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FINANCIAL MARKETS & OPEREATIONS

Module 1: Indian Financial System

Savings and Investment

Savings refers to a part of income which is not spent for consumption. Investment
refers to allocation of savings to buy assets which will generate income or appreciate
its value in future. So we can say that investments are savings used to buy the assets
or to make capital to increase the productivity.

Financial system

Financial system refers to a set of activities which facilitate the transfer of resources
from savers to users. A financial system consists of financial institutions, financial
markets, financial instruments and financial services. Financial system regulates
dealings between various economic units in money or monetary assets. Economic
units are individuals and institutions. An efficient financial system facilitates
economic growth in a country.

Features of financial system

A well developed financial system is characterized by well regulated financial

markets, financial instruments and financial services. The following points state the
essential characteristics of a well developed financial system:

 There are organised and unorganised financial markets

 It regulates transactions between various economic units
 It promotes efficient allocation of financial resources.
 It promotes economic development
 It facilitates expansion of financial markets

Conclusion:
We can conclude that basic elements required for a well developed financial system
are strong legal and regulatory environment, stable currency system, dynamic
central bank, sound banking system and well functioning securities market.

Indian financial system

Our financial system includes both organised and unorganised sectors. The organised
sector consists of financial institutions, financial markets, financial instruments and
securities markets. This sector comes under the purview of Ministry of finance,
ministry of corporate affairs, Reserve bank of India, SEBI and IRDA.

The unorganised sector consists of indigenous bankers, money lenders chits and
nidhis.
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Role of Reserve bank of India in the Indian financial system

RBI being the apex banking institution in our country plays a crucial role in the
Indian financial system.

It is the authority for the creation and control of currency and credit. It is the banker
to bank and controls the credit or money circulation in Indian financial system

It controls the entire banking system in the country. It provides financial assistance
to our banks. It also protects the interests of customers of the banks. It ensures the
safety of investments by the customers in the commercial banks.

The RBI Act of 1934 and and the banking Regulation Act of 1949 have given wide
powers to RBI to control our financial system. In addition to that the securities
market, money market and Foreign exchange markets are directly controlled by RBI.

In 1994 a board of financial supervision was set up by RBI to have close watch on our
financial markets. In order to supervise the NBFCs a department of non banking
supervision was set up by the RBI in the year 1997.

Role and functions of financial system

Introduction

Financial system refers to a set of activities which facilitate the transfer of resources
from savers to users. A financial system consists of financial institutions, financial
markets, financial instruments and financial services. Financial system regulates
dealings between various economic units in money or monetary assets. Economic
units are individuals and institutions. An efficient financial system facilitates
economic growth in a country.

Features of financial system

A well developed financial system is characterized by well regulated financial

markets, financial instruments and financial services. The following points state the
essential characteristics of a well developed financial system:

 There are organised and unorganised financial markets

 It regulates transactions between various economic units
 It promotes efficient allocation of financial resources.
 It promotes economic development
 It facilitates expansion of financial markets

The financial system performs the following which are essential to modern economy.
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1) Encourages savings:It encourages saving habit by facilitating higher returns and

safety investments.
2) Mobilization of savings: Financial system serves as a link between savers and
investors. It actually channelizes flow of savings into productive investments.
3) Allocation of funds: Another important function is to arrange smooth, efficient
and socially equitable allocation of credit
4) Pooling of funds: Financial system helps in pooling of funds for undertaking large
scale enterprise. It helps in mobilizing scattered savings in more efficient
manner.
5) Helps in capital formation: It promotes capital formation by bringing together
the supply of savings and the demand for investments.
6) Generates information: It provides a detailed information to the players in the
market such as individuals, business houses and government.

Conclusion:

Financial system plays a crucial role in channelizing the flow of savings into
productive investments. It is the heart and soul of a successful economy.

Recent development in Indian Financial System

Our financial system includes both organized and unorganized sectors. The organized
sector consists of financial institutions, financial markets, financial instruments and
securities markets. This sector comes under the purview of Ministry of finance,
ministry of corporate affairs, Reserve e bank of India, SEBI and IRDA.

The unorganized sector consists of indigenous bankers, money lenders chits and
nidhis.

Major developments happened in our financial system are:

a) Foreign companies are allowed to raise capital by issuing Indian depository

receipts.
b) Issue of licenses for the establishment of new banks for corporate sector and
NBFCs. Two new banks were given licenses and they were IDFC limited and
Bandhan Financial services private limited
c) Our domestic equity market was opened to foreign individual investors. This has
actually helped in the flow of overseas capital
d) In order to help micro financial units with limited capital MUDRA scheme was
introduced.
e) RBI has recently granted licenses to ten small finance banks and eleven Payment
banks. These banks were developed with aim promoting banking activities in
rural India.
f) Soon after demonetization, digital economy and digital payments were
promoted. Many number of mobile apps were introduced for facilitating easy
digital banking.
g) Introduction of GST in 2017 is a milestone in the financial sector of our country.
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Conclusion:

All the above developments have given a facelift to our financial system and
economy.

Classifications of Financial Markets

Financial markets are broadly classified into Organized markets and organized
markets. The Organized markets are further classified into Capital Markets and
Money markets. The unorganized sector consists of indigenous bankers, money
lenders, local bankers pawn brokers etc.

Capital market

Capital market is the market for long term funds. It is a market where long term
funds are raised by issuing securities such as shares, debentures or bonds. Initially
the shares are issued by a company in the new issue market. These share are traded
in the secondary market. The two wings of capital market are new issue market and
secondary market.

Functions of capital market (Significance of capital market)

Introduction
This market is the important component of the financial system. Capital market is
actually a medium through which small savings of investors scattered across the
country are collected and invested in productive activities. It provides liquidity safety
and profitability to the investors. The major functions of an efficient capital market
are the following:

 It promotes capital formation and ensures economic development.

 The savings of the people are mobilized
 The funds are channelized to most productive investments
 With help of the funds channelized, technological upgradation is made possible
 It facilitates the growth and expansion of corporate sector
 It increases the production and productivity and enhances economic welfare of
the society.

Conclusion:
Thus we can conclude that capital market serves as the artery of Indian financial
system.
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Capital market instruments ( Financial instruments)

The following are the major financial instruments in the capital market:

Equity shares

These are the share having no preferential rights. They will rank only after
preference shares for the purpose of dividend and repayment of capital in the event
of winding up of the company.The rate of dividend of these shares is not fixed. It
depends on the availability of divisible profits and the intention of the
directors.These shares have the chances of earning good dividends in times of
prosperity of the company. The equity shareholders have the right to to vote based
on the number of shares held in the company.

Types of equity shares

1. Equity shares with detachable warrant

The fully paid equity shares can be issued with detachable warrants. This will enable
them to buy a certain number of equity shares at a pre-determined price within a
limited time span.

2. Shares with differential voting rights (WSWDVR)

The holders of these shares enjoy more voting rights than other equity shares, Tata
motors was the first company to issue such shares.

3. Non Voting shares (NVS) The holders of these shares do not have any voting
rights. But they are eligible for more dividends.

4. SWEAT equity shares

As the name implies these shares are issued by the company to its employees or
directors at a lower rate for a consideration other than cash as a token of recognition
for their contributions to the growth of the company. The employees will be given
the option to purchase shares on favourable terms. Such scheme of offering shares
to employees is also called Employees Stock Option Plan (ESOP)
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Preference Shares

The preference share capital is raised by the issue of preference shares. These shares
enjoy preferential rights as to:

 Preference in payment of dividend at a fixed rate over equity shares during the
life time of the company
 Preference over equity shares on repayment of capital at the time of winding up
of the company
1) Redeemable preference shares: These shares are to be redeemed after the
expiry of the period for which they are issued. But for redemption the following
conditions are to be fulfilled:
 They must be fully paid up shares
 They must be redeemed out of revenue profits
 Premium on redemption if any is to be paid to them

2) Irredeemable preference shares: These preference shares are not to be

redeemed except on liquidation of the company
3) Convertible preference shares: Holders of these shares are given an option to
convert their holdings into equity shares, They are also known as quasi equity
shares
4) These preference shares for which the holders are entitled to participle in the
surplus profit after given a fixed dividend to them.
5) Cumulative preference shares: For these preference shares the holders have the
right to get cumulative dividend for the years of non payment of dividend to
them.

Debentures: These are the documents issued by the company under its common
seal for the borrowings form public. The holders of these instruments are creditors
of the company. They are entitled to a fixed dividend and also the preference of
repayment of capital when the company goes into liquidation.

Types of debentures

1. Secured debentures: these are those debentures for which the holders have a
charge on the assets of the company. There may be fixed charge and floating
charge on the assets of the company.

2. Unsecured debentures: These are ordinary debentures for which the holders
have no charge on the assets of the company. They are also called naked
debentures.
3. These are the debentures payable to the bearer. Interest coupons are attached to
such debentures. When the interest date approaches, the appropriate coupon is
clipped off by the holder and deposited in his bank for collection. Such debentures
are negotiable by delivery.
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4. Registered debentures: These are the debentures for which the name of the
holder is registered in the books of the company.

5. Redeemable debenture:These debentures are to be redeemed after expiry of the

period for which they are issued.

6. Convertible dentures: These are the ones for which the holders have the right to
get them converted into equity shares,

7. Non convertible debenture with detachable warrants: The holders such

debentures can buy s a specified number of shares from the company at a specified
price.

Bonds:

Bonds are debt instruments issued by the companies or governments to raise funds
for financing their capital requirements. By purchasing a bond an investor lends
money to the company for fixed period at a fixed rate of interest. Interests are
usually paid half yearly or yearly. Interest is calculated as a certain percentage of
face value of bonds and is known as coupon payment.

Both bonds and debentures are the same. In our country bonds are issued by
government or semi government bodies. The debentures are issued by corporates.

Types of bonds.

The bonds are classified as:

a) Zero coupon bonds: Zero coupon bonds are issued at a discount to their face
value and at the time of maturity the face value is given to them. No interest or
coupon is paid to them. The difference between issue price and redeemable
price is termed interest. These types of bonds are also known as deep discount
bonds.
b) Mortgage bonds: This is the common type of bonds issued by the companies.
These bonds have charge on the assets of the company.
c) Convertible bonds: These types of bonds allow the holders to convert their
holdings bonds into equity shares after a few years of issue of such bonds.
d) Step-up bonds are those ones for which interest will be lower during the initial
period and later it increases to higher rate.
e) If the bond can be called before maturity it is known as callable bond. If the
bond cannot be called before maturity it is called non callable bonds.
f) Option bonds: here the bond holder has the option to choose between
cumulative or non cumulative bonds.
g) Floating rate bonds: These are the bonds wherein the interest rate is not fixed.
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Money Market

Introduction
Money market is the market for borrowing and lending for short periods. This
market deals in short term financial assets and debt instruments such as treasury
bills, commercial papers etc. The major players in this market are RBI, Discount and
finance house of India, commercial banks other financial institutions, mutual funds
etc. Actually money market instruments bridge the gap of short term liquidity
problems.

Features of money market

The following are the essential features of Money market:

1. There are no geographical constraints for money market. The financial

institutions are actually spread over large geographical areas.

2. It is a wholesale market for short term debt instruments.

3. It is a market for short term funds
4. It is not a single homogeneous (same kind) market. There are various sub
markets.
5. Money market establishes a link between RBI and commercial banks and helps
RBI to implement monetary policy for the country.
6. There is no fixed place for the conduct of transactions or operations.
7. Transactions can even be conducted without the help of brokers.
8. A wide variety of short term debt instruments are traded in money market.

Money market instruments

Objectives of Money market

A well established money market has the following features:

1. To maintain monetary equilibrium: The money market has to keep a balance

between the demand and supply of money for short term monetary transactions.
2. To promote economic growth: It makes available the funds for various sectors in
the economy such as agriculture and small scale industries.
3. To provide financial assistance: It provides adequate financial assistance to trade
and industry.
4. To help in capital formation: It makes available the investment avenues for short
period. Savings and investments are generated in large sums.

5. To provide financial assistance to government: Money market facilitates non

inflationary source of finance to government.

6. To provide parking place: it provides parking place to employ short term funds.
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Money market instruments

Money market instruments are liquid assets and interest bearing debts which
mature within a short period of time. The maturity period varies from one day to one
year. The important money market instruments are:

1. Commercial papers
2. Certificates of deposits
3. Treasury bills
4. Commercial bills
5. Call money
6. Repurchase Agreements (REPOs)

The sub markets in the money market are the markets where these instruments are
traded. These markets consists of call money market, treasury bill market,
Commercial bill market, discount market etc. These sub markets are together called
money markets.

1. Commercial papers (CPs)

Commercial paper is the unsecured promissory note issued by a company with a

fixed maturity and approved by RBI. This was introduced in our country in 1990.

The period of maturity ranges from 7 days to 1 year. The instrument is transferable
by endorsement and delivery. It is usually issued at a discount on face value. The
total amount of CP issued should not exceed the working capital limits sanctioned by
banks or financial institutions.

Manufacturing companies, Leasing and finance companies, Mutual funds and

financial institutions are the major issuers of commercial paper.

Advantages of CPs

a) It is very simple ot operate. There is no much documentation required between

teh issuer and investor.
b) It is a very flexible instrument. The maturity date can be fixed based on teh cash
requirements
c) The companies can issue CPs directly to investors. That is why CPs are also
known as Direct paper.
d) This is of low cost. Hence it can be considered as an attractive source of working
capital.
e) It ensures teh best return to teh investor.
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Certificate of Deposits (CDs)

They are negotiable money market instruments issued in demat form for funds
deposited at bank or financial institutions for a fixed period of time. It is issued at a
discount. They are negotiable instruments issued by banks or other financial
institutions. The CDs were introduced by RBI in 1989.

Advantages
1) They ensure the best return for short term, surplus funds.
2) They ensure maximum liquidity as they are transferable by endorsement and
delivery.
3) This is an ideal instrument for banks with short term surplus fund to invest.
4) As the interest rates are high, the investors hold them till maturity.

Treasury Bills(T-Bills)

Treasury bills are short term promissory notes issued by RBI on behalf of the central
government when there is a deficit budget. The shortage funds in the budget will be
met by issuing T Bills at a discount for a fixed date like 91 days, 182 days and 364
days. On the specified date the investor gets the amount mentioned in the Bill.
T Bills are issued at a discount. On maturity the payments will be made at face value
and the difference is the income for the investor. As they are issued by the
government, they are called zero risk investments.The T Bills are available at a
minimum amount of Rs 25000 and multiples thereof.

Advantage of T Bills

 They help the Union government to bridge the gap in the deficit budget.
 It is an important tool for the central bank to control liquidity and short term
interest rates.
 They are zero risk investments
 They are highly liquid investments
 Very low transaction cost
 No tax will be deducted at source
 Commercial banks can maintain their SLR and CRR requirements by using T bills.

Commercial Bills

Commercial bills arise out of trade transactions. The maturity period varies from 30
days to 90 days depending on credit given. They are transferable by endorsement
and delivery and can be discounted or re discounted. Commercial banks, co
operative banks, financial institutions and mutual funds can participate in the bill
market. If the holder is need of immediate financial requirement he can discount the
bill with the bank.
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Call money or notice money

These are loans for a very short period of one to fourteen days. Call money is
otherwise called money at call. Call money market is the market where short term
surplus funds are traded for commercial banks. This is very highly liquid market. If
the money is lent for one day, it is called call money. If lending is for a period of more
than one day and less than 14 days, it is called notice money.

Re purchase agreements (REPOs)

REPO is the sales of securities together with an agreement by the seller to to buy
back the securities on a future date at a pre- determined price. Here the security
serves as collateral. The person who sells the security is the borrower and the one
who buy the security is the lender. The securities traded are usually the central and
state government bonds, T Bills corporate bonds and the bonds issued by public
sector units.

Reverse Repo is the mirror image (exactly opposite) of repo. The same transaction is
the repo for one person and reverse repo for the other. The difference between the
sale and repurchase price expressed in percentage of sales price is known as repo
rate or reverse repo rate.

There are two types of Repos. They are inter bank repo or market repo and RBI repo.
The inter bank repo is among the banks themselves. RBI repo is exercised by the RBI
as part of the open market operations to control the money circulation in the
economy.

Advantage of Repos

Advantage of Repos or reverse Repos

1. Repos are safer than other short term money market instruments as they are
collateralized short term borrowings.
2. For the buyer repo is an opportunity to invest cash for a customized period of
time.
3. The Central bank uses repo as an essential tool for open market operation to
control money circulation in the economy.
4. Repo enables banks to invest their surplus cash for adjusting CRR position.
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Indian Money Market- Introduction

Indian money market is for short term borrowings and lending of money. It is true
that this market is not a well developed market, but it is the leading money market
in the developing nations. RBI is the major player in this market. RBI controls money
circulation in the economy through its direct intervention in this market.

Structure of Indian money market

Our money market is broadly classified into two. They are:

1. Organized money market and

2. Unorganized money market.

RBI is the head of the organized sector of our money market. The major constituents
of this money market are Government, RBI, commercial banks, Discount houses,
Financial institutions, mutual funds etc.

The unorganized sector is not under the direct control of RBI. This sector consists of
indigenous bankers and village money lenders. The interest rate in this sector is
usually very high.

Characteristics of Indian money market

a) Dichotomic structure: Our money market has a simultaneous existence of both

the organized and the unorganized sectors.
b) Seasonality: The financial requirement in our money market is seasonal in
nature
c) Different interest rates: The interest rates differ from bank to bank from period
to period.
d) Lack of organized bill market: In our money market the organized bill market is
not prevalent.
e) Limited instruments: There are very limited financial instruments available for
circulation, when compared to the developed nations.

Components or Sub markets of Indian money market

Refer the text book, pg number 41.

Weaknesses of Indian Money Market

1. Our money market is not a well developed money market. It does not have the
features of a well developed money market like free flow of funds, high degree of
specialization with regard to dealing in different instruments etc.

2. There is no active secondary market for many instruments like treasury bills, CPs
and CDs
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3. Seasonality: There is seasonality in the demand for funds required for

agricultural operations

4. No foreign players: There are restrictions for foreign players. But now a days
there is some liberalization in this regard.

5. There is no integration and cohesion in Indian money market when compared to

foreign money market.

Conclusion: we can conclude that are various ways in which our money market is to
be improved. Still there are further defects like multiple interest rates, shortage of
interest rates and lesser number of dealers.

Role of RBI in Money market

Reserve bank of India is the nerve centre and major regulator of Indian money
market. The following points illustrate the role of RBI in this regard.

1. The monetary policy of RBI plays a crucial role in the Indian money market.
Monetary policy refers to the policy of the Reserve Bank to control the money
circulation in the economy. Reserve bank of India exercises the monetary policy
through our financial market
2. Money market helps the RBI to regulate and control the credit creation by
commercial banks. It also helps RBI to control the inflation rate in the economy.
3. Depending up on the economic situation and available market trends the RBI
interferes in the money market through various tools like bank rate policy, variable
cash reserve ratio, open market operation margin requirements.

4. The Liquidity Adjustment facility of RBI helps commercial banks to adjust their
daily liquidity mismatches. LAF has two components. They are Repo and Reverse
Repo.

Very important. Difference between money market and capital market. (Refer pg
44 of text book.)
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Securities and Exchange Board of India (SEBI)

Introduction

SEBI is a statutory authority to deal with all matters relating to the capital market. It
is the only regulatory authority to co ordinate and control the securities market. The
chief aim of SEBI is to to protect the interest of investors and also to promote the
development of securities market.

Origin and development

SEBI was set up in 1988 as an administrative body to control and regulate the work
of stock exchanges. It was given legal status in the year 1992 by an Act of the
Parliament. It has got more role when the Controller of capital issue was abolished.
With policy of economic liberalization, the government adopted a free price policy
for securities. SEBI assumes new role in this context.

The rationale for setting up SEBI (Reasons for setting up SEBI)

SEBI was set up to resolve many problems faced by securities market. The chief aim
behind setting up SEBI was to protect the interest of investors. The following
situations which were prevalent in the securities market which compelled the setting
up of SEBI

1) Primary markets were not in the main stream of financial market.

2) Fragmented regulations and multiplicity of administration
3) Poor disclosure in the prospectus.
4) Investors faced the problem of refund delays and transfer delays of their
investments
5) There was no inspection of stock exchanges
6) Stock exchanges were dominated by brokers
7) Mutual funds were not unregulated
8) There were poor disclosures by mutual funds. The NAVs were not published and
no valuation norms were prescribed.
9) There were no prohibition on insider trading
10) Fraudulent trade practices were quite common.

Objectives of SEBI
SEBI was established with the following objectives:
 To protect the interest of investors
 To promote the development of securities market
 To regulate the securities market
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Powers of SEBI
In order to protect the interest of investors, SEBI exercises the following funtions:

1) Make rules and regulations for the disciplined growth of securities market.
2) Issue directions in the interest of investors and orderly development of
securities market.
3) Regulate the functioning of different stock brokers
4) Cancel or suspend the registration of brokers or intermediaries
5) Regulate the issue of capital
6) Granting and renewal of registration to stock exchanges
7) Consider the appeals against listing refusals
8) Oversee the bye-laws and listing agreements of stock exchanges
9) Conduct the audit of stock exchanges
10) Act against the fraudulent inducements to investors for investing in securities
11) Regulate the disclosures in the prospectus
12) Grant incorporation of companies
13) Inspect company affairs
14) Levying fees or other charges from related persons
15) Performing such functions as prescribed by the SEBI Act.

Conclusion

In addition to the above mentioned powers, SEBI has all the powers of a civil court in
exercising its functions. Thus we can say that SEBI has wider scope and powers for
protecting the interest of investors.

Functions of SEBI

The different functions performed by SEBI as per SEBI Act 1992 are explained
below:

a. Regulatory functions and b. Developmental functions

Regulatory functions: These functions include

i. Regulation of stock exchanges and self regulatory organizations
ii. Registration and regulation of stock brokers, sub brokers, Registrar to issues and
merchant bankers etc.
iii. Registration and regulation of mutual funds
iv. Prohibition of unfair trade practices
v. Prohibition of insider trading
vi. Suspending or canceling the registration of market intermediaries
vii. Performing such other functions as may be required to protest the interest of
investors and for the development of securities market.
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Developmental functions: These include

viii. Promoting investor education
ix. Training intermediaries
x. Conducting researches and publishing information useful to all market
participants
xi. Promotion of fair practices
xii. Promotion of self regulatory organizations