unit 2
Financial Market
Definition: Financial Market refers to a marketplace, where creation and trading of financial assets, such as shares, debentures, bonds, derivatives, currencies, etc. take place. It plays a crucial role in allocating limited resources, in the country’s economy. It acts as an intermediary between the savers and investors by mobilising funds between them.
Functions of financial market
= price determination
= fund mobilization
= liquidity
= risk sharing
= easy access
= reduction in transaction cost
= capital formation
Classification of Financial Market
- By Nature of Claim
Debt Market: The market where fixed claims or debt instruments, such as debentures or bonds are bought and sold between investors.
Equity Market: Equity market is a market wherein the investors deal in equity instruments. It is the market for residual claims.
2. By Maturity of Claim
Money Market: The market where monetary assets such as commercial paper, certificate of deposits, treasury bills, etc. which mature within a year, are traded is called money market.
Capital Market: The market where medium and long term financial assets are traded in the capital market. It is divided into two types:
Primary Market, Secondary Market
3. By Timing of Delivery
Cash Market: The market where the transaction between buyers and sellers are settled in realtime.
Futures Market: Futures market is one where the delivery or settlement of commodities takes place at a future specified date.
4. By Organizational Structure
Exchange-Traded Market: A financial market, which has a centralised organisation with the standardised procedure.
Over-the-Counter Market: An OTC is characterized by a decentralized organization, having customized procedures
The Role of Financial Markets
Financial markets facilitate the interaction between those who need capital with those who have capital to invest. In addition to making it possible to raise capital, financial markets allow participants to transfer risk (generally through derivatives) and promote commerce.
Six key roles of financial markets
To facilitate saving by businesses and households: Offering a secure place to store money and earn interest
To lend to businesses and individuals: Financial markets provide an intermediary between savers and borrowers
To allocate funds to productive uses: Financial markets allocate capital to where the riskadjusted rate of return is highest
To facilitate the final exchange of goods and services such as contactless payments systems, foreign exchange etc.
To provide forward markets in currencies and commodities: Forward markets allow agents to insure against price volatility To provide a market for equities: Allowing businesses to raise fresh equity to fund their capital investment and expansion.
What Is a Financial Institution (FI)?
A financial institution (FI) is a company engaged in the business of dealing with financial and monetary transactions such as deposits, loans, investments, and currency exchange.
Types of Financial Institutions
Commercial Banks
A commercial bank is a type of financial institution that accepts deposits, offers checking account services, makes business, personal, and mortgage loans, and offers basic financial products like certificates of deposit (CDs) and savings accounts to individuals and small businesses. A commercial bank is where most people do their banking, as opposed to an investment bank.
Investment Banks
Investment banks specialize in providing services designed to facilitate business operations, such as capital expenditure financing and equity offerings, including initial public offerings (IPOs). They also commonly offer brokerage services for investors, act as market makers for trading exchanges, and manage mergers, acquisitions, and other corporate restructurings
Insurance Companies
Among the most familiar non-bank financial institutions are insurance companies. Providing insurance, whether for individuals or corporations, is one of the oldest financial services. Protection of assets and protection against financial risk, secured through insurance products, is an essential service that facilitates individual and corporate investments that fuel economic growth.
Brokerage Firms
Investment companies and brokerages, such as mutual fund and exchange-traded fund (ETF) provider Fidelity Investments, specialize in providing investment services that include wealth management and financial advisory services. They also provide access to investment products that may range from stocks and bonds all the way to lesser-known alternative investments, such as hedge funds and private equity investments.
Asymmetric Information in Financial Market
Financial markets exhibit asymmetric information in any transaction in which one of the two parties involved has more information than the other and thus has the ability to make a more informed decision.
Understanding Asymmetric Information
Asymmetric information in the financial markets can occur whenever either the buyer or seller has more information on the past, present, or future performance of an investment. One party can make an informed decision, but the other party cannot.
Ignoring Risks
Economists who study asymmetric information suggest that such situations can pose a moral hazard to one party in a transaction. Such a moral hazard can occur when the seller or buyer knows or reasonably suspects that a real but undisclosed risk is involved in the transaction.
Role and Functions of Derivatives
Financial derivatives are used for two main purposes to speculate and to hedge investments. A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets.
1) Price discovery of the underlying asset
Price discovery is a method of determining the price for a specific commodity or security through basic supply and demand factors related to the market. Price discovery is the general process used in determining the spot price. These prices are dependent upon market conditions affecting supply and demand. For example, if the demand for a particular commodity is higher than its supply, the price will typically increase and vice versa.
2) Techniques of risk management
Financial derivatives are useful for dealing with various types of risks, mainly market, credit and operational risks. The importance of derivatives has been increasing since the instrument has been used to hedge against price movements. The financial tool assists with the transfer of risks associated with a specific portfolio without requiring selling the portfolio itself. Essentially, derivatives allow investors to manage their risks and so reach the desired risk profile and allocation more efficiently.
3) Operational advantages
Derivative markets entail lower transaction costs. They have greater liquidity compared to spot markets. Derivative markets allow short selling of underlying securities more easily.
4) Market efficiency
Spot markets for securities probably would be efficient even if there were no derivative markets. A few profitable arbitrage opportunities exist, however, even in markets that are usually efficient. The presence of these opportunities means that the price of some assets is temporarily out of line. Investors can earn return s that exceed what the market deems fair for the given risk level.
Why Derivatives are important?
Derivatives play a vital role in keeping transaction costs in the market low. The cost of derivatives trading must be low and when this is done, subsequently the overall transaction cost in the economy is kept low. Derivatives also benefit investors and the economy by providing liquidity and encouraging short-selling.
Money Market in India
Meaning of Money Market:
Money market is a market for short-term funds. We define the short-term as a period of 364 days or less. In other words, the borrowing and repayment take place in 364 days or less. The manufacturers need two types of finance: finance to meet daily expenses like purchase of raw material, payment of wages, excise duty, electricity charges etc., and finance to meet capital expenditure like purchase of machinery, installation of pollution control equipment etc.
Features and Objectives of Money Market:
Features of Money Market:
Following are the features of money market:
- Money market has no geographical constraints as that of a stock exchange. The financial institutions dealing in monetary assets may be spread over a wide geographical area.
- Even though there are various centers of money market such as Mumbai, Calcutta, Chennai, etc., they are not separate independent markets but are inter-linked and interrelated.
- It relates to all dealings in money or monetary assets.
- It is a market purely for short-term funds.
- It is not a single homogeneous market. There are various sub-markets such as Call money market, Bill market, etc.
- Money market establishes a link between RBI and banks and provides information of monetary policy and management.
- Transactions can be conducted without the help of brokers.
- Variety of instruments are traded in money market.
Objectives of Money Market:
Following are the objectives of money market:
- To cater to the requirements of borrowers for short term funds, and provide liquidity to the lenders of these funds.
- To provide parking place for temporary employment of surplus fund.
- To provide facility to overcome short term deficits.
- To enable the central bank to influence and regulate liquidity in the economy.
- To help the government to implement its monetary policy through open market operation.
Structure of Indian Money Market:
The money market instruments mainly comprise:
(i) call money,
(ii) certificates of deposit,
(iii) treasury bills,
(iv) other short-term government securities transactions, such as, repos,
(v) bankers’ acceptances/commercial bills,
(vi) commercial paper, and
(vii) inter-corporate funds
Constituents of Indian Money Market:
Money market is a centre where short-term funds are supplied and demanded. Thus, the main constituents of money market are the lenders who supply and the borrowers who demand shortterm credit.
Supply of Funds:
There are two main sources of supply of short-term funds in the Indian money market:
(a) Unorganised indigenous sector, and
(b) Organised modern sector.
Demand for Funds:
In the Indian money market, the main borrowers of short-term funds are:
(a) Central Government,
(b) State Governments,
(c) Local bodies, such as, municipalities, village panchayats, etc.,
(d) traders, industrialists, farmers, exporters and importers, and
(e) general public.
Sub-Markets of Organised Money Market:
Call Money Market:
An interbank call money market is a short-term money market which allows for large financial institutions to borrow and lend money at interbank rates. The loans in the call money market are very short, usually lasting no longer than a week.
Call money allows banks to earn interest, known as the call loan rate, on their surplus funds. It consists of overnight money and money at short notice for a period of upto 14 days. The call money market essentially serves the purpose of equilibrating the short-term liquidity position of banks and other participants.
Treasury Bill Market:
Treasury bills are money market instruments issued by the Government of India as a promissory note with guaranteed repayment at a later date. Funds collected through such tools are typically used to meet short term requirements of the government, hence, to reduce the overall fiscal deficit of a country.
Commercial Bill Market:
A commercial bill is essentially a bill of exchange. In a credit sale, the seller will draw a bill of exchange. The buyer of the goods will accept such bill, and the bill becomes a trade bill which is a marketable financial instrument.
Collateral Loan Market:
A collateral loan is a secured loan that allows the borrower to pledge any asset to seek a loan. The loan amount depends on the value of the collateral. This type of loan is relatively risk-free for the lender, as they can liquidate the asset if the borrower defaults.
Participants in Money Market:
Central Government
Public Sector Undertakings
Insurance Companies
Mutual Funds
Banks
Corporates
Defects of Indian Money Market
- Dichotomy between Organised and Unorganised Sectors.
- Predominance of Unorganised Sector.
- Wasteful Competition.
- Absence of All-India Money Market.
- Inadequate Banking Facilities.
- Shortage of Capital.
- Seasonal Shortage of Funds.
- Diversity of Interest Rates.
Money Market Reforms
- Deregulation of Interest Rates.
- Introduction of New Money Market Instruments.
- Repurchase Agreements (Repos)
- Liquidity Adjustment Facility (LAF)
- Discount and Finance House of India (DFHI)
- Regulation of NBFCs.
- The Clearing Corporation of India Limited (CCIL)
Reserve Bank and Indian Money Market:
The Reserve Bank of Indian has taken various measures to improve the existing defects and to develop a sound money market in the country.
Reserve Bank of India (RBI) is India’s central bank. It controls the monetary policy concerning the national currency, the Indian rupee. The basic functions of the RBI are the issuance of currency, to sustain monetary stability in India, to operate the currency, and maintain the country’s credit system
Recent Measures Taken by RBI
Cash Reserve Ratio: As a one-time measure, RBI has reduced the cash reserve ratio of all banks by 100 basis points to 3% of Net Demand and Time Liabilities (NDTL) which will result in liquidity enhancement of about INR 1.37 lakh cr.
Certificate of Deposit (CD) and Commercial Paper (CP):
Certificates of deposit (CDs), commercial paper (CP) and Treasury bills (T-bills) are all securities issued to borrow money short-term (typically no longer than a year). In most markets, investors are usually professional – companies, fund managers, banks, etc.
Capital Market in India: Classification and Growth
The capital market provides the support to the system of capitalism of the country. The Securities and Exchange Board of India (SEBI), along with the Reserve Bank of India are the two regulatory authority for Indian securities market, to protect investors and improve the microstructure of capital markets in India.
Classification
The capital Markets are of two main types. The Primary markets and the secondary markets. In a primary market, companies, governments or public sector institutions can raise funds through bond issues. Alos, Corporations can sell new stock through an initial public offering (IPO) and raise money through that.
Growth
Capital growth, or capital appreciation, is an increase in the value of an asset or investment over time. Capital growth is measured by the difference between the current market value of an investment and its purchase price.
Indian Capital Market after Independence
In 1951, the number of joint stock companies (which is a very important indicator of the growth of capital market) was 28,500 both public limited and private limited companies with a paid up capital of Rs.
New Financial Intermediaries in Capital Market
Intermediaries that facilitate initial public offering are share transfer agents, registrar, merchant bankers, underwriters, credit rating agencies, and custodians.
Merchant Banking
In India, a merchant banker is defined as “an individual who is who is involved in the business of issue management either by making arrangements regarding buying, selling or subscribing to the securities as a manager, advisor, consultant in relation to such an issue management.”
Leasing and Hire-Purchase Companies
The deal in which one party can use the asset of the other party for the payment of equal monthly installments is known as Hire Purchasing. Leasing is an agreement where one party buys the asset and allows the other party to use it by paying consideration over a specified period is known as Leasing.
Mutual Funds
A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds
Global Depository Receipts (GDR)
A Global Depository Receipt (GDR), also known as international depository receipt (IDR), is a certificate issued by a depository bank, which purchases shares of foreign companies and deposits it on the account. GDR is an important concept in the Indian Economy segment of the IAS Exam.
Venture Capital Companies (VCC)
A venture capital corporation (VCC) is formed for the sole purpose of investing in start-ups and emerging and expanding eligible small businesses. VCCs are usually managed by venture capitalists or angel investors who provide small businesses with the benefit of their expertise, experience, and business knowledge.
Other New Financial Intermediaries
There are various types of financial intermediaries, such as banks, credit unions, insurance companies, mutual fund companies, stock exchanges, building societies, etc. Banks provide well-known financial services to invest and borrow funds seamlessly.
Capital Market Reforms in India
The five measures are: (1) Establishment of SEBI, (2) Setting up of Private Mutual Funds, (3) Opening up to Foreign Capital, (4) Access to International Capital Markets, and (5) Banks and Capital Markets.
irtayag academy 