Capital Market is the market that facilitate buying and selling of securities such as stocks / shares and bonds or debentures. It is a place where business enterprises and governments raise their long term funds. The two major functions of capital market are liquidity and pricing securities. Capital Market consists of EQUITY MARKETS or STOCK MARKET, which provide financing through the issuance of shares, and enable the subsequent trading thereof and DEBT MARKETS or BOND MARKET, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. The main difference between the two markets is the amount of risk and the return involved with stock and shares. Equity or stock market is governed by high risk and return, while debt market is a bit secured than the equity market. There are two types of capital market i.e. Primary market and Secondary market. Primary market: It is that market in which shares, debentures and other securities are sold for the first time for collecting long-term capital. This market is concerned with new issues. Therefore, the primary market is also called NEW ISSUE MARKET. In this market, the flow of funds is from savers to borrowers (industries), hence, it helps directly in the capital formation of the country. The money collected from this market is generally used by the companies to modernize the plant, machinery and buildings, for extending business, and for setting up new business unit. Secondary Market: The secondary market is that market in which the buying and selling of the previously issued securities is done. The transactions of the secondary market are generally done through the medium of stock exchange. The chief purpose of the secondary market is to create liquidity in securities.
A primary market follows a particular trend, i.e. bull market and bear market. In bull market an investors buy in order to increase capital gains in the future whereas in a bear market an investors anticipate losses thus they are obliged to sell. When the Gross Domestic product and stock prices GDP Price fluctuation is an important tendency of an open market. Secondary market is affected by the change in primary market trend.
Shares or stock are basically the certificate of ownership of the company. These are the one which are traded in the market. There are two types of stock i.e. common stock and preferred stock. Both these stock represent a partial ownership interest in the firm. Preferred stock has certain priority over the common stock they are generally paid fixed dividends. When a company becomes bankrupt they have an advantage of getting paid. Preferred shares do not have nay maturity date thus, they have more interest rate risk than bonds. The stock market is basically the trading groundA capital market investmentA in the Company’s stocks, Derivatives, and other securities. The trading in stock market is either done physically i.e. through the open outcry or through online transactions. An investor can invest i.e. buy or sell any stock as per his choice.
The analysis of stock is done by considering the fundamental factors i.e. macroeconomics information, industry news and firm’s financial statements. Stocks are analysed through two different methods of analysis i.e. Fundamental Analysis and Technical Analysis. Fundamental Analysis: This analysis includes the economic, Industry and company analysis of the stock. Economic Analysis: It is generally noted that the stock’s performance depends on the market influence that affects all stock indexes such as Dow Jones industrial average and S&P 500 stock indexes. While analysing the stock prices the analyst must consider the economic conditions of the market or country. The investor should decide the time when he can invest in stock as per the economic conditions of the nation. The analyst must consider the systematic risk before investing in the stock as the prices of market are highly influenced by the economic conditions. It is important for an analyst to forecast the short tem as well as the long term economic conditions before making the investment decision. Short term forecast refers to four to five years ahead whereas long term investment refers to more than five years of the forecasting. The Indexes of Economic Indicators: The economic indicators are classified on the basis of cyclic timings i.e. leading, roughly coincident or lagging. The leading indicators are those time series of data that historically research their high points and low points in advance of total economic activity. Roughly coincident indicators reach their peaks at approximately same time as the economy and lagging indicators reached their turning point when economy has already turned in. To consider the economic factors we should also look into the GDP, disposal income, demographic factors and demand as these also affect the stock process. Industry Analysis: The stocks of different industries react differently to the market condition. Cyclic stocks are more likely to get recovered than the defensive stock. Cyclic stocks are tied up closely with the economic condition. For Industry analysis one should use the competitive strategy analysis. The key characteristics in an Industry Analysis is done by analysing past sales and past earnings performance of the industry, permanence, attitude of government towards the industry, labour conditions, competitive conditions, Industry life cycle. These are the several factors used for industry analysis. There are quite a lot of external sources of information for industry analysis such as Federal government, Investment services which includes the data in respect to Standards and Poor’s; the value line, Forbes, trade publications, funk and Scott index. Company Analysis: For the analysis of the stock prices of a company, it is very important to do study about the company. One need to know the performance of the company from last few years, financial analysis of last few years performance, growth rates of the company for last several years. The investor has to analyse the price to book ratio, return on assets and return on equity. The analysts tried to compute and analyse the financial health of the company by the above factors which will help in analysing the stock and value of the company. The analyst should also analyse and forecast the earnings of the company will helps in analysing the return of the stock. The regression and correlation analysis is also done in forecasting. To analyse the performance of the company trend analysis is used which utilizes regression analysis.
Technical analysis looks for the recurring patterns of the stock prices and its movement so that the price of the stock can be analysed. The technical analysis is done through wide range of graphs. The graphs used for technical analysis are as under: Line graphs; Bar graphs; Candlestick graphs; Point and figure charts; Market profiles; Moving averages; “Oscillators”, such as relative strength indicators, stochastics, and moving average convergence and divergence indicators.
To analyse the stock movements, technicians rely on charts or graphs of price movements and on relative strength analysis. According to the technicians, the prices of stock follow a trend and the prices of the stock are analysed can be recognized by the same. The prices of stock generally depend on the forces of supply and demand which helps the technicians to predict the likely direction of future movements. The stock is analysed through its trendline, which shows the way in which the stock is moving. If demand is increasing more rapidly than supply and the stock shows successively higher low points, it is in an uptrend whereas lower highs indicate that supply is increasing more rapidly, and the stock is in a downtrend. An investor buys a stock when the stock follows an upward trend.
Line charts are the simplest form of chart. It consists of the line connecting series of points which indicate the prices of the shares. It can be drawn on linear as well as logarithm scale. Logarithm scales are used when the price use through wide ranges.
This chart is used to present the economic data. This chart depicts the periodic low and high and closing prices of the stock or security. There is a vertical line which connects the period’s high and low prices, with a cross mark indicating the price at the close of the period. This chart is useful in analysing the daily trading of a particular stock.
This chart helps in depicting the increase and decrease in price of the stock. ‘X’ represents the prices increase and the ‘O’ represents the price decline. Xs and Os are never shown in the same column. As soon as there is a reversal in the price of the stock the analysts moves to the next column for a new entry.
This chart shows a stock’s open, close, high and low in a modified three dimensional format. Horizontal axis depicts the passage of time whereas vertical axis shows the stock price. The white candles in the chart depict stock advances, with black candle representing declines. The thick portion of an entry is called the real body and the vertical line represents the wick.
The stock market keeps fluctuating. The price movements of the stock are random and it required lot of study and analysis to study the performance of the stock. They are quite vulnerable to the economic conditions, speculation, press release, rumors and mass panic. The stock market prices may be very volatile due to the occurrences of the fast market changing events.
A bond is a debt capital market instrument issued by a borrower, who is then required to repay to the lender/investor the amount borrowed plus interest, over a specified period of time. Bonds are also known as fixed income instruments, or fixed interest instruments in the sterling markets. Usually bonds are considered to be those debt securities with terms to maturity of over one year. Debt issued with a maturity of less than one year is considered to be money market debt. There are many different types of bonds that can be issued. The most common bond is the conventional (or plain vanilla or bullet) bond. This is a bond paying regular (annual or semi-annual) interest at a fixed rate over a fixed period to maturity or redemption, with the return of principal (the par or nominal value of the bond) on the maturity date. All other bonds will be variations on this. A bond is therefore a financial contract, in effect an IOU from the person or body that has issued the bond. Unlike shares or equity capital, bonds carry no ownership privileges. An investor who has purchased a bond and thereby lent money to an institution will have no voice in the affairs of that institution and no vote at the annual general meeting. The bond remains an interest-bearing obligation of the issuer until it is repaid, which is usually the maturity date of the bond. The issuer can be anyone from a private individual to a sovereign government. Bond investment is different from that of stock investment. Bond investment is investing in the debt instrument that is issued by a company or government. The bond investor is actually lending money to the company while in return is promised to be paid the full principal amount plus a fixed periodic payout. The yield on the bond is calculated by putting together the final principal and total payouts received. The yield is the effective interest rate for the tenure of the bond.
For the analysis of bonds several arithmetical methods are used. The concepts of simple and compound interest, time vale of money, future and present value of bonds or securities are used to analyze the bonds.
The value of money what we invest or receive today is not the same as we get in future. The amount of money will be different as the amount invested will bear a rate of interest. Through the different rate of interests given on a particular security using the time value one can analyse the future of the money invested.
A loan that has one interest payment on maturity is accruing simple interest. On short-term instruments there is usually only the one interest payment on maturity, hence simple interest is received when the instrument expires. FV = PV(1 + r) (2.1) Where, FV is the terminal value or future value PV is the initial investment or present value r is the interest rate.
A loan has different interest amount on maturity. The principle amount is compounded and the interest is applied on the compounded amount. FV = PV (1 + r)n where r is the periodic rate of interest (expressed as a decimal) n is the number of periods for which the sum is invested.
The concept of time value of money is applied to analyze the present and the future value of the bond or any other security. Present value can be calculated when the future value of the amount is given along with the rate of interest or vice versa.
Bonds are always approaching in maturity, and because some are redeemed early, the set of bonds in a basket changes more frequently than the shares in an equity index. Considering a hypothetical international “ten-year benchmark index”, as a bond falls to less than say eight years maturity, it may be replaced by the current ten-year benchmark bond. This will have different risk characteristics to the bond it replaced and will trade differently in the market as a result. As the constituents of a bond index have to change more frequently, we may not always be comparing like-for-like when we consider historical index values. There is also the issue of bond coupon payments, which make up a significant proportion of a bond’s overall return, and which must therefore be incorporated in the index valuation. Nevertheless bond indices are important for the same reason that equity indices are, and form the benchmark against which fund managers’ performance is measured.
Price of a bond is equal to the present value of its cash flows. A vanilla bond’s cash flows are the interest payments or coupons that are paid during the life of the bond, together with the final redemption payment. It is possible to determine the cash flows with certainty only for conventional bonds of a fixed maturity. So for example, we do not know with certainty what the cash flow are for bonds that have embedded options and can be redeemed early. The coupon payments for conventional bonds are made annually, semi-annually or quarterly. Some bonds pay monthly interest. Therefore a conventional bond of fixed redemption date is made up of an annuity (its coupon payments) and the maturity payment. If the coupon is paid semi-annually, this means exactly half the coupon is paid as interest every six months. The interest rate that is used to discount a bond’s cash flows (therefore called the discount rate) is the rate required by the bondholder. It is therefore known as the bond’s yield. The yield on the bond will be determined by the market and is the price demanded by investors for buying it, which is why it is sometimes called the bond’s return. The required yield for any bond will depend on a number of political and economic factors, including what yield is being earned by other bonds of the same class. Yield is always quoted as an annualised interest rate, so that for a semi annually paying bond exactly half of the annual rate is used to discount the cash flows. The fair price of a bond is the present value of all its cash flows. Therefore when pricing a bond we need to calculate the present value of all the coupon interest payments and the present value of the redemption payment, and sum these. In most markets bonds are generally traded on the basis of their prices but because of the complicated patterns of cash flows that different bonds can have, they are generally compared in terms of their yields. This means that a market-maker will usually quote a two-way price at which she will buy or sell a particular bond, but it is the yield at which the bond is trading that is important to the market-maker’s customer. This is because a bond’s price does not actually tell us anything useful about what we are getting. Remember that in any market there will be a number of bonds with different issuers, coupons and terms to maturity. Even in a homogeneous market such as the gilt market, different gilts will trade according to their own specific characteristics. To compare bonds in the market therefore we need the yield on any bond and it is yields that we compare, not prices. A fund manager quoted a price at which she can buy a bond will be instantly aware of what yield that price represents, and whether this yield represents fair value. So it is the yield represented by the price that is the important figure for bond traders. For analysing the yield one need to calculate the current yield, simple yield to maturity, yield to maturity.
Plain vanilla bonds the coupon is fixed, therefore it is the price of the bond that will need to fluctuate to reflect changes in market yields. It is useful sometimes to plot the relationship between yield and price for a bond. A typical price/yield profile is a convex curve. To reiterate, for a plain vanilla bond with a fixed coupon, the price is the only variable that can change to reflect changes in the market environment. When the coupon rate of a bond is equal to the market rate, the bond price will be par (100). If the required interest rate in the market moves above a bond’s coupon rate at any point in time, the price of the bond will adjust downward in order for the bondholder to realise the additional return required. Similarly if the required yield moves below the coupon rate, the price will move up to equate the yield on the bond to the market rate. As a bond will redeem at par, the capital appreciation realised on maturity acts as compensation when the coupon rate is lower than the market yield.
The most commonly occurring yield curve is the yield to maturity yield curve. The curve itself is constructed by plotting the yield to maturity against the term to maturity for a group of bonds of the same class. Bonds used in constructing the curve will only rarely have an exact number of whole years to redemption; however it is often common to see yields plotted against whole years on the x-axis. This is because once a bond is designated the benchmark for that term, its yield is taken to be the representative yield. The yield to maturity yield curve is the most commonly observed curve simply because yield to maturity is the most frequent measure of return used. Since market rates will fluctuate over time, it will not be possible to achieve this (a feature known as reinvestment risk). Only zero-coupon bondholders avoid reinvestment risk as no coupon is paid during the life of a zero-coupon bond. The yield to maturity yield curve does not distinguish between different payment patterns that may result from bonds with different coupons, that is, the fact that low-coupon bonds pay a higher portion of their cash flows at a later date than high-coupon bonds of the same maturity. The curve also assumes an even cash flow pattern for all bonds. Therefore in this case cash flows are not discounted at the appropriate rate for the bonds in the group being used to construct the curve. To get around this bond analysts may sometimes construct a coupon yield curve, which plots yield to maturity against term to maturity for a group of bonds with the same coupon. This may be useful when a group of bonds contains some with very high coupons; high coupon bonds often trade “cheap to the curve”, that is they have higher yields, than corresponding bonds of same maturity but lower coupon. This is usually because of reinvestment risk and, in some markets (including the UK), for tax reasons.
The coupon yield curve is a plot of the yield to maturity against term to maturity for a group of bonds with the same coupon. If we were to construct such a curve we would see that in general high-coupon bonds trade at a discount (have higher yields) relative to low-coupon bonds, because of reinvestment risk and for tax reasons. It is frequently the case that yields vary considerably with coupon for the same term to maturity, and with term to maturity for different coupons. Put another way, usually we observe different coupon curves not only at different levels but also with different shapes. Distortions arise in the yield to maturity curve if no allowance is made for coupon differences. For this reason bond analysts frequently draw a line of “best fit” through a plot of redemption yields, because the coupon effect in a group of bonds will produce a curve with humps and troughs. The figure below shows a hypothetical set of coupon yield curves, however since in any group of bonds it is unusual to observe bonds with the same coupon along the entire term structure this type of curve is relatively rare.
The par yield curve is not usually encountered in secondary market trading, however it is often constructed for use by corporate financiers and others in the new issues or primary market. The par yield curve plots yield to maturity against term to maturity for current bonds trading at par. The par yield is therefore equal to the coupon rate for bonds priced at par or near to par, as the yield to maturity for bonds priced exactly at par is equal to the coupon rate. Those involved in the primary market will use a par yield curve to determine the required coupon for a new bond that is to be issued at par. This is because investors prefer not to pay over par for a new-issue bond, so the bond requires a coupon that will result in a price at or slightly below par. The par yield curve can be derived directly from bond yields when bonds are trading at or near par. If bonds in the market are trading substantially away from par then the resulting curve will be distorted. It is then necessary to derive it by iteration from the spot yield curve. As we would observe at almost any time, it is rare to encounter bonds trading at par for any particular maturity. The market therefore uses actual non-par vanilla bond yield curves to derive zero-coupon yield curves and then constructs hypothetical par yields that would be observed were there any par bonds being traded.
Capital market risk in the bond market arises due to interest rate changes. There is an inverse relationship existing between the interest rate and the price of the bond. Hence the bond prices are sensitive to the monetary policy of the country as well as economic changes.
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