4 Newbie] Securities, Derivatives, Financial Market
As usual nothing 100% politically / technically correct.
This article is about some very basic concepts. But I’m writing this because you’ll need these concepts to understand the more complex topics like SEBI, Stock Exchange etc.
Issues & Securities,
1. If I write on a piece of paper saying “anyone who gives me 100 Rs., I’ll give him 120 rupees after 6 months” = this is public issue
2. If you give me 100 Rs. And take that paper- then that paper becomes the ‘security’
Keep in mind that The 100 Rs you give to me or the 120 Rs. I’ll give to you after 6 months- that is NOT Security. That Piece of paper is the security.
Technical definition
· Security means a formal declaration that documents a fact of relevance to finance and investment gives the holder a right to receive interest or dividends.
· Security means A guarantee that an obligation will be met
Shares, debentures.
They’re also securities of one type. You must be knowing about them already so just in brief--
1. If for your 100 rs, I give you a limited ownership in my company and promise to give you the share from my profit = this is share
2. But if I say that, I’ll give you 15 Rs. Every year no matter I get any profit / not = this is debenture.
Derivatives / Stock Market Derivatives
· you gave me 100 Rs and I gave you a paper saying I’ll payback 120 Rs. (=Mrunal’s security paper)
· there is another guy named Mitul who, same way borrowed 100 Rs. And gave you another paper saying he’ll pay you 120 Rs after 6 months. (Mitul’s security paper.)
· Now you need money before 6 months, so you write on a new paper, “anyone who gives me 220 Rs, I’ll give him 240 Rs. Worth Security papers of Mrunal and Mitul.”
· that new paper you crated is again a ‘security ’ but it doesn’t have ‘direct-money attached with it’ –instead, it derives its value from the security papers for Mrunal and Mitul. So your new paper is called ‘Derivatives’
lets now deviate from our article’s topic for a while to learn a few things related to recession from above talk.
Mortgage, Asset bubble & derivatives
· You give me 100 Rs. And I give you paper saying “if I don’t pay back, you can take away my house”
· this is mortgage. But again this is also one kind of ‘security paper’
· Now you’re a big bank, so you’ve plenty of such mortgage papers because you give loans to lot of people. (even to those who can’t afford to pay back the loan)
· Then you repack those mortgage papers (security ) and make a new security paper “anyone who gives me 500 Rs. I’ll give him mortgage papers of 5 houses” = this is derivative product.
· Suppose 3rd guy bought such derivative papers and after few months, he repacks them- makes another derivative product and sell it to 4th guy.
· Such papers are one sort of ‘asset’ (because you can get money from someone using it.)
· but as you can see, you did not create any ‘new asset’ you’re just keep reselling same stuff over and over to different people. So you’re blowing a ‘bubble’
· After few months, I refuse to pay money, and tell the 4th guy to take away my home. But the prices in reality sector are low so even if you sell my home you can’t recover your 100 Rs. = this is ‘toxic asset’ / NPA = non-performing asset and your asset bubble is ‘burst’
Financial Market
· You gave me money I gave you a piece of paper (security)
· The place where we did this business is called financial market.
· If I had promised to pay back money in less than 1 year (=short term loan) , this will be called Money Market
· If I had promised to pay back money after long time like 10-20 years (=long term loan) , this will be called a CAPITAL MARKET.
Players in Capital Market (diagram)
· As said above, when I take long term loan = its capital market.
· When initially I took money from you and give you piece of paper = this is ‘PRIMARY market.’ *
· But after sometime, you need the money while I’m going to pay back after 10 years.
· So you borrow 100 Rs from another guy and give that piece of paper (=security) to that guy. And tell him to recover the money from Mrunal = you traded my security. This is ‘SECONDARY MARKET’ (Sharemarket / BSE/NSE etc)
(*this primary market will be discussed in another article) our current article deals only with capital market.)
It’s the job of SEBI to control both Primary & Secondary Capital market in India. (detailed article about SEBI,BSE,&NSE is coming soon.)
As you saw on above diagram that Govt. is also a ‘player’ in capital market. So,
Why does Government issue securities?
· Suppose I’m the Govt.
· My expenses are more than my income
· = I’m in deficit (gap)
I’ve following options to cover that deficit
1. Increase tax rates (income tax, VAT, import duties)
But this will make people unhappy and they’ll not vote for me in next election
2. Print more money
But this will create inflation= again unhappy people= less votes.
3. Borrow from international institution (world bank / IMF)
But if I borrow too much, I’ll have to play by their tunes regarding Kashmir, Copenhagen, WTO-Doha.
4. Borrow from people within India
This sounds safer!
· So I’ll issue securities. (When you issue for the first time = you’re in primary market.)
· keep in mind that Govt. does this for short term deficits. (its like I need money in October 2010 but you’re going to pay income tax in March 2011 so I’ll use this trick to cover my money needs.)
· Govt. generally plays only in the primary market.
· When you give me your money and receive that piece of paper (security) = you can be certain that I’m going to pay back and won’t run away like Ashok Jadeja. After all I’m the Government. And I pay good profits.
· that’s why Govt. securities are called ‘Gilt-Edged securities’
How does this thing work?
· As I decided to issue security in primary market, but that doesn’t mean I’ll send my peon/clerk/Secretary to the primary market with bag full of papers (security) and sell it like vegetables.
· I give my piece of papers (security / treasury bills) to RBI- they’ll give me the money and then RBI’s men will sell it in the primary market. = RBI is Govt.’s debt manager.*
· *Security Paper= I’m going to pay money after some time. = I’m in your debt. And RBI manager’s my security papers so they’re my ‘debt manager.’
Separate debt Management office.
· Ok so now you know that RBI is Govt.’s debt manager. But consider this
· RBI’s main job = maintain liquidity (=money supply) in market via monetary policy (=CRR,Repo etc crap)
· But, When RBI sells Govt. securities in primary market, and give the money to Govt. = money supply flow is interrupted = liquidity is drying = harder to get loans
· = conflict of interest.
· That’s why many people are calling for separate Public debt Management office and relieve RBI from this duty.
Ok now ,final part in this article-As we saw, there are 2 types of capital market : Primary and secondary. but
Why do we need Secondary market?
Gives Exit Route
· I’m going to return money to you after 10 years. So your hands are ‘tied’ – you can’t recover it from me until next 10 years, so what if you needed money in emergency? You’ve secondary market so you’ll sell my security to someone else and recover the money. Otherwise,
· In the absence of a secondary market, many of the investors would probably not agree to supply capital (money) in the primary market because they would not have an exit route for their investment.
Gives Price information
By active trading by millions of investor, you get price information regarding the securities.
This price information is used to judge
1. the corporate performance (share prices)
2. performance of the Government
3. economy (through interest rates on Government debt).
4. facilitating value-enhancing control activities (mergers & acquisitions) and
5. enabling implementation of incentive-based management contracts (employee stock options).
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