SEMCOM, a constituent college of CVM University

TYB.Com/BBA/ ITM
Course Title: Indian Financial System (IFS), Course Code: 203000518
Unit-1 Financial System
Unit-1 Financial System
• Introduction & meaning, • Classification of Financial System,• Financial Market,
• Functions and Significance of Primary Market, Secondary Market, Capital Market, &
Money Marke

1. Introduction & Meaning

The economic development of a nation is reflected by the progress of the

various economic units, broadly classified into corporate sector, government
and household sector. There are areas or people with surplus funds and there
are those with a deficit. A financial system or financial sector functions as an
intermediary and facilitates the flow of funds from the areas of surplus to the
areas of deficit. A Financial System is a composition of various institutions,
markets, regulations and laws, practices, money manager, analysts, transactions
and claims and liabilities.

Financial system comprises of set of subsystems of financial institutions,

financial markets, financial instruments and services which helps in the
formation of capital. It provides a mechanism by which savings are transformed
to investment.

Financial System;

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The word "system", in the term "financial system", implies a set of complex
and closely connected or interlinked institutions, agents, practices, markets,
transactions, claims, and liabilities in the economy. The financial system is
concerned about money, credit and finance -the three terms are intimately
related yet are somewhat different from each other. Indian financial system
consists of financial market, financial instruments and financial intermediation.

Meaning of Financial System: A financial system functions as an intermediary

between savers and investors. It facilitates the flow of funds from the areas of
surplus to the areas of deficit. It is concerned about the money, credit and finance.
These three parts are very closely interrelated with each other and depend on each
other.

A financial system may be defined as a set of institutions, instruments and

markets which promotes savings and channels them to their most efficient use.
It consists of individuals (savers), intermediaries, markets and users of savings
(investors).

In the worlds of Van Horne, “financial system allocates savings efficiently

in an economy to ultimate users either for investment in real assets or for
consumption”.

According to Prasanna Chandra, “financial system consists of a variety of

institutions, markets and instruments related in a systematic manner and
provide the principal means by which savings are transformed into
investments”.

Thus, financial system is a set of complex and closely interlinked financial

institutions, financial markets, financial instruments and services which
facilitate the transfer of funds. Financial institutions mobilize funds from suppliers
and provide these funds to those who demand them. Similarly, the financial
markets are also required for movement of funds from savers to intermediaries and
from intermediaries to investors. In short, financial system is a mechanism by
which savings are transformed into investments.

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 2. Classification of Financial System
The financial system comprises of four major components. These components are:
1) Financial Institutions
2) Financial Markets
3) Financial Instruments
4) Financial Services

1. FINANCIAL INTERMEDIARIES/FINANCIAL INSTITUTIONS: Different kinds of

organizations/institutions which intermediate and facilitate financial transactions of both
individual and corporate customers are called as financial intermediaries or financial
institutions. Basically, they are classified into two types:
1. Unorganized Sector
2. Organized Sector
➢ Unorganized Sector: The sector that is not governed by any statutory or legal authority is
known as unorganized sector. This sector consists of the individuals and institutions for
whom there are no standardized rules and regulations governing their financial dealings.
They are not under the supervision and control of RBI or any other regulatory body. This
sector consists of the individuals and institutions like Local money lenders, Pawn brokers,

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 Traders, Landlords, Indigenous bankers, etc., who lend money to needy persons and
institutions.
➢ Organized Sector: The sector that is governed by some statutory or legal authority is
known as organized sector. This sector consists of the institutions like Commercial Banks,
Non-Banking Financial Institutions, etc.
They are further classified into two:
1. Capital Market Intermediaries
2. Money Market Intermediaries
➢ Capital Market Intermediaries: Capital Market refers to the market for long term
finance. The intermediaries provide long term finance to individuals and corporate
customers. IDBI, SFCs, LIC, GIC, UTI, MFs, EXIM BANK, NABARD, NHB NBFCs
(Hire Purchasing, Leasing, Investment and Finance Companies) Government (PF, NSC)
etc., are in the organized sector providing long term finance.
➢ Money Market Intermediaries: Money Market refers to the market for short term
finance. The intermediaries provide short term finance to individuals and corporate
customers. RBI, Commercial Banks, Co-operative Banks, Post Office Savings Banks,
Government (Treasury Bills) are in the organized sector providing short term finance.
The financial institutions can further be divided into two types:
➢ Banking Institutions or Depository Institutions – This includes banks and other credit
unions which collect money from the public against interest provided on the deposits made
and lend that money to the ones in need
➢ Non-Banking Institutions or Non-Depository Institutions – Insurance, mutual funds and
brokerage companies fall under this category. They cannot ask for monetary deposits but
sell financial products to their customers.
Further, Financial Institutions can be classified into three categories:
• Regulatory – Institutes that regulate the financial markets like RBI, IRDA, SEBI, etc.
• Intermediates – Commercial banks which provide loans and other financial assistance
such as SBI, BOB, PNB, etc.
• Non-Intermediates – Institutions that provide financial aid to corporate customers. It
includes NABARD, SIBDI, etc.
2. FINANCIAL MARKETS The group of individuals and corporate institutions dealing in
financial transactions are termed as financial markets. The centers or arrangements that
facilitate buying and selling of financial assets, claims and services are the constituents of

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financial market. Basically, they are classified into two categories:
1. Unorganized Market
2. Organized Market
➢ Unorganized Market: The sector that is not governed by any statutory or legal authority
is known as unorganized sector. This sector consists of the individuals and institutions for
whom there are no standardized rules and regulations governing their financial dealings.
They are not under the supervision and control of RBI or any other regulatory body. Local
money lenders, Pawn brokers, Traders, Landlords, Indigenous bankers, etc., who lend
money are in the unorganized sector.
➢ Organized Market: The sector that is governed by some statutory or legal authority is
known as organized sector. This sector consists of the institutions for whom there are
standardized rules and regulations governing their financial dealings. They are under the
supervision and control of RBI and other statutory bodies.
They are further classified into two:
A. Capital Market
B. Money Market
C. Foreign Exchange Market
➢ Capital Market: Capital Market refers to the market for long term finance. Financial
assets which have a long or indefinite maturity period are dealt in this market. Capital
Market is further classified into the following three:
• Industrial Securities Market
• Government Securities Market
• Long-term Loans Market
a) Industrial Securities Market - The financial market where industrial securities like equity
shares, preference shares, debentures, bonds, etc., are dealt with is called as Industrial
Securities Market. In this market, the industrial concerns raise their capital and debts by issuing
appropriate securities. This market is again classified into the following two viz., Primary
Market and Secondary Market
• Primary Market - The financial market concerned with the fresh issue of industrial
securities is called as primary market. It is also called as new issue market. In this market,
industrial securities which are issued for the first time to the public are dealt.
• Secondary Market - The financial market concerned with the purchase and sale of already
existing industrial securities is called as secondary market. In this market, industrial

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 securities which are already held by the individuals and institutions are bought and sold.
Generally, these securities are quoted in the stock exchanges. This market consists of all
the stock exchanges recognized by the Government of India. Securities Contracts
(Regulation) Act, 1956 regulates the stock exchanges and Bombay Stock Exchange is the
main stock exchange in India which leads the other stock exchanges.
b) Government Securities Market or Gilt-edged Securities Market - The financial market
where Government securities like stock certificates, promissory notes, bearer bonds, treasury
bills, etc., are dealt with is called as Government Securities Market. The long-term securities
issued by the Central Government, State Governments, Semi-government authorities like City
Corporations, Port Trusts, etc., Improvement Trusts, State Electricity Boards, All India and
State level financial institutes and public sector enterprises are bought and sold in this market.
c) Long-term Loans Market - The financial market where long-term loans are provided to
the corporate customers is called as Long-term Loans Market. Development Banks and
Commercial Banks play a major role in this market. This market is classified into three
categories viz., Term loans market, Mortgages market and financial guarantees market: Term
loans market - This market consists of the industrial financing institutions which supply long
term loan to corporate customers. They are created by the Government both at the national
level and regional level. They provide term loans to corporate customers and also help them in
identifying investment opportunities. They also encourage new entrepreneurs and support
modernization efforts. IDBI, IFCI, ICICI, SFCs, etc., come under this market. Mortgages
market - This market consists of the institutions which supply mortgage loan mainly to
individuals. The term ‘mortgage’ refers to the transfer of interest in a specific immovable
property to secure a loan. Financial guarantees market - This market consists of the institutions
which provide financial guarantee to individuals and corporate customers. The term
‘guarantee’ refers to a contract whereby one person promises another person to discharge the
liability of a third person in case of his default. There are different types of guarantees
prominent among them are Performance guarantee and financial guarantee.
B. Money Market: Money Market refers to the market for short term finance. Financial assets
which have a short period of maturity are dealt in this market. Near money like Trade Bills,
Promissory Notes, Short term Government Papers, etc., are traded in this market. Composition
of money market (Financial instruments dealt in money market) - The money market comprises
of the following:
1. Call money market
2. Commercial bills market

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3. Treasury bills market
4. Short-term loan market
• Call money market - The market where finance is provided just against a call made by the
borrower is called call money market. In this market finance is provided for an extremely
short period of time.
• Commercial bills market - The market where finance is provided by discounting of
commercial bills is called as commercial bills market. The term ‘commercial bills’ refer to
the bills of exchange arising out of genuine trade transactions.
• Treasury bills market - The market where finance is provided against the treasury bills is
called as treasury bills market. The term ‘treasury bill’ refers to the promissory notes or
finance bills issued by the government for its short-term finance requirements.
• Short-term loans market - The market where finance is provided in the form of short-
term loans is called as short-term loans market. The term ‘short-term’ refers to a period less
than one year. Commercial banks provide short term loans in the form of overdrafts and
cash credits. These loans are given to meet the working capital requirements of traders and
industrialists.
C. Foreign Exchange Market: The market where foreign currencies are bought and sold
against domestic currency is called foreign exchange market. In other words, the system where
the domestic currency is converted into foreign currency and vice-versa is called as foreign
exchange market.
3. FINANCIAL INSTRUMENTS/ASSETS: Financial instruments refer to the documents
that represent financial claim. A financial claim is claim to the repayment of a certain amount
of money at the end of a specified period along with interest or dividend. Shares, Government
Securities, Bonds, Mutual Funds, Units of UTI, Debentures, Bank Deposits, Provident Funds,
LIC Policies, Company Deposits, Post Office Certificates, etc., are some of the examples of
financial instruments. These instruments are classified into two types, viz., Primary securities
and Secondary securities.
• Primary Securities – These are the financial instruments that are issued directly to the
savers by the users of the funds. For example, shares or debentures issued by a joint stock
company directly to the public and institutions are called as primary securities.
• Secondary Securities – These are the financial instruments that are issued to the savers by
some intermediaries. For example, units issued by Unit Trust of India and other Mutual
Fund Organizations are called as secondary securities

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4. FINANCIAL SERVICES: Financial services refer to the activities of channelizing the
flow of funds from the savers to the users. It involves the mobilization of savings of the persons
and institutions who have surplus funds and allocating or lending them to the persons and
institutions who are in need of such funds. Services provided by Asset Management and
Liability Management Companies. They help to get the required funds and also make sure that
they are efficiently invested. The main aim of the financial services is to assist a person with
selling, borrowing or purchasing securities, allowing payments and settlements and lending
and investing.
The financial services in India include:
• Banking Services – Any small or big service provided by banks like granting a loan,
depositing money, issuing debit/credit cards, opening accounts, etc.
• Insurance Services – Services like issuing of insurance, selling policies, insurance
undertaking and brokerages, etc. are all a part of the Insurance services
• Investment Services – It mostly includes asset management
• Foreign Exchange Services – Exchange of currency, foreign exchange, etc. are a part of
the foreign exchange services
The financial services are categorized into two groups, viz., Traditional services and Modern
services
1. Traditional services refer to the services that the financial institutions are rendering from a
very long time. They are further classified into two viz., a) Fund based services and b) Non-
fund or Fee based services.
2. Modern services refer to the services that the financial institutions are rendering in the recent
years.

3. Financial Market

Financial Markets Financial markets are another part or component of financial system.
Efficient financial markets are essential for speedy economic development. The vibrant
financial market enhances the efficiency of capital formation. It facilitates the flow of savings
into investment. Financial markets bridge one set of financial intermediaries with another set
of players. Financial markets are the backbone of the economy. This is because they provide
monetary support for the growth of the economy. The growth of the financial markets is the
barometer of the growth of a country’s economy.

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Financial market deals in financial securities (or financial instruments) and financial services.
Financial markets are the centers or arrangements that provide facilities for buying and selling
of financial claims and services. These are the markets in which money as well as monetary
claims is traded in. Financial markets exist wherever financial transactions take place.
Financial transactions include issue of equity stock by a company, purchase of bonds in the
secondary market, deposit of money in a bank account, transfer of funds from a current account
to a savings account etc.
The participants in the financial markets are corporations, financial institutions, individuals and
the government. These participants trade in financial products in these markets. They trade
either directly or through brokers and dealers.
In short, financial markets are markets that deal in financial assets and credit instruments.
Functions of Financial Markets: The main functions of financial markets are outlined as below:
1. To facilitate creation and allocation of credit and liquidity.
2. To serve as intermediaries for mobilization of savings.
3. To help in the process of balanced economic growth.
4. To provide financial convenience.
5. To provide information and facilitate transactions at low cost.
6. To cater to the various credits needs of the business organizations.
Classification of Financial Markets: There are different ways of classifying financial
markets. There are mainly five ways of classifying financial markets.
1. Classification on the basis of the type of financial claim: On this basis, financial markets
may be classified into debt market and equity market.
• Debt market: This is the financial market for fixed claims like debt instruments.
• Equity market: This is the financial market for residual claims, i.e., equity instruments.
2. Classification on the basis of maturity of claims: On this basis, financial markets may be
classified into money market and capital market.
• Money market: A market where short-term funds are borrowed and lend is called money
market. It deals in short term monetary assets with a maturity period of one year or less.
Liquid funds as well as highly liquid securities are traded in the money market. Examples
of money market are Treasury bill market, call money market, commercial bill market etc.
The main participants in this market are banks, financial institutions and government. In
short, money market is a place where the demand for and supply of short-term funds are
met.

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• Capital market: Capital market is the market for long term funds. This market deals in the
long-term claims, securities and stocks with a maturity period of more than one year. It is
the market from where productive capital is raised and made available for industrial
purposes. The stock market, the government bond market and derivatives market are
examples of capital market. In short, the capital market deals with long term debt and stock.
3. Classification on the basis of seasoning of claim: On this basis, financial markets are
classified into primary market and secondary market.
• Primary market: Primary markets are those markets which deal in the new securities.
Therefore, they are also known as new issue markets. These are markets where securities
are issued for the first time. In other words, these are the markets for the securities issued
directly by the companies. The primary markets mobilize savings and supply fresh or
additional capital to business units. In short, primary market is a market for raising fresh
capital in the form of shares and debentures.
• Secondary market: Secondary markets are those markets which deal in existing securities.
Existing securities are those securities that have already been issued and are already
outstanding. Secondary market consists of stock exchanges. Stock exchanges are self-
regulatory bodies under the overall regulatory purview of the Govt. /SEBI.
4. Classification on the basis of structure or arrangements: On this basis, financial markets
can be classified into organized markets and unorganized markets.
• Organized markets: These are financial markets in which financial transactions take place
within the well-established exchanges or in the systematic and orderly structure.
• Unorganized markets: These are financial markets in which financial transactions take
place outside the well-established exchange or without systematic and orderly structure or
arrangements.
5. Classification on the basis of timing of delivery: On this basis, financial markets may be
classified into cash/spot market and forward / future market.
• Cash / Spot market: This is the market where the buying and selling of commodities
happens or stocks are sold for cash and delivered immediately after the purchase or sale of
commodities or securities.
• Forward/Future market: This is the market where participants buy and sell
stocks/commodities, contracts and the delivery of commodities or securities occurs at a pre-
determined time in future.
6. Other types of financial market: Apart from the above, there are some other types of

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financial markets. They are foreign exchange market and derivatives market.
• Foreign exchange market: Foreign exchange market is simply defined as a market in
which one country’s currency is traded for another country’s currency. It is a market for
the purchase and sale of foreign currencies.
• Derivatives market: The derivatives are most modern financial instruments in hedging
risk. The individuals and firms who wish to avoid or reduce risk can deal with the others
who are willing to accept the risk for a price. A commonplace where such transactions take
place is called the derivative market. It is a market in which derivatives are traded. In short,
it is a market for derivatives. The important types of derivatives are forwards, futures,
options, swaps, etc.
4. Functions and Significance of Primary Market
Primary Market
• Primary market deals with the securities which are issued for the first time in the market
and is also known as new issues market.
• Banks, financial institutions, insurance companies, mutual funds and individuals are the
main participants in the primary market.
Features of primary markets include:
• the securities are issued by the company directly to the investors.
• The company receives the money and issues new securities to the investors.
• The primary markets are used by companies for the purpose of setting up new ventures/
business or for expanding or modernizing the existing business
• Primary market performs the crucial function of facilitating capital formation in the
economy
Methods of Floatation
• Offer through prospectus: The public companies issue prospectus to raise funds from
the public by issuing financial instruments like shares, debentures, etc., through an
advertisement in the newspaper and magazines.
• Offer for sale: Public companies offer securities for sale to the brokers or issuing
houses at an agreed price and in turn, these intermediaries resell them to the investors.
• Private placement: Private placement means issue and allotment of shares to the
selected individuals and companies privately and not to the general public through
public issue.

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 • Rights issue: Rights issue refers to issue of new shares to the existing shareholders in
accordance to the terms and conditions of the company.
• e-IPOs: A company can raise funds by issuing capital to the public through the online
system of stock exchange and this is called an initial public offer (IPO).
Functions significance of Primary Market
(1) Mobilization of Funds – Primary market plays intermediary role between the public and
companies. It is a platform whereby savings of individual become the source of funds for the
companies. This transmission of funds creates a win win situation for both the parties because
savers idle money generates earning for them in the form of dividend or interest and companies
‘capital needs also get fulfilled.
(2) Capital Formation – Large companies require huge amount of funds for their successful
operation such as expansion programs etc. Primary market helps companies in the acquisition
of required funds from the public across the country / world by issuing securities.
(3) Origination – Raising money from the open market is an irreversible and risky job as it
requires huge amount of time and money. Therefore, companies have to be very careful while
acquiring money from the market. Origination is the most prominent step wherein specialised
agencies investigate the technical, economic, financial and legal aspects of the company and
find out the answer of following questions –
• Type of instruments to be issued – There are many instruments available in the market i.
e. equity shares, debentures, preference shares etc. Every instrument has its pros and cons
such as preference shares have to be redeemed after the expiry of stipulated time,
debentures demand regular interest payment and redemption as well and equity shares
increase holders ‘interference in the companies ‘working. So first of all, Companies must
choose the most suitable instrument for the acquisition of capital.
• Selling price of an Instrument – Price at which securities must be offered to the public is
a very crucial decision. Companies while choosing the selling price must consider their
own goodwill.
• Timings – Companies must consider the economic condition of the market while issuing
new securities in the market.
(4) Underwriting – It is an agreement wherein financial institutions known as underwriters
guarantee the issuer for buying unsold portion of the issue size.
(5) Distribution – This is the last function of primary market (performed by brokers or agents)
which includes the delivery of securities from the issuer to the buyer

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Significance of Primary Market
Companies can raise capital at relatively low cost, and the securities so issued in the primary
market provide high liquidity as the same can be sold in the secondary market almost
immediately. The primary market is an important source for mobilization of savings in an
economy. Funds are mobilised from commoners for investing in other channels. It leads to
monetary resources being put into investment options.
The chances of price manipulation in the primary market are considerably less when compared
to the secondary market. Such manipulation usually occurs by deflating or inflating a security
price, thereby deliberately interfering with fair and free operations of the market. The primary
market acts as a potential avenue for diversification to cut down on risk. It enables an investor
to allocate his/her investment across different categories involving multiple financial
instruments and industries. It is not subject to any market fluctuations. The prices of stocks are
determined before an initial public offering, and investors know the actual amount they will
have to invest.
Functions and Significance of Secondary Market
The secondary market, also known as the aftermarket, is a financial market where investors
buy and sell previously issued securities, such as stocks, bonds, options, and futures contracts.
It is a market where securities that were previously sold in the primary market are traded among
investors rather than being sold directly by the issuing company.
The secondary market provides investors with liquidity, enabling them to sell their securities
easily and quickly if they need to raise cash. Additionally, it allows investors to buy securities
to add to their portfolio, adjust their asset allocation, or hedge against market risks.
The secondary market works by providing a platform for investors to buy and sell previously
issued securities, such as stocks, bonds, options, and futures contracts. These securities are
typically issued by companies or governments in the primary market and are subsequently
traded on the secondary market. In the secondary market, investors can buy and sell securities
based on the prices determined by supply and demand; if there is high demand for a security,
its price increases, and if there is low demand, its price decreases. This dynamic pricing
mechanism helps to ensure that securities are priced efficiently and that investors receive fair
value for their investments.
Types of secondary market
Primarily there are two types of secondary market – stock exchanges and over-the-counter
markets. However, they are a fraction of the secondary market.

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• Stock exchange: Stock exchanges are centralized platforms where the trading of securities
is executed, without any connection or contact between the buyer and seller. National Stock
Exchange (NSE), Bombay Stock Exchange (BSE), New York Stock Exchange (NYSE)
and NASDAQ are some examples of such platforms. Trading of securities in stock
exchanges are subject to stringent regulations for the safety of investors transactions. Stock
exchanges guarantee trades that have less interstate fraud or manipulation.
• Over-the-Counter (OTC) Market: Over-the-counter (OTC) markets are decentralized
markets where participants engage in trading directly with each other. As a result,
unregulated OTC market traders have to deal directly with counterparty risks in absence of
regulatory oversight. FOREX or Foreign Exchange Market is an example of the OTC
market. As it is an unregulated market, both parties are exposed to inherent risks.
• Stock market and OTC constitute only a fraction of the secondary markets. Apart from it,
other options like fractional ownership in commercial real estate, auction, etc. are available
in the market. Unconventional assets like CRE and unlisted shares offer higher returns than
these assets
Functions of Secondary Market
Secondary markets perform some very important economic activities. Some of these are as
follows −
1. Maintaining the Fair Price of Shares: The secondary market is a market of already issued
securities after the initial public offering (IPO). Capital markets run on the basis of supply
and demand of shares. Secondary markets maintain the fair price of shares depending on
the balance of demand and supply. As no single agent can influence the share price, the
secondary markets help keep the fair prices of securities intact.
2. Offering Liquidity and Marketability: Second-hand shares are of no use if they cannot
be sold and bought for liquid cash whenever needed. The shareholders usually use the share
markets as the place where there is enough liquidity and marketability of shares. That
means that the secondary markets play the role of a third party in the exchange of shares.
3. Without a secondary market, the buyers and sellers would be left with a self-exchange in
one-to-one mode that is not quite effective till now. Therefore, the secondary market is a
facilitating body of liquidity and marketability for the shareholders.

4. Facilitating Capital Allocation :Secondary markets facilitate capital allocation by price

signalling for the primary market. By signalling the prices of shares yet to be released in
the secondary market, the secondary markets help in allocating shares.

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5. Adjusting the Portfolios: Secondary markets allow investors to adapt to adjusting
portfolios of securities. That is, the secondary markets allow investors to choose shares for
buying as well as for selling to build a solid portfolio of shares that offers maximum returns.
Investors and shareholders can change their investment portfolios in secondary markets
that cannot be done anywhere else.

Significance of Secondary Market Transactions

Secondary market transactions offer several advantages for investors, issuers, and the overall
financial system. Here are some of the key advantages:

1. Liquidity: The secondary market provides liquidity for investors by allowing them to
easily buy and sell previously issued securities. This makes it easier for investors to adjust
their portfolios in response to changing market conditions and allows them to access cash,
if needed, quickly.
2. Price discovery: The secondary market facilitates price discovery by allowing investors
to trade securities based on the supply and demand dynamics of the market. This helps to
ensure that securities are priced efficiently and that investors receive fair value for their
investments.
3. Transparency: Secondary market transactions are often transparent, with information
about the securities, the issuers, and the trading volume readily available to investors. This
helps to ensure that investors are well-informed and can make informed decisions about
their investments.
4. Risk transfer: The secondary market allows investors to transfer risk by buying and
selling securities. For example, an investor who owns a stock and is concerned about a
potential market downturn can sell the stock to another investor, thereby transferring the
risk to the new owner.
5. Capital raising: It can also facilitate capital raising by allowing companies to issue new
securities to raise funds from investors. This can be done through follow-on offerings or
secondary offerings.
6. Diversification: It provides investors with a wide range of investment opportunities,
which allows them to diversify their portfolios and potentially earn higher returns.
Functions and Significance of Capital Market
There are many persons or organizations that require capital. Similarly, there are several
persons or organizations that have surplus capital. They want to dispose of (or invest) their
surplus capital. Capital market is a meeting place of these two broad categories of persons or

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organizations.
Meaning and Definition of Capital Market
Capital market simply refers to a market for long term funds. It is a market for buying and
selling of equity, debt and other securities. Generally, it deals with long term securities that
have a maturity period of above one year.
Capital market is a vehicle through which long-term finance is channelized for the various
needs of industry, commerce, govt. and local authorities.
Thus, capital market may be defined as an organized mechanism for the effective and smooth
transfer of money capital or financial resources from the investors to the entrepreneurs.
Functions of Capital Markets
The capital markets serve several important functions that contribute to the efficient allocation
of capital and facilitate economic growth. Here are the key functions of capital markets:
1. Capital Formation: Capital markets provide a platform for companies, governments, and
other entities to raise long-term capital by issuing stocks, bonds, and other securities. This
enables them to finance investments, expand operations, fund projects, and support
economic development.
2. Investment Opportunities: Capital markets offer a wide range of investment opportunities
to individuals and institutions. Investors can participate in the capital market by purchasing
securities and earning returns through dividends, interest payments, and capital
appreciation.
3. Liquidity Provision: Capital markets provide liquidity, allowing investors to buy and sell
securities easily. The secondary market facilitates the transfer of securities, enabling
investors to convert their investments into cash when needed.
4. Price Discovery: Capital markets help in determining the fair prices of securities through
the interaction of buyers and sellers. The forces of supply and demand in the market
determine the prices, reflecting the perceived value and market sentiment.
5. Risk Management: Capital markets provide instruments such as derivatives that enable
investors to manage risks associated with price fluctuations, interest rate changes, and other
market uncertainties. Hedging and risk transfer mechanisms offered by capital markets help
in mitigating risk exposure.
6. Efficient Allocation of Capital: Capital markets play a crucial role in allocating capital to
its most productive uses. Investors direct funds towards companies and projects with strong
growth prospects, contributing to economic efficiency and resource allocation.
7. Wealth Creation and Distribution: Capital markets allow individuals and institutions to

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 participate in wealth creation. Through investments in securities, investors have the
opportunity to earn returns and accumulate wealth, which can contribute to wealth
distribution and economic inclusiveness.
8. Corporate Governance and Transparency: Capital markets promote corporate
governance practices by requiring listed companies to adhere to disclosure and reporting
standards. This enhances transparency, accountability, and investor confidence in the
financial system.
Overall, the functions of capital markets are essential in mobilizing savings, facilitating
investment, managing risks, allocating capital efficiently, and supporting economic growth
and development.
Importance of Capital Market
The importance of capital market is outlined as below:
1. Mobilization of savings: Capital market helps in mobilizing the savings of the country. It
gives an opportunity to the individual investors to employ their savings in more
productive channels.
2. Capital formation: large amount is required to invest in infrastructural foundation. Such a
large amount cannot be collected from one individual or few individuals. Capital market
provides an opportunity to collect funds from a large number of people who have investible
surplus. In short, capital market plays a vital role in capital formation at a higher rate.
3. Economic development: With the help of capital market, idle funds of the savers are
channelized to the productive sectors. In this way, capital market helps in the rapid
industrialization and economic development of a country.
4. Integrates different parts of the financial system: The different components of the
financial system includes new issue market, money market, stock exchange etc. It is the
capital market which helps to establish a close contact among different parts of the financial
system. This is essential for the growth of an economy.
5. Promotion of stock market: A sound capital market promotes an organized stock
market. Stock exchange provides for easy marketability to securities. A readymade market
is available to buyers and sellers of securities.
6. Foreign capital: Multinational Corporations and foreign investors will be ready to invest
in a country where there is a developed capital market. Thus capital market not only helps
in raising foreign capital but the foreign technology also comes within the reach of the local
people.
7. Economic welfare: Capital market facilitates increase in production and productivity in

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 the economy. It raises the national income of the country. In this way, it helps to promote
the economic welfare of the nation.
8. Innovation: Introduction of a new financial instrument, finding new sources of funds,
introduction of new process etc. are some of the innovations introduced in capital market.
Innovation ensures growth.
Functions and Significance of Money Market
Money market is the market for dealing in monetary assets of short-term nature. Short term
funds up to one year and financial assets that are close substitutes for money are dealt in the
money market. In other words, it refers to the institutional arrangements facilitating borrowing
and lending of short-term funds. The money market brings together the lenders who have
surplus short term investible funds and the borrowers who are in need of short-term funds.
The money market is thus a reservoir of short-term funds. It is a region where short term funds
are bought and sold through telephone or mail. Funds are borrowed in the market for a short
period ranging from a day to six months or less than one year. The assets which are used as
credit instruments are known as “near money assets.”
Some of the common instruments of the money market are Call Money, Commercial Bills, T.
Bills, Commercial Paper, Certificates of Deposits, etc.
Some of the features of a Money Market are as follows:
1. It is a market for the short term.
2. There is no fixed geographical location of a money market.
3. Some of the common instruments of the money market are Call Money, Commercial Bills,
Certificates of Deposits, etc.
4. Some of the major institutions involved in the money market are LIC, GIC, RBI, Commercial
Banks, etc.
Some of the Instruments of Money Market are as follows:
1. Call Money: The money borrowed or lent on demand for a short period of time (generally
one day) is known as Call Money. The term of the call money does not include Sundays and
other holidays. It is used mostly by banks. It means that when one bank faces a temporary
shortage of cash then the bank with surplus cash lends the former bank with money for one or
two days. It is also known as Interbank Call Money Market.
2. Treasury Bills (T. Bills): On behalf of the Government of India, Treasury Bills are issued
by the Reserve Bank of India (RBI). With the help of T. Bills, the Government of India can get
short-term borrowings as they are sold to the general public and banks. The Treasury Bills are

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freely transferable and negotiable instruments and are issued at a discount. As Treasury Bills
are issued by the Reserve Bank of India, they are considered the safest investments. The
maturity period of the Treasury Bills varies from 14 days to 364 days.
3. Commercial Bills: Commercial Bills also known as Trade Bills or Accommodation Bills
are the bills drawn by one organisation on another. Commercial Bills are the common
instruments of the money market which are used in credit sales and purchases. The maturity
period of commercial bills is for short-term, generally of 90 days. However, one can get the
commercial bills discounted with the bank before the maturity period. The Trade Bills are
negotiable and easily transferable instruments.
4. Commercial Paper: An unsecured promissory note issued by private or public sector
companies with a fixed maturity period varying from 15 days to one year, is known as a
Commercial Paper. It was for the first time introduced in India in 1990. As this instrument is
unsecured, it can be issued by companies with creditworthiness and good reputation. The main
investors of commercial papers are commercial banks and mutual funds.
5. Certificate of Deposits: A time or deposit that can be sold in the secondary market is known
as a Certificate of Deposits (C.D.). It can be issued by a bank only and is a bearer certificate or
document of title. A Certificate of Deposits is a negotiable and easily transferable instrument.
The banks issue the Certificate of Deposits against the deposit kept by the institutions and
companies. The time period of a Certificate of Deposits ranges from 91 days to one year. The
C.D.’s can be issued to companies, corporations, and individuals during a period of tight
liquidity. It is that time when the bank’s deposit growth is slow, but the credit demand is high.
Functions of a Money Market:
A money market performs a number of functions in an economy.
1. Provides Funds: It provides short-term funds to the public and private institutions needing
such financing for their working capital requirements. It is done by discounting trade bills
through commercial banks, discount houses, brokers and acceptance houses. Thus the money
market helps the development of commerce, industry and trade within and outside the country.
2. Use of Surplus Funds: It provides and opportunity to banks and other institutions to use
their surplus funds profitably for a short period. These institutions include not only commercial
banks and other financial institutions but also large non-financial business corporations, states
and local governments.
3. No Need to Borrow from Banks: The existence of a developed money market removes the
necessity of borrowing by the commercial banks from the central bank. If the former find their
reserves short of cash requirements they can call in some of their loans from the money market.

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The commercial banks prefer to recall their loans rather than borrow from the central banks at
a higher rate of interests.
4. Helps Government: The money market helps the government in borrowing short-term
funds at low interest rates on the basis of treasury bills. On the other hand, if the government
were to issue paper money or borrow from the central bank. It would lead to inflationary
pressures in the economy.
5. Helps in Monetary Policy: A well-developed money market helps in the successful
implementation of the monetary policies of the central bank. It is through the money market
that the central banks is in a position to control the banking system and thereby influence
commerce and industry.
6. Helps in Financial Mobility: By facilitating the transfer for funds from one sector to
another, the money market helps in financial mobility. Mobility in the flow of funds is essential
for the development of commerce and industry in an economy.
7. Promotes Liquidity and Safety: One of the important functions of the money market is that
it promotes liquidity and safety of financial assets. It thus encourages savings and investments.
8. Equilibrium between Demand and Supply of Funds: The money market brings
equilibrium between the demand and supply of loanable funds. This it does by allocating saving
into investment channels. In this way, it also helps in rational allocation of resources.
9. Economy in Use of Cash: As the money market deals in near-money assets and not money
proper, it helps in economising the use of cash. It thus provides a convenient and safe way of
transferring funds from one place to another, thereby immensely helping commerce and
industry.
Significance of Money Market
1. Provides funds on a short notice: Money markets allow investors to withdraw their funds
on very short notice. Hence, it is advised that institutions borrow funds from the market
instead of borrowing from banks, as the process is hassle-free and the interest rate is also
lower than that of commercial loans. Sometimes, commercial banks also use these money
market instruments to maintain the minimum cash reserve ratio as per the RBI guidelines.
2. Utilisation of surplus funds: Money Market makes it easier for investors to dispose of
their surplus funds while retaining their liquid nature and offering significant profits on the
same. It facilitates investors’ (such as banks, non-financial corporations, state and local
government) savings into investment channels.
3. Financial mobility: The money market enables financial mobility to investors by allowing
easy transfer of funds from one sector to another, thereby ensuring transparency in the

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 system. High financial mobility is important for the overall growth of the economy as it
promotes industrial and commercial development.
4. Implementation of monetary policies: A developed money market helps RBI in
efficiently implementing monetary policies. Transactions in the money market affect short
term interest rate which gives an overview of the current monetary and banking state of the
country. This further helps RBI in formulating the future monetary policy, deciding long
term interest rates, and creating suitable banking policy.

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