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An institutional framework existing in a country to enable financial transactions Three main parts

Financial assets (loans, deposits, bonds, equities, etc.) Financial institutions (banks, mutual funds, insurance

companies, etc.)

Financial markets (money market, capital market, forex market, etc.)

Regulation is another aspect of the financial system (RBI,

SEBI, IRDA) Channel that enables transfer of funds from the savers to



Funds flow from lenders to borrowers Creating liquidity and money

Providing a payments mechanism

Providing financial services

Portfolio management


Enable channelizing funds from surplus units to deficit units

Instruments for savers - deposits, equities, mutual fund units, etc. Instruments for borrowers - loans, overdrafts, etc.
Governments too raise funds through issuance of bonds, Treasury bills, etc. Instruments like PPF are available to savers who wish to lend money to the government


Includes institutions and mechanisms which

Affect generation of savings by the community Mobilization of savings Effective distribution of savings

Institutions are banks, insurance companies, mutual funds - promote/mobilize savings

Individual investors, industrial and trading companies - borrowers


Organizational framework within which financial instruments can be bought or sold Segments based on Time to Maturity - Money market and Capital market

Primary market and Secondary market

Foreign Exchange markets Credit markets Commodity markets Derivatives markets


Mechanism that deals with lending and borrowing of shortterm funds less than one year

Financial instruments with high liquidity and very short maturities are traded
Participants Government, Central Bank, Banks, Fis, Corporates, Other institutional bodies (MFs, FIIs), Dealers Objectives To provide a parking place to employ short-term funds, a room for overcoming short-term deficits, to enable the central bank to influence and regulate liquidity in the economy through its intervention in this market, provide a reasonable access to users of short-term funds to meet their requirement quickly, adequately at reasonable cost


Certificates of Deposit Commercial Paper Inter-bank participation certificates Treasury Bills Bill rediscounting Call/notice/term money CBLO Market Repo Money market mutual funds


Aims at financing long-term investments Refers to all the facilities and the institutional arrangements for borrowing and lending term funds Backbone of the capital market various securities exchanges that provide a forum for equity (equity market) and debt (debt market transactions) Comprises

New issue / primary market / IPO market Stock / securities exchanges / markets (secondary markets)


Primary Market

Markets that involve the issue of new securities by the borrower in return for cash from investors (Capital formation occurs)

Secondary Market

Markets that involve buyers and sellers of existing securities. Funds flow from buyer to seller. Seller becomes the new owner of the security. (No capital formation occurs)



Forum where the currency of one country is traded for the currency of another country Foreign currency requirements payment for imports, foreign direct investment, lendings World wide markets and the worlds largest financial markets Main Participants

Commercial banks At the retail level for individual exporters and

corporations and at wholesale levels in the inter bank market Foreign exchange brokers involve either individual brokers or corporations. Bank dealers often use brokers to stay anonymous since the identity of banks can influence short term quotes Monetary authorities mainly involve the central banks of various countries, which intervene in order to maintain or influence the exchange rate of their

currencies within a certain range and also to execute the orders of the


Govt securities - Marketable debt issued by the government and semigovernment bodies which represent a claim on the government Most important and unique financial instruments in the financial markets in any economy Also referred to as Gilt-edged securities Loans floated by the govt, become a part of national debt of the country and

payment of interest on them and also their repayment becomes first charge on
the nationss purse

Absence of default risk regarded as risk-free investments Issued by central and state govts, semi-govt authorities and govt financial institutions Play a vital role in the open market operations conducted by the central bank of the country


You [along with two friends] want to go for a show, for which tickets are sold out. Through one of your close friends, you obtain a recommendation letter, which will enable you to buy three tickets. The price of a ticket is Rs 1,000. Which is the commodity that you are supposed to buy? In order to buy the________ what is required now? Money / recommendation letter (instrument) or both? The recommendation letter is a derivative instrument. It gives you a right to buy the ticket

The underlying asset is the ticket

The letter does not constitute ownership of the ticket It is indeed a promise to convey ownership The value of the letter changes with changes in the price of the ticket. It derives its value from the value of the ticket

What are derivatives? A derivative contract is a financial instrument whose payoff structure is derived from the value of the underlying asset Derivatives are synthetic instruments they derive their value from an underlying asset class They have no independent value

They are leveraged products

They are not always priced at respective asset value As per Securities Contracts (Regulations) Act derivative includes a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; a contract which derives its value from the prices, or index of prices, of underlying securities


The underlying asset may assume many forms:

Commodities including grain, coffee beans, orange juice; Precious metals like gold and silver; Foreign exchange rates or currencies; Bonds of different types, including medium to long term negotiable debt securities issued by governments, companies, etc. Shares and share warrants of companies traded on recognized stock exchanges and Stock Index Short term securities such as T-bills; and Over- the Counter (OTC) money market products such as loans or deposits

Derivative means a forward, future, option or any other hybrid contract of predetermined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities Participants hedgers, speculators, arbitrageurs OTC and Exchange-traded derivatives



Prior to 1980, national markets were largely independent of each other and financial intermediaries in each country operated principally in that country Globalization of financial markets during the eighties has been driven by two underlying forces Growing (and continually shifting) imbalance between savings and investment within individual countries, reflected in their current account balances, has necessitated massive cross-border financial flows

For instance, during the late seventies, the massive surpluses of the OPEC countries had to be recycled, i.e. fed back into the economies of oil importing nations During the eighties, the large current account deficits of the US had to be financed primarily from the mounting surpluses in Japan and Germany


Increasing preference on the part of investors for international diversification of their asset portfolios, resulting in gross cross-border financial flows Significant risk reduction possible via global diversification of portfolios Demand-side forces accompanied by liberalization and geographical integration of financial markets has led to enormous growth in crossborder financial transactions Most important international financial centers are London, Tokyo and New York Two sources of capital private and public Private sources - Foreign direct investment and Portfolio investment (both debt and equity flows) Public sources of capital - Official non-concessional loans of both multilateral and bilateral aid and Official development assistance (ODA)


International Equity markets - Global depository receipts (GDRs) / American Depository Receipts (ADRs), Foreign Currency Convertible Bonds (FCCBs), External Commercial Borrowings (ECBs) International Debt markets Foreign Bonds and Euro bonds Euro-currency markets Eurocurrency is a dollar or other freely convertible currency deposited in a bank outside the country of its origin. Thus US dollars on deposit in London become Eurodollars. Eurocurrency market consists of those banks called Euro banksthat accept deposits and make loans in foreign currencies. Eurocurrency markets enables investors to hold short-term claims on commercial banks, which then act as intermediaries to turn these deposits into long term claims on final borrowers