A Microeconomic Study of the Indian Stock Market A brief overview of the Indian stock market3 Purpose of the stock exchange3 PRIMARY MARKET3 SECONDARY MARKET4 Role of ‘Supply and demand’ on the stock price movement4 EVOLUTION OF MARKET STRUCTURE AND THE SELF REGULATORY APPROACH5 Traditional structure of the stock exchanges:5 Changes in the market structure and demutualization:5 Stock Markets as Perfectly Competitive markets:6 Transaction Costs in the present day stock markets:6 Current transaction costs:7 Importance of Risk in Stock market:7 Utility Analysis9
Stock Market Risks at different levels:11 Simplistic methods to Mitigate Risk:11 Types of Different Risks in Stock Market:11 A brief overview of the Indian stock market The origin of the stock market in India goes back to the end of the eighteenth century when long-term negotiable securities were first issued. However, for all practical purposes, the real beginning occurred in the middle of the nineteenth century after the enactment of the companies Act in 1850, which introduced the features of limited liability and generated investor interest in corporate securities.
An important early event in the development of the stock market in India was the formation of the native share and stock brokers ‘Association at Bombay in 1875, the precursor of the present day Bombay Stock Exchange. This was followed by the formation of associations/exchanges in Ahmadabad (1894), Calcutta (1908), and Madras (1937). In addition, a large number of ephemeral exchanges emerged mainly in buoyant periods to recede into oblivion during depressing times subsequently. Bombay Stock Exchange (BSE) was the major exchange in India till 1994. National Stock Exchange (NSE) started operations in 1994.
NSE was primarily setup after the Harshad Mehta scam which surfaced in 1992. Purpose of the stock exchange The purpose of the stock exchange is to regulate or control the business of buying, selling or dealing in securities. These securities include: • Shares, scrip, stocks, bonds, debentures stock or other marketable securities of a like nature in or of any incorporated company or other body corporate. • Government securities, and • Rights or interest in securities In general, the financial market divided into two parts, Money market and capital market.
Securities market is an important, organized capital market where transaction of capital is facilitated by means of direct financing using securities as a commodity. Securities market can be divided into a primary market and secondary market. PRIMARY MARKET The primary market is an intermittent and discrete market where the initially listed shares are traded first time, changing hands from the listed company to the investors. It refers to the process through which the companies, the issuers of stocks, acquire capital by offering their stocks to investors who supply the capital.
In other words primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is called an initial public offering (IPO). Dealers earn a commission that is built into the price of the security offering, though it can be found in the prospectus.
SECONDARY MARKET The secondary market is an on-going market, which is equipped and organized with a place, facilities and other resources required for trading securities after their initial offering. It refers to a specific place where securities transaction among many and unspecified persons is carried out through intermediation of the securities firms, i. e. , a licensed broker, and the exchanges, a specialized trading organization, in accordance with the rules and regulations established by the exchanges. Role of ‘Supply and demand’ on the stock price movement pic] [pic] Fig. 1 Fig. 2 The prices of stocks are determined by their individual supply-demand equilibrium as shown in Fig 1. Factors affecting the supply and demand of a company’s stock: •The current prices of the stock. •Current earnings/profits/dividends. •Expected future earnings. •Expected future stock price. •The price of substitutes like bonds or other stocks. A breakout above a resistance level is evidence of an upward move as more buyers (demand) are willing to buy at higher prices (as shown in Fig 2).
Similarly, the failure of a support level indicates that more supply (seller) is available and ready to sell at lower levels. In a bull market, we see strong demand and weak supply for shares which pushes up the market price of the share. Bear market is one that is in decline, share prices are continuously dropping, resulting in a downward trend that participants believe will continue in the long run, having a spiralling effect. During a bear market, the economy typically slows down and unemployment may rise. EVOLUTION OF MARKET STRUCTURE AND THE SELF REGULATORY APPROACH Traditional structure of the stock exchanges:
Traditionally stock exchanges were a place where the brokers accepted buy or sell orders of the securities of various firms and manually matched the orders to complete the transactions. Thus the stock exchanges were physical locations where the trade of securities took place because there was gathering of brokers at the exchange floor. These brokers were the members of the stock exchanges. The need to conduct the transaction in person restricted the access to the exchange members who were the intermediaries for investor’s transaction, which gave the exchange members the market power.
Since the members of the exchange had a better knowledge of the order flow and the prices of the securities, they took advantage of information asymmetry and started charging monopoly rents in the form of brokerage commissions. In order to prevent the expropriation of the monopoly, which the members were enjoying by the virtue of the formation of the exchange, these exchanges required to have a common economic purpose, equity of the status of the members, solidarity among the members and self responsibility. These values typically lead to the formation of a mutual or a cooperative structure.
The exchange however remained a nonprofit seeking organization, only providing a platform to its members to conduct business. The self-regulatory function of a mutual stock exchange conforms to principles of a cooperative enterprise. The exchanges, which are primarily owned by the members whose incomes were derived from the volumes of the exchange, adopted investor friendly rules since the investors were ultimate beneficiaries of the exchange. Also, these exchanges in order to attract order flows would not only have to compete with other stock exchanges but other markets like real estate and precious metals.
Changes in the market structure and demutualization: Changes in the market structure can be primarily attributed to the advent of electronic trading system. In the current electronic trading environment the buy or sell orders are placed onto a computer system which matches the orders on the basis of price-time priority or any other priority set by the administrator of the system. Thus in the current situation an erstwhile major function of matching the orders by the members have been taken up by the system. This has resulted in a drastic reduction in the trading cost or the transaction cost.
The electronic trading platform being proprietary asset of the exchange, it is in economic prudence to capitalize the investment on the asset. The exchanges capitalized their investment on the trading platform by providing the service of trading. Thus the members of a stock exchange are now more like customers of stock exchange who pay rent to the exchange for transacting on their trading platform. Hence the business model of exchanges have become more or less like a profit seeking organization. The electronic trading system does not require the physical presence of the trader at a market place.
In fact the market place itself is now virtual. This has led to the removal of spatial constraints, which in the earlier model of trading were being capitalized by the members of the exchange. Since the reason for the members to assemble at a place and transact has been eliminated the cause of mutuality is lost. Hence most of the exchanges in the world with electronic trading system have either become demutualized or are rapidly moving towards demutualization. A demutualized exchange is expected to be more sensitive to cost of regulation than a mutual exchange as profit is one of its principal objective.
With a shift in exchange governance choice from mutual, member controlled cooperative structure to a demutualized, profit seeking corporate structure there arises a need to rethink about the regulatory choice. Self regulation has been prescribed as a suitable regulatory choice. However self-regulation along with demutualization throws up issues of conflict of interest. It is believed that a demutualized profit seeking exchange will be less motivated to regulate those who are its customers. The regulators feel that a demutualized, profit seeking exchange unless regulated properly may not be a reliable gatekeeper.
This lead to the introduction of a regulatory body named Securities and Exchange Board of India or SEBI to regulate the present day stock exchange. Stock Markets as Perfectly Competitive markets: • All price-takers, no seller is large enough to affect market price by its own actions • Shares of the same company are homogeneous • Restrictions on entering and leaving the stock market in response to market rallying • Minimal transaction costs and current day media and technology strength ensures common knowledge of asking prices of sellers and bids by buyers
Transaction Costs in the present day stock markets: An investor has to incur costs under the following heads: • Brokerage (payable to the broker who provides interface and executes trades) • Exchange Transaction Charges (payable to the NSE/BSE) • Depository Charges (payable to participant of NSDL/CDSL) • SEBI turnover fees (payable to SEBI) • Security Transaction Tax (payable to the government of India) • Stamp Duty which varies from state to state (payable to the local government) • Service Tax on brokerage (payable to the government of India)
Current transaction costs: • NSE charges Rs. 3. 25 for every Rs. 1,00,000 worth of trade till Rs. 1,250 crore in its cash segment. As the turnover goes up, the charges progressively come down • In a recent announcement, MCX-SX said it will levy a transaction charge of Rs. 2 per Rs. 100,000 for the first Rs. 1,000-crore trade. The charges come down as the turnover goes up • Rival BSE Ltd charges between Rs. 2. 25 and Rs. 3. 25 per Rs. 1,00,000 in the cash segment. • Table A illustrates the overall cost incurred by an investor for executing a trade for Rs. 1, 00,000.
Since the various heads cause confusion in the minds of investors, a single head would have been better. The proportion of statuary taxes of the overall transaction cost is huge and a matter of concern • Out of the total cost, nearly 55% is accounted for by various statutory levies. Further, STT alone accounts for 46% of the total statutory taxes/levies. This is extremely high when compared to the global markets • High transaction cost may reduce market depth and liquidity, and increase volatility and make Indian markets less competitive than its global peers.
Importance of Risk in Stock market: Risk refers to the variability of the outcomes of some uncertain activities. In such situations, individuals are more concerned with the expected utility associated with various outcomes. For an example, if there are two options available of which one has to pay Rs 300 or take a gamble based on the flip of a coin, where he will lose Rs 600 if the coin comes up head but he would neither lose nor win anything if it comes up tails. In the first framing, the individual focuses heavily on the zero point, hence the name ‘Zero Illusion’.
Rather than accept a loss for sure of Rs 300, the individual is willing to gamble since there is an even chance of losing nothing. But when framed in terms of expected utility, the expected monetary value (EMV) [0. 5*$600 + 0. 5*0] $300 is equal in both the cases. Individuals who prefer the EMV for sure are to be termed as Risk Averse whereas Risk Neutral is a person who is indifferent between gamble and EMV. One who prefers a gamble to EMV is called Risk Seeking. Depending on the size of gamble, its value can be set at a precise amount that makes one risk neutral and this value is known as Certainty Equivalent (CE).
Hence risk aversion means a certainty equivalent less than EMV (CE ;lt; EMV) and risk seeking behavior is CE ;gt;EMV. Options having EMV of zero are called fair games which is no way popular. In this context, there is one exception called St Peterburg Paradox where a coin is flipped until a head appears and if a head appears on the nth flip, the player is paid Rs 2n. Hence EMV of the St. Petersburg paradox game is infinite. But no player would pay a lot to play this game; it is not worth its infinite expected value. Hence assuming diminishing marginal utility of wealth, St.
Petersburg game converges to a finite expected utility value. This is a measure how much the game is worth to the individual. Expected utility can be calculated in the same manner as expected value. Because utility may rise less rapidly than the stock price, it is possible that expected utility will be less than the monetary expected value. Application of the von Neumann-Morgenstern theorem here can reasonably assign specific utility numbers to the stocks available and a rational individual will choose the option that maximizes the expected value of their von Neumann-Morgenstern utility index.
Two stocks may have the same expected value but differ in their riskiness like investment in stocks for amount of Rs 100 vs Rs 1,000. In general, we assume that the marginal utility of stocks falls as investment amount in stocks gets larger. A stock for Rs 1,000 promises a small probability to gain in utility, but a large probability of loss in utility whereas a stock of Rs 100 is inconsequential as the gain in utility from it is not much different as the drop in utility from a loss. [pic] Suppose that an individual is offered with two stock options: — a 50-50 chance of gaining or losing $h Uh(W*) = ? U(W* + h) + ? U(W* – h) — a 50-50 chance of winning or losing $2h U2h(W*) = ? U(W* + 2h) + ? U(W* – 2h) [pic] The person will prefer current stock to the stock associated with a fair gamble. The person will also prefer a small gamble over a large one. Utility Analysis Assume that there are two contingent stocks – Stock in good times (Wg) and Stock in bad times (Wb) – Individual believes the probability that good times will occur is ( The expected utility associated with these two contingent goods is V(Wg,Wb) = (U(Wg) + (1 – ()U(Wb).
This is the value that the individual wants to maximize given his initial investment W. Assume that the person can buy Rs 1 of wealth in good times for pg and Rs 1 of wealth in bad times for pb His budget constraint is W = pgWg + pbWb pg = ( and pb = (1- (), The price ratio pg /pb shows how this person can trade rupees of wealth in good times for rupees in bad times. If markets for contingent stock claims are well-developed and there is general agreement about (, prices for these stocks will be actually fair.
If contingent stock markets are fair, a utility-maximizing individual will opt for a situation in which Wg = Wb . The person will arrange matters so that the wealth obtained is the same irrespective of what state occurs. [pic] [pic] Hence in uncertain situations, if individuals obey the von Neumann-Morgenstern axioms, they will make choices in a way that maximizes expected utility. Risk-averse people exhibit a diminishing marginal utility of wealth. Decisions under uncertainty can be analyzed in a choice-theoretic framework by using the state-preference approach among contingent commodities.
If preferences are state independent and prices are actuarially fair, individuals will prefer allocations along the ‘certainty line’ and will receive the same level of wealth regardless of which state occurs. Stock Market Risks at different levels: • SMALL-CAP STOCKS: Being small enterprises, growth spurts dramatically affect their values and revenues, sending prices soaring. On the other hand, the stocks of these companies tend to be volatile and may decline dramatically. • MID-CAP STOCKS: They offer you the twin advantages of acquiring stocks with good growth potential as well as the stability of a larger company.
These stocks tend to grow well over the long term. • LARGE-CAP STOCKS: Investors, however gain the advantages of reaping relatively higher dividends compared to small- and mid-cap stocks while also ensuring the long-term preservation of their capital. Simplistic methods to Mitigate Risk: • Diversification: Proper investments in different segments ensures compensatory measures • Weathering Market Fluctuations: Sticking to ones choices in times of downturns • Value At Risk (VaR): Statistical methods used to understand risk involved in investments Mutual Funds: Aggressive on small cap stocks, and investing in bulk and bundles Types of Different Risks in Stock Market: a) Financial risk: Amount of risk present with any type of financial investment b) Liquidity risk: Ability to trade large quantities quickly at low cost without moving price c) Regulatory risk: Change in laws and regulation impacts security, stock and sector as well as capital market d) Market risk: Risk due to losses in positions arising from movements in market prices. Some market risks include: o Equity risk o Interest rate risk Currency risk o Commodity risk e) Exchange Rate risk: Risk due to potential change in the exchange rate of one currency in relation to another. • Transaction Exposure: A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. • Economic Exposure: A firm has economic exposure (also known as operating exposure) to the degree that its market value is influenced by unexpected exchange rate fluctuations. Translation Exposure: A firm’s translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to domestic currency. • Contingent Exposure: A firm has contingent exposure when bidding for foreign projects or negotiating other contracts or foreign direct investments. ) Political risk: Political risk is a type of risk faced by investors, corporations, and governments. can be defined as “the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket factors as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and developmental), or events related to political instability (terrorism, riots, coups, civil war, and insurrection). Portfolio investors may face similar financial losses.
Moreover, governments may face complications in their ability to execute diplomatic, military or other initiatives as a result of political risk. g) Interest Rate risk: Risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond’s duration. Asset liability management is the complete set of techniques used to manage such risks. h) Personal risk : Risk from investor’s perspective [pic] ———————– [pic] [pic] [pic] [pic]