What do we typically associate with the word ‘finance’? Nattily dressed men and women strutting around mouthing financial jargons. Complex products and institutions that are hard to understand. However, at its core, finance is fairly simple to understand.
There are two categories of economic entities—Surplus Budget Units (SBUs) and Deficit Budget Units (DBUs). The former have more than they want while the latter want more than they have. The financial industry enables the channelisation of surplus resources from the former to the latter. In return for the investment, DBUs issue securities. There are two broad categories of securities— equity and debt. An equity share is issued when the investor takeS an ownership stake in the DBU. On the other hand, a debt security represents a loan from an SBU. In return he will get periodic interest. While equity securities are perpetual, most debt securities have a prescribed maturity date, although perpetual debt issues also exist.
Platform for securities
These securities need a platform to be traded, because the original investor may not want to hold them forever. Such a trading arena is a stock exchange. Today’s exchanges like the BSE and the NSE are sophisticated electronic systems that facilitate security trading. In addition, we also have Over-the-Counter (OTC) markets. This is a market made by security dealers and brokers and is an alternative to the exchange traded mechanism. Bonds, unlike stocks, are primarily traded in an OTC environment.
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The government sets up a market regulator which will specify guidelines and norms to be followed by potential issuers. Since the issuer typically has little knowledge of such requirements, he needs professional guidance. This is where an investment banker comes in. He would be abreast of all issue related rules and guidelines. Also when an issue is made, a potential investor needs some reassurance about the quality of the issue while the issuer needs assurance that the issue will bring in the desired capital even if the market response were to be lukewarm.
Investment bankers as underwriters
Consequently, investment bankers also act as underwriters. They provide an assurance that they will take up whatever is unsubscribed. Since the underwriter has done the due diligence, a potential investor is reassured. And since the investment banker stands ready to buy in the event of undersubscription, the issuer gets a guarantee.
When the issues come into existence, they come with certain inherent risks. The first is price risk or market risk, or the chance that securities prices may move in an adverse direction from the standpoint of the investor. The second is credit risk or default risk which represents the risk that the issuer of the security may be unable to repay the investor. Since debt securities get priority over equities, they are less exposed to credit risk.
Post issue, investors need a deep playing field to buy and sell securities. Liquidity risk is the risk that markets may be illiquid or thin, and buyers and sellers may face difficulty in locating a suitable counterparty. Finally, all investors may not be domestic. Foreign investors are also exposed to currency risk. If the rupee were to depreciate, foreign entities would be able to repatriate smaller amounts in terms of the dollar or the euro.
The author, Sunil K Parameswaran, is visiting faculty at various business schools including IIMs.