The Stock Stethoscope

What are the different types of Indian stock markets?

In the previous blogs we have learnt about the primary and secondary markets. Now, in the secondary market, once the stocks are available on the exchanges for trading, the Indian stock market can be further categorized into two sections, based on the type of traded financial instrument. As a result, we have the EQUITY MARKET and the DERIVATIVES MARKET. The one feature they have in common is that they can both be purchased and sold. Here is a detailed comparison of the two.Equity Market?

Equity Market

In equity trading, those who hold equity are known as the company’s owners and assets. Large companies raise funds by issuing shares, and a buyer becomes part-owner of that company. This is a cash segment, and the buyer and seller arrive at a negotiated price. The buyer pays the entire value of the stock, which can be held off by multiplying the number of stocks with the current market price.Derivatives Market?

Derivatives Market

A derivative is an instrument that gets value from various underlying assets. Futures, swaps, forwards, and options are all examples of derivatives. Stocks, bonds, commodities, currencies, and interest rates qualify as underlying assets. Future and options contracts are the most frequent instruments.

Features Of The Equity And Derivatives Market?

The value of equity relies on a range of factors such as demand and supply, the performance of the company, and economic or political events.

The strength of the underlying asset analyzes the value of derivatives. When the asset is currency, its movement will establish the value of the derivative.

A transaction in the equity market is said to be concluded once the stocks are transferred to the buyer’s Demat account.

A futures contract in the derivatives market has to be closed within a specific time and at a fixed rate.

An options contract in the derivative market also gives you the option of ignoring it together.

The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) offer to trade equities and derivatives. Online trading and services such as zero brokerage have increased the number of trades in these segments.

---

Breaking Down of the Equity Market:

Equity markets are the meeting point for buyers and sellers of stocks. The securities traded in the equity market can be either public stocks, which are those listed on the stock exchange, or
privately traded stocks.

Trading in the Equity Market:

In the equity market, investors bid for stocks by offering a certain price, and sellers ask for aspecific price. When these two prices match, a sale occurs. Often, there are many investors bidding on the same stock. When this occurs, the first investor to place the bid is the first to get the stock. When a buyer will pay any price for the stock, he or she is buying at market value; similarly, when a seller will take any price for the stock, he or she is selling at market value.

Companies sell stocks in order to get capital to grow their businesses. When a company offers stocks on the market, it means the company is publicly traded, and each stock represents a piece of ownership. This appeal to investors, and when a company does well, its investors are
rewarded as the value of their stocks rise. The risk comes when a company is not doing well, and its stock value may fall. Stocks can be bought and sold easily and quickly, and the activity surrounding a certain stock impacts its value. For example, when there is high demand to invest in the company, the price of the stock tends to rise, and when many investors want to sell their stocks, the value goes down. Let us see more in-depth the advantages and disadvantages of investing in the equity share market.

What are the advantages of Equity Share Investment?

1. DIVIDEND
An investor is entitled to receive a dividend from the company. It is one of the two primary sources of return on his investment.

2. CAPITAL GAIN
The other source of return on investment apart from dividends is capital gains. Gains arise due to a rise in the market price of the share.

3. LIMITED LIABILITY
The liability of a shareholder or investor is limited to the extent of the investment made. If the company goes into losses, the share of loss over and above the capital investment would not be borne by the investor.

4. EXERCISE CONTROL
By investing in the company, the shareholder gets ownership in the company, and thereby he can exercise control. In official terms, he gets voting rights in the company.

5. CLAIM OVER ASSETS & INCOME
An investor of an equity share is the owner of the company, and so is the owner of the assets of that company. He enjoys a share of the income of the company. He will receive some part of that income in cash in dividends, and the remaining capital is reinvested in the company.

6. RIGHTS SHARES
Whenever companies require additional capital for expansion, they tend to issue ‘rights shares.’ By issuing such shares, ownership and control of existing shareholders are preserved, and the investor receives investment priority over other general investors. Right Shares are issued at a price lower than the current market price of the equity share. So, an existing investor can take that advantage or renounce right in someone’s favor to get the value of right.

7. BONUS SHARES
At times, companies decide to issue bonus shares to their shareholders. It is also a type of dividend. Bonus shares are free shares given to existing shareholders, and they are often given in place of dividends.

8. LIQUIDITY
The shares of the company which is listed on stock exchanges have the benefit of any time liquidity. The shares can very easily transfer ownership.

9. STOCK SPLIT
Stock split means splitting a share into parts. How should an investor benefit from this? By splitting shares, the per-share price reduces in the market, which eventually increases share readability. At the end, a stock split results in higher volumes with several investors leading to the high liquidity of the share.

What are the disadvantages of Equity Share Investment?

1. DIVIDEND
The dividend which a shareholder receives is neither fixed nor controllable by the investor. The management of the company decides how much dividend should be given. If there is a loss, there is no question of dividend. If there is a profit, investors will not receive the dividend unless the Board of Directors proposes a dividend.

2. HIGH RISK
Equity share investment is a risky investment compared to any other investment like debts etc. The money is invested based on an investor’s faith in the company. There is no collateral security attached to it.

3. FLUCTUATION IN MARKET PRICE
The market price of any equity share has a wide variation. It is always very difficult to book profits from the market. On the contrary, there are equal chances of losses.

4. LIMITED CONTROL
An equity investor is a small investor in the company, therefore, it is hardly possible to impact the decision of the company using the voting rights.

5. RESIDUAL CLAIM
An equity shareholder has a residual claim over both the assets and the income. Income that is available to equity shareholders is after the payment of all other stakeholders’ viz., debenture holders, etc.

---

Breaking down of the Derivatives Market

Derivatives can be broadly classified into two types of market namely, EXCHANGE-TRADED derivatives and OVER-THE-COUNTER (OTC) derivatives. The former includes contracts that are regulated and managed by the market and have standardized contracts with a comparatively lower risk of default. OTC derivatives on the other hand are unregulated non-standardized contracts that do not have any intermediaries or any exchange to be traded on. These are flexible contracts that can be easily modified and hence carry huge risks.

Who are the participants of the derivatives market?

Derivative markets consist of four major participants. Given below are a few details of the same.

1. HEDGERS
Hedgers are the investors that invest in the derivatives market to eliminate the risk of any change in the future prices of the asset. The primary intention is to secure the existing exposure in the market or to reduce the risk and not to earn profits.

2. SPECULATORS
Speculators are traders who predict the prices of an asset or derivative based on the future movement of the underlying asset and take calculated risks to earn profits. It is the most common market activity.

3. MARGIN TRADERS
Margin is the nominal percentage of the value of the investment to be deposited by the investor to cover the risk of the investment. Margin traders use this margin money to purchase more stocks.

4. ARBITRAGEURS
Arbitrage is the activity of earning profit based on the difference in prices of an asset in two different markets. Arbitrageurs purchase an asset at a lower price in one market and sell it in another market at a higher price to gain profits.

What are the different types of derivative contracts?

The derivative market is essentially divided into four types of market instruments. These instruments are explained below.

1. FUTURES
These are standard agreements or a contract between two parties that are executed on the exchange market. Under this contract, the buyer or the holder of the contract has the right as well as an obligation to buy or sell an underlying asset at the agreed future prices.

2. OPTIONS
Like futures contracts, options also provide the right but not an obligation to buy or sell an underlying asset at a future price. There are many types of options like American, European, etc which can be bought using call (option to buy) or put (option to sell) options

3. FORWARDS
Forward contracts are similar to futures contracts with the only difference being that they are over-the-counter contracts and hence are not traded on any recognized exchange. The parties in the contract can customize the contract based on their needs and risk-return parameters.

3. SWAPS
Swaps are another type of over-the-counter instrument where the parties are allowed to swap or exchange their obligations. The most common type of swaps is the interest rate swaps along with currency swaps or commodity swaps, etc.

What are the advantages of the derivatives market?

Derivative markets, although riskier than primary markets, have many advantages. Some of these advantages are discussed below.

1. REDUCED CAPITAL INVESTMENT
Derivatives and an excellent option to invest in stock markets with limited capital. Investors can get attractive returns from lower capital investment as compared to primary investment instruments like shares and mutual funds.

2. REDUCED COST OF INVESTMENT
The cost of investment in derivative markets is lower than the cost of investment in primary assets like shares and debentures. The reduced capital investment further decreases the cost of investment for the investors.

3. EFFECTIVE RISK MANAGEMENT
Derivative markets are an effective tool to reduce the risk of investment. The participants of the derivative market can hedge their risks and also gain the benefit of arbitrage along the way. This increases the potential returns for the participants of derivatives markets.

4. FLEXIBILITY TO TRADE IN EXCHANGE TRADED CONTRACTS OR OTC CONTRACTS
Another benefit of the derivatives market is the flexibility to trade in standard or nonstandard contracts. Participants can customise the contract to suit their needs and gain maximum returns at calculated risks.

What are the disadvantages of the derivatives market?

After discussing the above advantages of derivatives markets, let us now discuss their limitations.

1. RISKS
The first and foremost limitation of the derivatives market is the risk. These markets carry significantly more risk than primary markets. If the risk is not effectively managed, it can result in huge losses for the participants.

2. COMPLEXITY
The contracts in derivatives markets are quite complex and need thorough market knowledge before participation. A novice person may end up losing more money than making some if they do not understand the functionality of these markets and the contracts entered by them.

3. SPECULATION
Speculation is the key to these markets to maximize the returns. The unpredictability of these markets and the higher risks may lead to higher losses and can potentially drain all the capital investment of the investors.