What is a Market Maker

Who and what are the market makers

If you have traded in a standardized security market, you may have noticed that except for a few illiquid securities, your orders are executed pretty fast. There is almost always a bid or ask price available. You just have to type in an order and your order is matched with an opposite order almost immediately. 

Market makers play a major role in ensuring the liquidity of securities and smoother transactions.

 Please do no get confused with security exchanges and market makers. Security exchanges are exactly what their name suggests. They ensure a platform or a place where the securities can be exchanged. These days most of the securities are in the de materialized form. The exchanges ensure, the various transactions of all the securities registered with it or are open to trade in it.

So what are Market makers. Market Makers are also essentially participants in the security exchanges, just like investors and traders of securities. A market maker is a broker or a dealer firm which assumes the risk of holding a certain amount of a security, in order to smoothly expedite the trading in that security. Essentially they build up a large inventory of a security, so that when the buyers and sellers comes calling for that particular security, it is is available for easy trading. They buy up all the securities that the sellers have and re sells it to all the incoming buyers and vice versa. They display bid and ask quotations for the securities they hold, for a guaranteed number of securities. 

Suppose a seller puts up a security for sale, the market maker buys it up immediately and seeks an opposite order. If a buyer puts an order, they immediately sell the security to the buyer. There is almost always an inventory with the market maker for all the securities traded in an exchange. If the market maker does not have the essential inventory of a security, either due to low float or low volume of trades, orders are matched between available buyers and sellers. If the bid and ask price of a buyer and seller is matched, then a trade happens. The market makers competes for customer orders by displaying bid and ask quotes for the securities they deal in.

Since the market makers need to facilitate large amounts of orders, in order to satisfy the supply and demand in the market, they take the opposite side of the trading volume, essentially buying and selling what the traders have put up in the market. In between they maintain a healthy inventory of the securities too. All these helps executing the trades very fast.

Different types of Market Makers

Market makers comes in all shapes and sizes. Most common type are the brokerage firms who offer various solutions for their clients, to facilitate trading in securities. In certain over the counter securities like bespoke forward contracts, there may be individual intermediaries, who act as market makers, but by and large, market makers are established firms.

How do they function and profit

Before we try to understand what the market makers do, let us ponder over what the price of a security or for that matter price of anything in a market means.

Bid, Ask and Last Traded Price

If you have been looking around for purchasing a real estate property, the first thing you would have asked about is the  price. You would inquire about the price at which the last transaction took place, you also would check what is the asking price of the owner, latest bids on the property and would form an opinion on what you would bid. So the price of that property can be the last traded price, the asking price, asking price for similar properties, or  bid price.

For a traded security in an organised exchange, the price displayed, is the last traded price. It is the price at which the security last changed hands. But if you are more keen, you can also find out the bids and asks,the last traded volume, the over all trade volume, the bid and ask volume, open position volume in case of futures and options, and various other price parameters. And then place an order.

Limit Order and Market Order

The limit order and the market order are the two basic orders a trader/ investor can put forward with the intention of buying or selling a security.

If you put a buy or sell order such that you give instruction to buy or sell a security, only for a certain specific price, irrespective of the prevailing  LTP, Bid or Ask price, then its a limit order. If the ask price comes down to your buy limit order, your trade gets executed and you get the security depending on the number of securities available for sale at that price. If the bid price rises up to your sell limit order, your order gets executed and you can sell your security depending on the number of bids available for your security at that price.

If you put a buy or sell order such that you give instruction to buy or sell a security, for the nearest available price, irrespective of the prevailing  LTP, Bid or Ask price, then its a market order. If its a buy market order, the trading system will match your order to the nearest ask price and the trade is executed. The same goes for a sell market order.

Profit for Market Makers

Now let us address the question of how the market makers profits. You know that they display bid and ask quotes for each and every security they deal with. But they keep a spread between the bid and ask price. For example if the Last Traded Price at a point of time for a security is $10. They would put up a bid price of $9.95 and $10.05. The difference of $0.1 is called the spread. when sellers match their order for the bid price of $9.95, the market maker buys the security for $9.95 and almost immediately sells it to the buyers who have put up order for $10.05 and vice versa. They pocket the $0.1 profit. Since they deal in extreme large quantities, they make good profit.

Two common confusions

What happens if a buyer puts up an order for $10 or a seller puts up an order for $10 using a limit order, when the prevailing bid ask is $9.95 and $10.05 respectively?

Normally a market maker do not allow orders in between the bid ask prices., even if it's a limit order. As I mentioned before if the security is illiquid due to low float or trading volume, and the inventory of the market maker gets depleted, sometimes the system allows an in between order, and if an opposite in between order is available, they are matched and the orders are executed.

What happens to the large inventory of a market maker when the market falls sharply, won't they incur a loss?

When the market nosedives sharply,the market makers increases the spread exponentially. This allows them to make up for the losses on their large inventory.

Types of leases Finance Lease, Operating Lease and Sales type lease

A simple table to understand the difference between various types of leases

CAPITAL LEASE

(i) FINANCE LEASE

In a finance lease, a leasing entity (the lessor or the owner) buys the asset for a user ( the lessee or the hirer), rents it to the user for an agreed period. The user pays a rent periodically for the usage of the asset. The payment terms are all according to the lease contract.  A lease is considered to be finance lease if:-

Either

The present value of all future rent payments is more than 90% of the FMV of the asset at date of lease inception                            

 Or

The lease is for more than 75% of the life of the asset

Or

The lease agreement allows the transfer of ownership to the user at the end of the lease term

Or

The lease agreement allows for a bargain purchase of the asset for the user at the end of the lease term.

The basic difference between a finance lease and an operating lease is that the asset is shown in the users balance sheet in a finance lease vis a vis an operating lease where the asset is shown in the owners balance sheet. Mind you, in both types, the owner legally owns the asset. Technically, the owner transfers substantially, the risks and rewards of the ownership to the user in case of the finance lease.

Why is it called a finance lease? The owner expects an interest on the leased value of the asset. The user will pay equated installments of lease payments, which will have a principal component and an interest component. The equated installments will be calculated using a target rate of return agreed  by the owner and the user. Whereas, in an operating lease, the profit for the owner comes from the rent payments and the resale value of the asset.

Now let us see an example

A leasing firm leases a machine to a user for 4 years starting January 1^st of the year. The cost, as well as the transfer price is the same $ 50000. The first lease payment is immediate, on January 1^st itself, with 3 more lease payments expected. The machine has an estimated life of 4 years. The owner expects a 10% return on his lease.

Here the equated lease installment amount is calculated as 50000/present value of annuity due. 10%, 4 periods

=50000/3.487

=$14339

If we multiply 14339 into 4, we get $57356. Therefore the owner makes a profit of $7356 throughout the lease term, which is the interest part.

 The accounting entries are.

Now let's see the amortization table. 

For finding the interest for the year, we use the 10% target rate of the owner. Since the first payment is received early in the year, the interest at the end of the year is (50000-14339) x 10%

So the profit of $7358 for the owner purely consists of the interest on the lease outstanding at his target rate of 10%

(ii)SALES TYPE LEASE

In simple words, a sales lease is only a finance lease, except the owner makes an initial profit over the cost of the asset when the lease starts. In other words, the lease amount is greater than the cost of the asset. It can also be said that the present value of all the future payments will be greater than the cost of the asset.

Let us look at the earlier example:

If the transfer price is set to $60000, that is $10000 more than the cost price of $50000

The accounting entries are

How did we get the figure of $17207 as the lease installment amount? Though the owner recognized a gain of $10000 in the accounting entry, it is a non cash gain. Where does he finally realize the cash of $10000 gain? It is along with the lease installments.

Here the equated lease installment amount is calculated as 60000/present value of annuity due. 10%, 4 periods

=60000/3.487

=$17207

If we multiply 17207 into 4, we get $68830. Therefore, the owner makes a profit of $18830 throughout the lease term, which is the interest part plus the profit of $10000.

 It will be much clearer if we look at the amortization entries.

So the profit of $18830 for the owner purely consists of the interest on the lease outstanding at his target rate of 10% plus the profit of $10000

OPERATING LEASE

In an operating lease, same as the capital lease, a leasing entity (the lessor or the owner) buys the asset for a user (the lessee or the hirer), rents it to the user for an agreed period. The user pays a rent periodically for the usage of the asset. The payment terms are all according to the lease contract. The difference is that:

1.    The lease term is considerably less than the life of the asset so that the asset retains a resale value at the end of the lease term

2.    The owner makes profit from the rent revenue stream. He may re-lease it to different parties at the end of each lease term. He may get good resale value too, once he is done with leasing.

3.    The asset remains in the balance sheet of the owner. The owner has to ensure that the resale value of the asset is not affected by use. The material risks and rewards lies with the owner.

This residual value is forecast at the start of the lease and the owner takes the risk that the asset will achieve this residual value or not when the contract comes to an end.

An operating lease is more typically found where the assets do have a residual value such as aircraft, vehicles and construction plant and machinery.  The customer gets the use of the asset over the agreed contract period in return for rental payments.  These payments do not cover the full cost of the asset as is the case in a finance lease.

Operating leases sometimes include other services built into the agreement, e.g. a vehicle maintenance agreement.

Ownership of the asset remains with the user and the asset will either be returned at the end of the lease, when the leasing company will either re-hire in another contract or sell it to release the residual value.   Or the user can continue to rent the asset at a fair market rent which would be agreed at the time.

Let us consider an example

A leasing company leases a machine for an agreed upon yearly rent of $5000. The cost of the machine for the owner is $12000. The lease period is for 3 years. The agreement starts on Jan 1^st of the year. The rent payment is expected at the beginning of the next year on wards.

Accounting entries are

If the owner had insisted on prepaying the whole rent at the beginning of the year itself

Accounting entries are.

Net interest Margin, Leverage and Capital Adequacy Ratio

Net interest Margin is one of the major parameters used in assessing the performance of a finance company

NIM = Net Interest Income / Asset(i)

= (Interest Income – Interest Expense)/Asset

= (Lending Rate X Asset – Borrowing Rate X Debt)/Asset First Formula

= Lending Rate – (Borrowing Rate X (Debt/Asset)) Second Formula

=Lending Rate -(Borrowing Rate X(Debt/Equity X Equity/Asset)

=Lending Rate -(Borrowing Rate X Leverage X Capital Adequacy Ratio) Expanded Formula

(i)  Please note that Assets here are the loans made by the finance company and not other assets.

How to Value the stock price of a Housing Finance NBFC

The HFCS in India catering only to sub prime housing loans must be valued at and only at the future growth prospects of its earnings, provided they have similar ROE/ ROA and NPA levels compared to their peers

When we value the price of a company's share, in the stock market, the parameters that comes to mind are P/E, P/B. ROE, ROA etc

So how do we value a finance company that primarily deals with housing loans catering to subprime category in India.

The subprime housing loan sector is one of the fastest growing in India. In India, unlike in most developed countries, people usually live in their mortgaged property rather than treating the property a trade commodity. As people do not like to lose their home in which they live, they tend to not to default on their loans. Therefore, the NPA for housing finance companies dealing with sub prime mortgage lending is much lower, when compared to other finance companies.

A typical sub prime mortgage HFC, has an average LTV ( loan to value ) of 70%. Thus the customers are required to put up 30% of the consideration as down payment. This also forces them to treat the loan seriously, unlike what happened in the US sub prime mortgage crisis, where more LTV reached more than 100% at one point.

According to estimates only 15% of the population in India are salaried, 35% non salaried, and rest 50% wage earners. Thus the HFCs which have 50% non salaried customers have a huge untapped market.  This lets them grow their loan book at a rate of more than 20%. Their ROE/ROA is also much higher than other Finance Companies.

Since their earnings also grow rapidly, and have a future predictable growth in earnings, the HFCs are typically values based on their P/E than the P/B multiple.

Normally a finance institution is value based on its P/B ie Price to Book value of Equity. But in case of HFCs, the P?B multiples typically are quite higher.

Why?

Let us examine the ROE

ROE=Earnings/ Book value of Equity

P/E = Price / Earnings

So ROE X PE = Price/ Book value of Equity

So P/B=P/E X ROE

Now we can see that, assuming ROE to be constant, P/B will only depend on P/E which in turn depends on the prospects of future earnings. Since the HFCs PE multiples are valued similar to FMCG companies due to their predictable future earnings growth, PE tends to be very high when compared to other finance companies. 

Another way to value an HFC is Market Cap/ AUM multip

AUM is assets under management

So MCap/ AUM = Price per Assets ( Here other assets are considered insignificant )

= P/A

=P/E X E/A

=P/E X ROA

So again we come to P/E multiple if we consider similar ROA companies.

Cost of goods sold for a manufacturing company

We know that the basic formula for COGS is

 COGS = Cost of Goods Available for sale-Closing Stock 

 Cost of Goods available for sale.= Opening stock + Purchases

The concise formula therefore is

COGS = Opening stock + Purchases - Closing stock.


But this formula is so basic that it can be applied only to a trading company where nothing is manufactured.

Why?

Because manufacturing company has to account for Raw materials consumed, Work in Progress, Manufacturing over heads such as electricity, fuel, salaries and wages,stores and spares consumed.  transport to warehouse, etc. Also the company may purchase and sale stock without manufacturing it.

The formula of COGS for a manufacturing company is

Formula No 1

COGS = (1) Cost of Raw materials consumed 
           + (2) Purchase of Stock in Trade 
           + (3) Opening stock of WIP 
           + (4) Opening stock of finished goods 
           + (5) Opening stock of stock in trade
            - (6) Closing stock of WIP
            - (7) Closing stock of finished goods 
            - (8) Closing stock of stock in trade 
           + (9)  Manufacturing overheads 
           + (10) Cost of Stores and spares ( including packing materials) consumed
           + (11) Stock adjustments due to mergers and acquisitions 
           + (12) Other adjustments.

Formula No 2

COGS       = Cost of stock in trade sold + Cost of finished goods sold + Cost of Stores and spares ( including packing materials) consumed + Other adjustments.



Most of the balance sheet for Indian companies use the first formula, so that they can represent all the cost components of manufacturing separately.

So, if I am able to start from Formula 2 and slowly expand and reach Formula 1, my mission will be complete.

Now for simplicity sake, let us ignore the Cost of stock in trade sold, Cost of stores and spares (including packing materials consumed) and Other adjustments and focus on Cost of finished Goods only, because, majority of the components of Formula No 1, is present in the Cost of finished goods.

Now before we go further, we need to make a primary assumption, a kind of visualisation, of how the  journey of finished goods, from the purchase of raw materials to the final finished state happens.

For this purpose, we need to imagine that the manufacturing process happens in 3 stages in 3 separate areas of the same building as seen in the image below.

THE FINISHED GOODS AREA

In order to fully understand the concept let us begin at the finished goods area.

In the finished goods area, we manufacture the finished goods, stock them and then sell the finished goods according to the demand from the market.

By using the general formula for COGS, and a bit of thinking, we can accept that the Cost of finished goods sold is

Cost of finished goods sold = Opening stock of finished goods + Cost of manufacturing of finished goods -Closing stock of finished goods. (FORMULA A)

What we need to understand is, what all adds up to the cost of manufacturing of the finished goods.

In the finished goods area, we take the necessary WIP stock from WIP area, use necessary equipments, consumables, fuel and labour to convert WIP to finished goods, which then adds to the finished goods stock.

Cost of manufacturing of finished goods = Cost of WIP used + All the manufacturing overheads for converting WIP to finished goods. (FORMULA B)

THE WIP AREA

In order to find the Cost of WIP used, we need to understand what is happening in the WIP area.

In the WIP area, we source raw material from the raw material area and convert the raw material into WIP, add to the WIP stock and transfer the necessary WIP to the finished goods area.

By using the general formula for COGS, and putting a little spin on it, we can accept that the Cost of WIP used is

Cost of WIP used = 

Opening stock of WIP + Cost of conversion of Raw Material to WIP - Closing stock of WIP. (FORMULA C)

Now let's see, what all adds up to the cost of conversion of Raw materials to WIP.

In WIP area, we take the necessary raw material from raw material area, use necessary equipments, consumables, fuel and labour to convert raw material to WIP, which then adds to the WIP stock.

Cost of conversion of Raw Material to WIP = Cost of Raw material consumed + All the manufacturing overheads for converting Raw material to WIP. (FORMULA D)

THE RAW MATERIALS AREA

In order to find the Cost of Consumed, we need to understand what is happening in the raw materials area.

In the Raw Material area, we purchase and stock raw material, and then supply the necessary raw material to the WIP area for converting to WIP.

Here we cab use the general formula for COGS directly

Cost of Raw material Consumed = 

Opening stock of Raw Material + Purchase Of Raw Material - Closing stock of Raw Material. (FORMULA E)

COST OF FINISHED GOODS SOLD  (A+B+C+D+E)

Cost of finished goods sold = (4) Opening stock of finished goods + (3) Opening stock of WIP + (1) Cost of Raw material consumed  - (7) Closing stock of finished goods - (6) Closing stock of WIP + (9) Manufacturing Overheads  (FORMULA F)

Now,  the formula for Cost of finished goods sold component of Formula No 2 is complete. Now we have to add the formula for Cost of stock in trade, Cost of Stores and spares ( including packing materials) consumed, to Formula F and Other Adjustments.

COST OF STOCK IN TRADE

Now we need to understand that a manufacturing company also trades goods, which either they do not manufacture. This means that they purchase finished goods (which they do not manufacture), stock them and sell them in the market, just like a trading company. These kind of goods are called stock in trade.

So they account for the inventory of  stock in trade, just like trading companies do.

So by using the general formula for the COGS

Cost of Stock in trade = Opening stock of Stock in trade + Purchase of Stock in trade-Closing stock of Stock in trade. (FORMULA G)

COST OF STORES AND SPARES AND PACKING MATERIALS

When a company manufactures goods, they consume spares, packing materials  as well as items in stores. The accounting for the cost of stores, packing materials and spares varies from company to company. Either they diclose the cost right away, in a different head, or they include the opening and closing stock along with raw materials, or with the finished goods. 

                                   

STOCK ADJUSTMENTS DUE TO MERGERS AND ACQUISITIONS

During mergers and acquisitions, the stock of the merged or the acquired company may be added to the opening stock and closing stock of the Raw materials, WIP and finished goods, in the year of the merger and acquisition, Normally, they are disclosed separately. 

OTHER ADJUSTMENTS

I will add the cases for other adjusments later.

CONCLUSION

FORMULA No 2 to FORMULA No 1

Let us write down the FORMULA F again

Cost of finished goods sold = (4) Opening stock of finished goods + (3) Opening stock of WIP + (1) Cost of Raw material consumed  - (7) Closing stock of finished goods - (6) Closing stock of WIP + (9) Manufacturing Overheads  (FORMULA F)

Merging formula G to Formula F and adding the additional costs of Stores, packing materials and spares, Stock adjustments due to mergers and acquisitions, and other adjustments

we get

Cost of  goods sold = (4) Opening stock of finished goods + (3) Opening stock of WIP + (1) Cost of Raw material consumed  - (7) Closing stock of finished goods - (6) Closing stock of WIP + (9) Manufacturing Overheads + (5) Opening stock of Stock in trade + (2) Purchase of Stock in trade-(8) Closing stock of Stock in trade + (10) Cost of Stores and spares ( including packing materials) consumed+ (11) Stock adjustments due to mergers and acquisitions + (12) Other adjustments.

So we have successfully assembled all the components of Formula No 1 by expanding Formula No 2

Accounting for unclaimed cash dividend

Lets start with an example. 

A company had 100000 shares outstanding (par value of Rs 1). The company plans to declare a 1:1 dividend. 

The following entry is made at the closure of financial statements

Provision for proposed dividend                                          100000

Appropriation to PL account                       100000

In the first quarter of the next financial year, the dividend is declared.

The entry is

Provision for proposed dividend                  100000

Dividend Payable                                                                100000

On the date of payment, the company is unable to pay a few shareholders amounting to Rs 10000, due to technical issues. 

The entry for the payment is

Dividend Payable                                        100000

Unclaimed dividend                                                             10000

Cash                                                                                   90000

And another entry for earmarking the fund for unclaimed dividend

Cash earmarked for  unclaimed dividend         10000

Cash                                                                                    10000

How Provisions and Contributions for Employee benefits is recorded.

PROVISIONS FOR EMPLOYEE BENEFITS

I am going to explain this in a simple manner. Provisions are required in defined benefits pan. Defined benefits, are estimates of expenses that has to be paid to the employees. Since they are estimates, they are provided for (provisions) in the balance sheet. Provisions for Gratuity, leave encashment are examples. 

There are two kinds of provisions for employee benefits that needs to be recorded by a company.

Short term provisions.

                       Short term provisions are quite simple to record. They are liabilities which are due to employees within a years time. Lets take a look at the entry for a short term provision.

 Employee benefit expense                   XXX

 Provision for Employee benefit                                  XXX

We do not need a separate fund for paying for these provisions, as they come under current liabilities.

Long term provisions.

                       Long term provisions are provisions estimated and recorded every year in anticipation of a lump sum payout to employees, when they retire, or when they complete the tenure required for availing the benefit. There are various methods used for estimating the long term liability to the company for these lump sum payments. Lets look into an example.

Company XYS Ltd  gives salary to an employee of 10000 per year. He is eligible to retire after 5 years with a gratuity of 10% of his last annual salary multiplied by the years of his service to the company. 

The company estimates a salary rise of 10% each year. 

His last year salary can be estimated as 10000 X (1.1)^5 = 16105

So the company will have to pay him 5 X 16105 X 10% = 8052.5 when he retires.

For this the company has to make a provision each year till he retires. 

For that the company divides 8052.5 by 5 and multiplies by the present value factor to obtain the estimate for the provision for each year. 

For year 1, year 2, year 3, year 4 and year 5  the provision estimate is calculated as 1099, 1209, 1330, 1464 and 1610. Along with that, some other costs are added such as interest costs and other costs. Now the provisions are increased to say 1500, 1750, 2000, 2250, and 2500. The entry for provisions for each year will be

Year 1

Employee gratuity expense                   1500

Provision for Employee gratuity                                  1500

Investments                                           1500

Cash                                                                              1500

Year 2

Employee gratuity expense                   1750

Provision for Employee gratuity                                  1750

Investments                                           1750

Cash                                                                              1750

Year 3

Employee gratuity expense                   2000

Provision for Employee gratuity                                  2000

Investments                                           2000

Cash                                                                              2000

Year 4

Employee gratuity expense                   2250

Provision for Employee gratuity                                  2250

Investments                                           2250

Cash                                                                              2250

Year 5

Employee gratuity expense                   2500

Provision for Employee gratuity                                  2500

Investments                                           2500

Cash                                                                              2500

Note that an equivalent amount of investments is done each year. Some companies do not make investments,but rather manage the expenses by insuring for the same.

Along with these expenses, additional expenses such as acturial Gain/loss, Gain/ Loss from Investments, and Actual settlements/ curtailments is charged to income statement each year.

CONTRIBUTIONS TO EMPLOYEE BENIFITS

These are contributions done by companies on monthly basis for future payments to the employees. The amount for these contributions are know to the company, so there is no need for any provisions. Which is why they come under defined contributions plan. They are recognized in Profit and loss as expenses.  Contributions to provident fund and superannuation are examples.

The entry for a contribution is


Contribution to PF/ Superannuation               XXX
Payables/cash                                                                                      XXX