STUDENT MENTORSHIP PROGRAM (MODULE 5-
FINANCE)
Module 1: Fundamentals of finance
By the end of this reading, you will understand
What the field of Financial is?
How Financial Markets work?
What different financial products are?
What is Finance?
Finance is the study of how and under what terms money are allocated between lenders
and borrowers.
The term finance may incorporate any of the following:
o The study of money and other assets
o The management and control of those assets
o Profiling and managing project risks
Finance is distinct from economics in that it addresses not only how resources
are allocated but also under what terms and through what channels
Finance is based on economic principles
The field of finance deals with the concepts of time, money, risk and how they
are interrelated. It also deals with how money is spent and budgeted
Behavioural Finance studies how the psychology of investors or managers
affects financial decisions and markets.
Financial System
The financial system consists of institutions that help to match one person’s
saving with another person’s investment.
It moves the economy’s scarce resources from savers to borrowers.
The financial system is made up of institutions(Markets and Intermediaries)
The household is the primary provider of funds to businesses and government.
Households must accumulate financial resources throughout their working life times to
have enough savings (pension) to live on in their retirement years
Financial intermediaries transform the nature of the securities they issue and
invest in Banks, trust companies, credit unions, insurance firms, mutual funds
Market intermediaries simply help make markets work
Investment dealers
Brokers
(Investment Advisors)
Financial Markets
Capital markets which consist of:
o Stock markets, which provide financing through the issuance of shares
or common stock, and enable the subsequent trading thereof.
o Bond markets, which provide financing through the issuance of bonds,
and enable the subsequent trading thereof.
Commodity markets, which facilitate the trading of commodities.
Money markets, which provide short term debt financing and investment.
Derivatives markets, which provide instruments for the management of
financial risk.
Futures markets, which provide standardized forward contracts for trading
products at some future date; see also forward market.
Insurance markets, which facilitate the redistribution of various risks.
Foreign exchange markets, which facilitate the trading of foreign exchange.
Financial Markets
1. Primary Markets: The 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. Primary markets creates long term instruments through which corporate
entities borrow from capital market.
Methods of issuing securities in the primary market are:
o Initial public offering
o Follow-on Public Offer (for existing companies)
o Rights issue (for existing companies)
o Preferential issue
2. Secondary Markets: The secondary market, also called aftermarket, is the
financial market where previously issued securities and financial instruments
such as stock, bonds, options, and futures are bought and sold. Ex: Stock
Exchanges, OTC Markets.
The stock exchanges, under the supervision of the regulatory authority, like
SEC/SEBI, provide a trading platform, where buyers and sellers can meet to
transact in securities.
Initial Public Offering
An initial public offering, or IPO, is the first sale of a corporation’s common
shares to investors on a public stock exchange.
The main purpose of an IPO is to raise capital for the corporation. It also gives
the company more exposure, prestige and public image
In an IPO the issuer obtains the assistance of an underwriting firm, which
helps determine what type of security to issue (common or preferred), best
offering price and time to bring it to market.
Underwriting is an agreement, entered into by a company with a financial
agency, in order to ensure that the public will subscribe for the entire issue of
shares or debentures made by the company. The financial agency is known as
the underwriter and it agrees to buy that part of the company issues which are
not subscribed to by the public in consideration of a specified underwriting
commission.
Book Runner is the primary underwriter
Bonds
A bond is a certificate of indebtedness that specifies obligations of the borrower
to the holder of the bond. It is an IOU between the Issuer and the investors.
Bond Terminology:
o Issuer of Bonds: Borrower
o Bond Holder: Lender
o Par Value: Amount which issuer pays interest on and which is repaid on
maturity date
o Issue Price: Price at which bonds are offered to investors
o Maturity Date: Length of time (More than one year)
o Coupon: Rate of interest paid by the issuer on the par/face value of the
bond
o Coupon Date: The date on which interest is paid to investors
Yield: The interest rate which can be earned on an investment, currently quoted
by the market or implied by the current market price for the investment.
Yield to maturity: The internal rate of return of a bond. The yield necessary to
discount all the bond’s cash flows to an NPV equal to its current price.
Types of Bonds (based on coupon payments):
o Fixed rate bonds: Pay fixed coupon (does not change with market
conditions)
o Floating rate bonds: Pay floating Coupon (changes with market
conditions)
o Zero-coupon bonds: Do not pay any coupon at all during the life
o Inflation linked bonds: Principal amount and interest payments –
indexed to inflation.
Types of Bonds (based on credit risk):
o Investment Grade: have low probability of default, hence low yield
o Speculative: have high probability of default, hence high yield
Types of Bonds (based on issuer):
Government Securities: Issued by Governments
o Bills – debt securities maturing in less than one year.
o Notes – debt securities maturing in one to 10 years.
o Bonds – debt securities maturing in more than 10 years.
Corporate Bonds: Issued by Corporates
Stocks
A stock is a tradable security that a firm issues to certify that the stockholder
owns a share of the firm.
A stock market or equity market is an entity for the trading of company stock
(shares) and derivatives at an agreed price; these are securities listed on a stock
exchange as well as those only traded privately.
Stocks are ownership in a company and are made up of shares. Each share is a
portion of the company „
A company has a finite number of shares. As a company’s value changes, so
does the value of it’s shares
The sale of stock to raise money is called equity financing.
Compared to bonds, stocks offer both higher risk and potentially higher returns.
How is Money Made by investors?
o Trading – Buy low, sell high!
o Dividends – Sharing profits
1. Common Stock: Common shares represent ownership in a company
and a claim (dividends) on a portion of profits. Investors get one vote per
share to elect the board members, who oversee the major decisions made by
management.
2. Preferred Stock: Represents some degree of ownership in a company but
usually doesn’t come with the same voting rights. With preferred shares,
investors are usually guaranteed a fixed dividend forever.
A bull market is when everything in the economy is great, people are
finding jobs, gross domestic product (GDP) is growing, and stocks are
rising. If a person is optimistic and believes that stocks will go up, he/she is
called a ‘bull’ and is said to have ‘bullish outlook’
A bear market is when the economy is bad, recession is looming and stock
prices are falling. If a person is pessimistic, believing that stocks are going
to drop, he/she is called a ‘bear’ and said to have a ‘bearish outlook’.
Derivative Markets
A financial contract of pre-determined duration, whose value is derived from the value
of an underlying asset. The underlying assets can be Securities, Commodities,
Bullion, Precious metals, Currency, Livestock, Index such as interest rates,
exchange rates.
Derivatives attempt either to
(i) Minimize the loss arising from adverse price movements of the
underlying asset (hedging)
(ii) Maximize the profits arising out of favorable price fluctuation
(speculating).
(iii) Price discovery (arbitraging)
Since they derive their value from the underlying asset, hence they are called
derivatives.
Based on the underlying assets derivatives are classified into.
o Financial Derivatives – Underlying: Financial Asset – Ex: Stocks
o Commodity Derivatives – Underlying: Commodity – Ex: Gold
o Index Derivative – Underlying: Index/Reference Rate – Ex: BSE Sensex
Forward contracts: A one to one bipartite contract, which is to be performed in
future at the terms decided today. Eg: A and B enter into a contract to trade in one
stock on Infosys 3 months from today the date of the contract @ a price of Rs 3500/–.
Product, Price, Quantity & Time have been determined in advance by both the parties.
Futures: Future contracts are organized/standardized contracts in terms of quantity,
quality, delivery time and place for settlement on any date in future. These
contracts are traded on exchanges.
Options: An option is a contract giving the buyer the right, but not the obligation, to
