What is stocks Simple Definition – equity and derivatives markets?

Last updated on May 2, 2023

What are Stocks? A stock is an instrument that is issued by a company to raise funds from the general public to meet the company’s capital requirement. It represents a part of ownership transferred by the company to the stockholder and hence is referred to as the smallest unit of the company’s overall net worth. The stockholder has the right to the company’s earnings if the company makes a profit. This part of the profit is paid to the stockholder in the form of a dividend.

A stockholders’ stake in the company and the amount of dividend to which a stockholder is eligible depends upon the number of stocks held them. This can be explained with the help of an example. Suppose a company has 1,00,000 stocks in circulation, and an individual holds 10,000 stocks, then it can be said that he holds a 10% stake in the company’s ownership.

Types of stocks in the Indian Market

Broadly, the stocks are divided into two categories

1. Equity Stocks
2. Preference stocks

1. Equity Stocks: Equity stocks are also called ordinary stocks in general. Equity stocks act as the main source of funds for the companies. The buying and selling of equity stocks take place through stock exchanges like BSE and NSE in India. Stockholders holding the equity stocks in a company have the voting right and are also entitled to receive the dividend amount. The amount of dividend to be paid to the equity stockholders is decided by the company’s board of directors. The amount of dividend paid to the equity stockholders is dependent on the company’s profit. Hence, the amount paid to these stockholders varies from year to year and is not fixed.

Companies issued equity stocks at different face values. The amount of dividend due to equity stockholders is paid after paying the amount of dividend to preference stockholders. Equity stockholders are the true owners of the company as they are at the highest risk.

In the event of winding up of the company, it is the equity stockholders that are paid in the end after the claims of creditors, debenture holders, and preference stockholders are cleared. Since they are the stocks with high risk, the returns generated on equity stocks are also high.

Equity stocks are of different types like right stocks, sweat equity stocks, bonus stocks, to name a few.

1. Preference Stocks: As the name suggests, preference stocks are the stocks that come with preferential rights. This means that preference stocks are preferred over equity stocks at the time of payment of dividend during the company’s lifetime and also at the time of repayment of the capital amount at the time of winding up.

The percentage of dividend paid to preference stockholders is fixed and is paid before the payment of dividend to any other class of stockholders.

Preference stocks are essential for hybrid financing in a company as they have features of both equity stocks and debentures.

Though preference stocks are a long-term source of financing for the company, preference stockholders do not enjoy the voting right in the annual general meetings of the company.

The dividend amount paid to preferred stockholders is more than the amount paid to debenture holders and has a fixed rate of dividend irrespective of the volume of the profit gained by the company. The dividend earned on preference stocks is not eligible for tax deduction.

There are various types of preference stocks:

1. Cumulative Preference Stocks: Cumulative Preference stocks are the ones that enjoy the right of earning dividend even in the years when the company fails to make any profit. In case the company, owing to the losses, fails to pay the amount of dividend, then it is carried forward to the following year. In this case, it is treated as an arrear by the company. Such amount of accumulated arrear, which is to be paid as a dividend by the company, is paid before the amount paid to equity stockholders and is called cumulative preference stocks.
2. Non-Cumulative Preference Stock: These stocks do not accumulate any dividend. In the case of non-cumulative preference stocks, if the company fails to pay the dividend, then these stockholders have the right to avail dividend from the profits of the company for that particular year. Dividends to these stockholders are paid only from the net profits earned by a company in that year. In case the company fails to earn any profit in a year, then these stockholders do not have the right to claim dividend in the subsequent years.
3. Participating Preference Stocks: Stockholders holding the participating preference stocks have the right to participate in the surplus profits earned by the company during the liquidation of the company. They receive a stipulated rate of dividend and are also entitled to stock any additional earnings of the company along with the equity stockholders.
4. Non-Participating Preference Stocks: These stockholders do not have the right of participating in the surplus profits or surplus earnings of the company at the time of its liquidation. They receive only a stated amount as dividend and nothing else.
5. Convertible Preference Stocks: These are the type of preference stocks that can be converted to equity stocks at a specified rate at the time of the expiry of a specified period. It is only possible to convert a preference stock to an equity stock within a specific time period.
6. Non-Convertible Preference Stocks: These stocks cannot be converted to equity stocks and hence are referred to as non-convertible preference stocks. However, these stocks can be redeemed.
7. Redeemable Preference Stocks: Redeemable preference stocks are the ones that can be redeemed by the stockholder or repaid after a specific period of time or prior to that.
8. Non-Redeemable Preference Stocks: These stocks cannot be redeemed during the lifetime of the company and hence are called as non-redeemable preference stocks.

What are derivatives?

Derivatives are financial instruments that derive their value from one or more underlying assets. These assets can either be commodities, precious metals, bonds, currency, stock indices, and so on. The value of these underlying assets keeps on changing depending on the market conditions.

The prime objective behind investors entering the derivatives market is to earn profit through speculations. They speculate the value of the underlying assets in the future to make profits from their derivative investments.

Types of Derivatives Contracts

The derivative contracts are classified into four broad categories:

1. Futures
2. Options
3. Forwards
4. Swaps

 Futures: A futures contract is a standardized contract that is listed on the stock exchange. It allows the holder to buy or sell the asset at an agreed price at a specific date. Both parties involved in the contract are under an obligation to perform the contract on the specified date. The terms of the futures contract cannot be modified, and the risk, therefore, is limited for both the parties. If the parties wish to further minimize the risk, they are required to maintain the daily margin requirements all the time. Since the futures contracts are traded on the stock exchange, they are required to follow a daily settlement process. This means that any profit or loss arising on a contract on a particular day is settled on that particular day itself.

1. Options: Options are one of the most important and popular derivatives contract among investors. Options are derivative instruments that give the investors, i.e., both the parties involved in the contract, the right to buy and sell the underlying asset at their discretion. There is no compulsion or obligation on the parties to buy or sell the assets in an options contract. Options are and can be traded in the exchange-traded markets and over-the-counter-markets. The party that enjoys the privilege of buying or selling the options contract is bound to pay a premium or privilege amount to the other party. There are two types of an options contract: the call option and the put option.

Call Option is the one that gives the right but not the compulsion to the other party to purchase something on a future date. The future date in this case is pre-decided.

Put Option, on the other hand, offers the right and not the obligation to sell something at a pre-decided date.

1. Forwards: Forwards are the oldest and the most basic types of derivatives instruments available in the Indian market. A forward contract is an agreement between two parties to buy or sell an asset in the future at a price which is decided in the present. These contracts are not traded on a stock exchange and are an agreement between two private parties. It is a customized contract that takes place between two parties. Since the contract is done without the involvement of the exchange, the chances of risk and defaults are high in case of forward contracts. The terms and conditions too of a forward contract vary from one contract to another and are not standardized. Forward contracts are traded over the counter as there is no involvement of an exchange in these contracts. The assets that are commonly traded as a forward contract include commodities like grains, oils, pulses, natural gas, electricity, and precious metal, to name a few. Global currencies and financial instruments also form a part of forward contracts.
2. Swaps: Swaps are the most complex derivative instruments being traded in the Indian derivatives market. Swaps allow both the parties to exchange their streams of cash flows which are what is suggested by the name of the instrument itself. ‘Interest Rate Swaps’ and ‘Currency Swaps’ are the most common types of swaps. One of the most common practices is to exchange fixed rate of interest for a floating rate of interest. Swaps are derivative instruments that are not traded between retail investors but are rather traded between financial institutions. These instruments are exposed to a higher extent of exchange rate risk.

Reasons why investors enter derivatives market?

Apart from making profits, these are the following reasons why investors enter the derivatives market:

• It offers arbitrage advantage. Arbitrage is the process of buying at a low price in one market and selling at a higher price in the other market. The investors here earn the benefit from the difference in the prices of the commodities in both the markets.
• By involving in the derivatives market, investors get the benefit of shielding their investments against the reduction in the price of the stocks.
• Some investors use investments in the derivatives market as a tool for transferring their risk. The other uses of the derivatives market includes speculations and profit making. The investors are likely to take the advantage of the price fluctuations without selling the underlying stock.

Who participates in the derivatives market?

• Hedgers are the first category that investors in the derivatives market. They are the risk-averse traders who wish to secure their investment portfolio against market risks and price movements taking place in the market. By hedging, they transfer the risk to the other party who is willing to take the risk and in return are required to pay a premium to the risk takes.
• The next category of participants entering the derivatives market is of the speculators. These are the people who are risk takers and are ready to take the risk in order to earn profits from their investments. They are completely opposite to the hedgers who are risk-averse. This difference between the hedgers and the speculators help both the parties in making the required profit.
• Margin traders are the next category of participants entering the derivatives market. The margin requirement helps the traders in maintaining a large outstanding position.
• Arbitrageurs are the last category of participants in the derivatives market. They take the benefit of low-risk market imperfections to earn profits. They buy low priced securities in one market and sell them at a higher price in the other market, thereby earning profit from price differences.