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Amity Campus

Uttar Pradesh
India 201303
ASSIGNMENTS
PROGRAM: BFIA
SEMESTER-II
Subject Name:
Study COUNTRY:
Roll Number (Reg. No.):
Student Name:

FINANCIAL MARKETS & REGULATIONS


SOMALIA
BFIA01512010-2013019
MOHAMED ABDULLAHI KHALAF

INSTRUCTIONS
a) Students are required to submit all three assignment sets.
ASSIGNMENT
Assignment A
Assignment B
Assignment C

DETAILS
Five Subjective Questions
Three Subjective Questions + Case Study
Objective or one line Questions

MARKS
10
10
10

b) Total weight-age given to these assignments is 30%. OR 30


Marks
c) All assignments are to be completed as typed in word/pdf.
d) All questions are required to be attempted.
e) All the three assignments are to be completed by due dates and
need to be submitted for evaluation by Amity University.
f) The students have to attach a scanned signature in the form.
Signature : _________________________
Date: 08. Jan. 2012
( ) Tick mark in front of the assignments submitted
Assignment A

Assignment B

Assignment C

FINANCIAL MARKETS & REGULATIONS


Assignment A
Q: 1).

What do you mean by Money Market and Money Market

instruments?
Answer:
Money market: is a market for short-term, high liquid debt securities with
maturities of less than one year. It is a highly liquid market wherein
securities are bought and sold in large denominations to reduce
transaction costs. Call money market, certificates of deposit, commercial
paper, and treasury bills are the major instruments of the money market.
Money market is a very important segment of the financial system of a
country. It is the market 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.
The money market functions include:
a) Money markets serve as an equilibrating force that redistributes
cash balances in accordance with the liquidity needs of the
participants.
b) Money markets form a basis for the management of liquidity and
money in the economy by monetary authorities.
c) Money markets provide a reasonable access to the users of shortterm money for meeting their requirements at realistic prices.
d) As it facilitates the conduct of monetary policy, money markets
constitute a very important segment of the financial system.
Money market Instruments are short-term, low risk, high liquid financial
instruments such as treasury bills, call money, notice money, certificates
of deposit, commercial paper etc.
1) Call Money: is money borrowed or lent on demand for a very short
period. It is borrowed or lent for a day, and sometimes called as
Overnight Money. Intervening holidays or weekends are excluded for this
purpose. Thus money, borrowed on a day and repaid on the next working
day is Call Money.
2) Notice Money: is money borrowed or lent for up to 14 days. No
collateral security is required to cover these transactions.
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3) Inter-Bank Term Money: are deposits of maturity beyond 14 days.


The entry restrictions are the same as those for Call and Notice Money
except that, as per existing regulations, the specified entities are not
allowed to lend beyond 14 days.
4) Treasury Bills: is a document by which the Government borrows
money in the short term (up to one year). It is borrowing instruments of
the union Government. The Government promises to pay a stated sum
after expiry of the stated period from the date of issue (14/91/182/364
days i.e. less than one year). They are issued at a discount to the face
value, and on maturity the face value is paid to the holder. The rate of
discount and the corresponding issue price are determined at each
auction.
5) Certificate of Deposits (CDs): is a negotiable money market
instrument and issued in dematerialized form or as a usance Promissory
Note, for funds deposited at a bank or other eligible financial institution
for a specified time period. CDs are similar to traditional term deposits
but are negotiable and can be traded in the secondary market.
6) Commercial Paper (CP): is a note in evidence of the debt obligation
of the issuer. On issuing commercial paper the debt obligation is
transformed into an instrument. CP is thus an unsecured promissory
note privately placed with investors at a discount rate to face value
determined by market forces. CP is freely negotiable by endorsement and
delivery.
Q: 2).

Explain role of depositories.

Answer:
Depositories are organizations which hold securities of investors in
electronic form at the request of the investors through a registered
Depository Participant. It also provides services related to transactions in
securities.
In the Depository System, the securities of a shareholder are held in the
electronic form by conversion of physical securities to electronic form
through a process called 'dematerialization' (demat) of share certificates
and facilitates transactions electronically without involving any share
certificate or transfer deed.
Depository system is playing a significant role in stock markets around the
world and hence has become popular and prevalent in many advanced
countries.

Depository participants are associates of a depository through whom the


investor will hold the beneficiary account of the investors to enable them to
trade in dematerialized shares.
The SEBI (Depository and Participants) regulations specify the eligibility
requirements for a DP. Banks, financial institutions, brokers, custodians,
R&T agents, NBFCs among others are eligible to become DPs. Apart from
this, the DPs are required to have minimum net worth as specified by the
regulations.
Roles of Depository participants are as follow:
1) They are responsible for executing the investors directions on
delivery and receipt of shares from their beneficiary account to settle
the trades done on the secondary markets.
2) The Depository participants are Similar to brokers, who act on
behalf of a client in the stock market they are also representatives in
the depository system.
3) DP provides various services with regard to your holdings such as:
a)
Maintaining the securities account balances.
b) Enabling surrender (dematerialization) and withdrawal
(rematerialization) of securities to and from the depository.
c)
Delivering and receiving shares.
d) Keeping updated with regard to status of holdings periodically.
Q: 3).

What do you mean by Primary Market? Explain its

objectives.
Answer:
Financial markets are the mechanism enabling participants to deal in
financial claims. The markets also provide a facility in which their
demands and requirements interact to set a price for such claims.
Financial markets are classified as primary market and secondary market.
Primary Market: It is the market where new issues of securities are
offered to the investors. It deals in new issues. Primary market is a part of
capital market meant for new issues. In other words, the primary market
creates long-term instruments for borrowings. It is a market where
securities are issued for the first time. For example, when StarTek, Inc.
sold 4,370,000 new shares of its common stock in June 2004, it did so in
the primary markets. In 2004, U.S. corporations issued bonds worth $5.5
trillion, and more than 240 companies came to market for the first time
with initial public offerings worth $34 billion.
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The Primary Market consists of arrangements, which facilitate the


procurement of long term funds by companies by making fresh issue of
shares and debentures. Companies make fresh issue of shares and
debentures at their formation stage and, if necessary, subsequently for the
expansion of business. It is usually done through private placement to
friends, relatives and financial institutions or by making public issue. In
any case, the companies have to follow a well-established legal procedure
and involve a number of intermediaries such as underwriters, brokers, etc.
who form an integral part of the primary market.
The main objectives of primary markets are:
1) To provide mechanism for establishing new productive assets and
expanding those existing.
2) To stabilize the demand for and supply of productive assets.
3) To facilitate the procurement of long term funds by companies by
making fresh issue of shares and debentures.
Q: 4).

What is Monetary Policy? Explain its objectives, tools

and targets in detail.


Answer:
Monetary policy is the process by which the central bank or monetary
authority of a country controls the supply of money, availability of money,
and the cost of money or rate of interest to attain a set of objectives
oriented towards the growth and stability of the economy.
Monetary policy rests on the relationship between the rates of interest in
an economy and the total supply of money. It uses a variety of tools to
control one or both of these, to influence outcomes like economic growth,
lower inflation, exchange rates with other currencies and unemployment.
Monetary policy is referred to as either being an expansionary policy, or a
contractionary policy. Expansionary policy increases the total supply of
money in the economy, and the contractionary policy decreases the total
money supply. Expansionary policy is used to combat unemployment in a
recession by lowering interest rates, while contractionary policy involves
raising interest rates to combat inflation. A policy is referred to as
contractionary if it reduces the size of the money supply or raises the
interest rate. An expansionary policy increases the size of the money
supply, or decreases the interest rate. Furthermore, monetary policies are
described as accommodative, if the interest rate set by the central
monetary authority is intended to create economic growth, neutral, if it is
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intended neither to create growth nor combat inflation, or tight if intended


to reduce inflation.
Within almost all modern nations, special institutions have the task of
executing the monetary policy such as the Bank of England, the
European Central Bank, Reserve Bank of India, and the Federal Reserve
System in the United States, the Bank of Japan, the Bank of Canada or
the Reserve Bank of Australia. In general, these institutions are called
central banks and often have other responsibilities such as supervising the
smooth operation of the financial system.
Monetary Policy Objectives:
The main objectives of the monetary policy are as following;
1)
2)
3)
4)
5)

Price Stability.
Exchange Stability.
Increase in Capital Accumulation.
Higher Employment Level.
Increase in Rate of Economic Growth

The monetary policy is operated through the instruments of credit control.


These instruments are:
1)
2)
3)
4)
5)
6)
7)
8)
9)

Bank rate policy.


Open market operations.
Reserve requirements.
Rationing of credit.
Margin requirements.
Consumers selective credit control.
Direct action, moral persuasion and publicity.
Increasing interest rates by fiat.
Reducing the monetary base.

All have the effect of contracting the money supply; and, if reversed,
expand the money supply. During inflation, the measures are taken to
decrease the supply of money in circulation and during deflation; the
supply of money is increased by adopting the above methods.
The monetary policy has the following effects on the economy;
1) It brings the desirable changes in the price level.
2) It helps to maintain foreign exchange reserves at a desirable level.
3) It creates more employment opportunities because the central bank
can encourage the commercial banks to provide more loans to the
sectors where more persons can be employed.
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4) It can affect the rate of economic growth. This policy can facilitate
more effective use of the resources of the country.
Limitations of Monetary Policy
Objectives of monetary policy cannot be achieved successfully due to the
following limitations:
1) Commercial banks do not cooperate fully with the central bank.
2) Money market is not properly organized.
3) Some of the financial institutions are not under the control of the
central bank.
Some of Monetary policy tools are as follow:
1) Monetary base: Monetary policy can be implemented by changing
the size of the monetary base. This directly changes the total amount of
money circulating in the economy. A central bank can use open market
operations to change the monetary base. The central bank would buy/sell
bonds in exchange for hard currency. When the central bank
disburses/collects this hard currency payment, it alters the amount of
currency in the economy, thus altering the monetary base.
2) Reserve requirements: The monetary authority exerts regulatory
control over banks. Monetary policy can be implemented by changing the
proportion of total assets that banks must hold in reserve with the
central bank. Banks only maintain a small portion of their assets as cash
available for immediate withdrawal; the rest is invested in illiquid assets
like mortgages and loans. By changing the proportion of total assets to be
held as liquid cash, the Federal Reserve changes the availability of
loanable funds. This acts as a change in the money supply. Central
banks typically do not change the reserve requirements often because it
creates very volatile changes in the money supply due to the lending
multiplier.
3) Discount window lending: Many central banks or finance
ministries have the authority to lend funds to financial institutions within
their country. By calling in existing loans or extending new loans, the
monetary authority can directly change the size of the money supply.
4) Interest rates: The contraction of the monetary supply can be
achieved indirectly by increasing the nominal interest rates. This rate has
significant effect on other market interest rates, but there is no perfect
relationship. By raising the interest rates under its control, a monetary
authority can contract the money supply, because higher interest rates
encourage savings and discourage borrowing. Both of these effects reduce
the size of the money supply.
5) Currency board: A currency board is a monetary arrangement that
pegs the monetary base of one country to another, the anchor nation. As
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such, it essentially operates as a hard fixed exchange rate, whereby local


currency in circulation is backed by foreign currency from the anchor
nation at a fixed rate. Thus, to grow the local monetary base an
equivalent amount of foreign currency must be held in reserves with the
currency board. This limits the possibility for the local monetary
authority to inflate or pursue other objectives.
The primary tool of monetary policy is open market operations. This entails
managing the quantity of money in circulation through the buying and
selling of various credit instruments, foreign currencies or commodities. All
of these purchases or sales result in more or less base currency entering
or leaving market circulation.
Usually, the short term goal of open market operations is to achieve a
specific short term interest rate target. In other instances, monetary policy
might instead entail the targeting of a specific exchange rate relative to
some foreign currency or gold.
The other primary means of conducting monetary policy include: (i)
Discount window lending (lender of last resort); (ii) Fractional deposit
lending (changes in the reserve requirement); (iii) Moral suasion (cajoling
certain market players to achieve specified outcomes); (iv) "Open mouth
operations" (talking monetary policy with the market).
The central bank influences interest rates by expanding or contracting the
monetary base, which consists of currency in circulation and banks'
reserves on deposit at the central bank. The primary way that the central
bank can affect the monetary base is by open market operations or sales
and purchases of second hand government debt, or by changing the
reserve requirements. If the central bank wishes to lower interest rates, it
purchases government debt, thereby increasing the amount of cash in
circulation or crediting banks' reserve accounts. Alternatively, it can lower
the interest rate on discounts or overdrafts (loans to banks secured by
suitable collateral, specified by the central bank). If the interest rate on
such transactions is sufficiently low, commercial banks can borrow from
the central bank to meet reserve requirements and use the additional
liquidity to expand their balance sheets, increasing the credit available to
the economy. Lowering reserve requirements has a similar effect, freeing
up funds for banks to increase loans or buy other profitable assets.
A central bank can only operate a truly independent monetary policy when
the exchange rate is floating. If the exchange rate is pegged or managed in
any way, the central bank will have to purchase or sell foreign exchange.
These transactions in foreign exchange will have an effect on the monetary
base analogous to open market purchases and sales of government debt; if
the central bank buys foreign exchange, the monetary base expands, and
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vice versa. But even in the case of a pure floating exchange rate, central
banks and monetary authorities can at best "lean against the wind" in a
world where capital is mobile.
Monetary policy targets include:
1) Inflation targeting: Monetary policy targets to keep inflation under
a particular definition such as Consumer Price Index, within a desired
range. This is achieved through periodic adjustments to the Central
Bank interest rate target. The interest rate used is generally the
interbank rate at which banks lend to each other overnight for cash flow
purposes.
2) Price level targeting: Price level targeting is similar to inflation
targeting except that CPI growth in one year is offset in subsequent
years such that over time the price level on aggregate does not move.
3) Monetary aggregates: This is based on a constant growth in the
money supply. It focuses on monetary quantities. This approach was
refined to include different classes of money and credit (M0, M1 etc).
This approach is also called monetarism.
4) Fixed exchange rate: This policy is based on maintaining a fixed
exchange rate with a foreign currency. There are varying degrees of fixed
exchange rates, which can be ranked in relation to how rigid the fixed
exchange rate is with the anchor nation.
5) Gold standard: The gold standard is a system in which the price of
the national currency is measured in units of gold bars and is kept
constant by the daily buying and selling of base currency to other
countries and nationals. The selling of gold is very important for
economic growth and stability. This might be regarded as a special case
of the "Fixed Exchange Rate" policy. And the gold price might be
regarded as a special type of "Commodity Price Index".
Q: 5).

Explain theories which decide level of interest rate in

any economy.
Answer:
Interest is the price paid for borrowing money. It is expressed as a
percentage rate over a period of time. It is the price the borrowers must
pay to lenders to obtain the use of money for a period of time.
There are many interest rates, and all are affected by certain underlying
economic conditions including supply of and demand for money. When
those conditions change, all rates change together. The equilibrium rate of
Interest is also determined by the forces of demand and supply in the
market.
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Economists have different theories in the forces assumed to be behind the


supply of and demand for money. Here are four of those theories: classical
theory, liquidity preference theory, loanable funds theory, and rational
expectations theory.
1) The Classical Theory
This theory is associated with the names of Ricardo, Hume, Fisher and
other classical economists. It is a static theory, and according to it the rate
of interest is a real phenomenon in the sense that it is determined by the
real factors. It is the supply of savings and the demand for investment that
determine the equilibrium rate of The Interest. The classical theory focused
on household savings as the primary source of the supply of money and
upon business investment as the primary demand. According to this
theory, households individuals and families change their level of
savings as interest rates change. This is because they view interest
earnings as a reward for deferring consumption. Households save more
when rates rise and save less as rates fall.
2) Keynesian Theory (Liquidity Preference)
The Keynesian theory was introduced by great economist John Maynard
Keynes in the twentieth century in response to changes in the economic
environment and to omissions of the classical theory. As the banking
system grew in importance, it was observed that banks, through their
money creation process, were important suppliers of money. In addition,
time value of money theory was developed and the relationship between
interest rates and security prices became understood.
This theory represents another extreme approach to the determination of
interest rate. According to Keynes, interest rate is a purely monetary
phenomenon. This means that the rate of interest, at least in the short
run, is determined by the monetary factors. It depends on the actions of
the monetary authorities The central bank and the Government and on
the attitude of the economic units towards holding money as an alternative
to holding bonds. In other words, interest rate is determined by the
interaction between the supply of money and demand for it to hold in the
economic system.
The rate of interest is the reward offered to people to influence them to
hold securities instead of cash. Cash is perfectly liquid and safe in the
sense that there is no danger of physical deterioration or capital loss. On
the other hand, securities can and do vary in value and, therefore, there is
a risk of incurring capital loss when securities are held rather than cash.
Interest is the difference between the yield on safe money and the yield on
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risky securities. It arises or exists as a price or inducement for giving up


liquidity of holding money in favour of holding securities.
Keynes suggested that the primary reason individuals demanded money
was their desire for liquidity, the ability to access their cash quickly and
without loss.
As interest rates rise, security prices will fall and investors will hold less
cash as they invest in the lower-priced securities. At very high interest
rates, investors will hold little cash. High interest rates are thus the
reward demanded by investors to surrender their liquidity.
3) Loanable Funds Theory
Both the classical and liquidity preference theories have major limitations.
The classical theory is generally considered a long-run theory. It is not very
good at explaining short-run rate movements since it is based on savings
habits and investment productivity, factors that are believed to be slow in
changing. By contrast, liquidity preference is seen as a short-run theory,
unable to explain long-run interest rate trends, because it ignores
(implicitly holds as constant) important macroeconomic variables such as
income, investment, and price levels. In the 1960s and 1970s, a third
theory, the loanable funds theory, was developed to provide a more general
and comprehensive explanation of the base level of interest rates.
This theory of interest rate determination is a dynamic theory opposed to
the static nature of the classical theory. It also combines real and
monetary factors as determinants of the rate of interest. Further, it takes a
short run view of the process of interest rate determination in place of the
secular or long run view taken by the classical theory.
Once the dynamic assumptions are made regarding the creation of money
and credit, the following two positions of classical interest theory
necessarily need to be modified:
a) Though interest is paid in money terms on money loans and assets,
the level of interest rate has nothing to do with the levels of money
and prices. And
b) The commercial banks are a mere conduit for the more efficient
channeling of saving into the best investment outlets; they cannot
affect the level of interest rate.
The aggregate supply of loanable funds is the sum of the quantity supplied
by the separate fund supplying sectors (e.g. households, business,
governments, foreign agents). Similarly, aggregate demand for loanable
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funds is the sum of the quantity demanded by the separate fund


demanding sectors.
Whenever the rate of interest is set higher than the equilibrium rate, the
financial system has a surplus of loanable funds. As a result, some
suppliers of funds will lower the interest rate at which they are willing to
lend and the demanders of funds will absorb the loanable funds surplus.
In contrast, when the rate of interest is lower than the equilibrium interest
rate, there is shortage of loanable funds in the financial system.
4) Rational Expectations Theory
In recent years, concepts of market efficiency have been applied to interest
rates.
The rational expectations theory argues that the market for money
displays the same efficiency often ascribed to the market for securities.
Investors are rational in that they promptly and accurately assess the
meaning of any newly received information which bears upon interest
rates. Interest rates therefore reflect all publicly known information, are
always at equilibrium levels, and change promptly as new information
arrives.
Rational expectations theory is the most general of all the explanations of
the base level of interest rates. No underlying relationships are specified.
No data are identified as particularly important. The theory simply states
that if a piece of information is meaningful to financial market
participants, they will promptly incorporate it into their analyses and it will
just as quickly be reflected in interest rates.

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Assignment B
Q: 1).

What do you mean by Financial System? Explain in detail.

Answer:
Financial System is a popularly known term consisting of two sub terms,
namely; Finance and System.
In order to understand better the term Financial System we have to
define each of these sub terms.
Firstly, the term "finance" in its simplest meaning is equivalent to 'Money'.
In other words most people perceive finance and money interchangeable.
But finance exactly is not money; it is the source of providing funds for a
particular activity. Thus public finance does not mean the money with the
Government, but it refers to sources of raising revenue for the activities
and functions of a Government.
Finance is the study and practice of how money is raised and used by
organizations. It is a discipline concerned with determining value and
making decisions. The finance function allocates resources, which includes
acquiring, investing, and managing resources.
Secondly, the word "system", in the term "financial system", implies a set
of complex and closely connected or interlined institutions, agents,
practices, markets, transactions, claims, and liabilities in the economy.
Financial system is a group of interrelated and interacting institutions in
the economy that help to match one persons saving with another persons
investment.
The term financial system is a set of inter-related activities/services
working together to achieve some predetermined purposes or goals. It
includes different markets, institutions, instruments, services and
mechanisms which influence the generation of savings, investment, capital
formation and economic growth.
Van Horne defined the financial system as the purpose of financial
markets to allocate savings efficiently in an economy to ultimate users
either for investment in real assets or for consumption.
Christy has opined that the objective of the financial system is to "supply
funds to various sectors and activities of the economy in ways that promote
the fullest possible utilization of resources without the destabilizing
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consequence of price level changes or unnecessary interference with


individual desires."
According to Robinson, the primary function of the system is "to provide a
link between savings and investment for the creation of new wealth and to
permit portfolio adjustment in the composition of the existing wealth."
From the above definitions, it may be said that the primary function of the
financial system is the mobilization of savings, their distribution for
industrial investment and stimulating capital formation to accelerate the
process of economic growth.
A financial system provides services that are essential in a modern
economy.
The use of a stable, widely accepted medium of exchange reduces the costs
of transactions. It facilitates trade and therefore, specialization in
production.
A financial system plays a vital role in the economic growth of a country. It
intermediates with the flow of funds between those who save a part of their
income to those who invest in productive assets. It mobilizes and usefully
allocates scarce resources of a country. A financial system is a complex
well integrated set of sub systems of financial institutions, markets,
instruments and services which facilitates the transfer and allocation of
funds, efficiently and effectively.
The financial system is possibly the most important institutional and
functional vehicle for economic transformation. Finance is a bridge
between the present and the future and whether it be the mobilization of
savings or their efficient, effective and equitable allocation for investment,
it is the success with which the financial system performs its functions
that sets the pace for the achievement of broader national objectives.
The formal financial system consists of these four segments or
components: Financial Institutions, Financial markets, financial
instruments and financial services.
Financial Institutions are intermediaries that mobilize savings and
facilitate the allocation of funds in an efficient manner.
Financial institutions can be classified as banking and non banking
financial institutions. Banking institutions are creators of credit while nonbanking financial institutions are purveyors of credit.
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Financial Markets are the mechanism enabling participants to deal in


financial claims. The markets also provide a facility in which their
demands and requirements interact to set a price for such claims. The
main organized financial markets are money market and capital market.
The first is market for short term securities while the second is a market
for long term securities with the maturity period of one year or more.
Financial markets are also classified as primary, market and secondary
market. The primary market deals in new issues of securities, and the
secondary market deals for trading in outstanding or existing securities.
Financial Instrument: is a claim against a person or an institution for the
payment at a future date a sum of money and/or a periodic payment in
the form of interest or dividend.
Financial securities may be primary or secondary securities. Primary
securities are also termed as direct securities as they are directly issued by
the ultimate borrowers of the funds to the ultimate savers. Examples of
primary or direct securities include equity shares and debentures.
Secondary securities are also referred to as indirect securities, as they are
issued by financial intermediaries to the ultimate savers. Bank deposits,
mutual fund units, and insurance policies are secondary securities.
Financial instruments differ in terms of marketability, liquidity,
reversibility, type of options, return, risk and transaction costs. Financial
instruments help the financial markets and the financial intermediaries to
perform the important role of channelizing funds from lenders to
borrowers.
Financial Services: Financial intermediaries provide key financial services
such as merchant banking, leasing, hire purchase, credit-rating, and so
on. Financial services rendered by the financial intermediaries bridge the
gap between lack of knowledge on the part of investors and increasing
sophistication of financial instruments and markets. These financial
services are vital for creation of firms, industrial expansion, and economic
growth.
Before investors lend money, they need to be reassured that it is safe to
exchange securities for funds. This reassurance is provided by the
financial regulator who regulates the conduct of the market, and
intermediaries to protect the investors interests. The Reserve Bank of
India regulates the money market and Securities and Exchange Board of
India (SEBI) regulates capital market.

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Q: 2).

What do you understand by capital market? Discuss

capital market instruments.


Answer:
Capital market: is a market for long-term debt instruments with the
maturity period of more than one year. It is composed of borrowers and
lenders and the rate of interest is determined by the demand for and
supply of capital forces. The Capital market is a market for securities with
maturity greater than one year including intermediate and long term
notes, bonds, and stocks.
The long term capital takes two forms: Equities or ordinary shares and
fixed interest capital like preference share capital or debentures.
The purpose of capital market is:
1)
2)
3)
4)

To mobilize long term savings to finance long term investments.


Provide risk-capital in the form of equity to entrepreneurs.
Encourage broader ownership to productive assets.
Provide liquidity with a mechanism enabling the investor to sell
financial assets.
5) Lower the costs of transactions and information.
6) Improve the efficiency of capital allocation through a competitive
pricing mechanism.
Capital markets can be classified into primary and secondary markets. The
primary market is meant for new issues and the secondary market is a
market where outstanding issues are traded. In other words, the primary
market creates long-term instruments for borrowings, whereas the
secondary market provides liquidity through the marketability of these
instruments. The secondary market is also known as the stock market.
The capital market consists of the following instruments:
1)
2)
3)
4)
5)
6)
7)

Stock Exchange.
Investment Trusts.
Insurance Companies.
Hire Purchase Companies.
Building Societies.
Pension Funds.
Commercial Banks.

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Q: 3).

Discuss all the participants in a stock market.

Answer:
A stock market which is also known as equity market is a public body in
which a free network of economic transactions occurs. It is not a physical
facility or secret body. It is the place for the trading of stock or shares of
company and its derivatives at an agreeable price. These shares and
derivatives are securities that are listed on a stock exchange.
Participants in the stock markets
The participants in a stock market process are: Investors, Intermediaries
and Companies.
1) Investors
Investors come to the stock exchange to buy and sell securities.
SEBIs regulations permit Resident investors, Non-resident Indians,
Corporate bodies, Trusts, FIIs who are registered with SEBI, among others,
to invest in stock markets in India. Foreign citizens and overseas corporate
bodies are prohibited from investing in Indian securities markets.
Investors cannot directly trade on the stock market. They have to go
through intermediaries called brokers. Brokers are members of the stock
exchange. The investors have to open a trading account with the broker.
They are required to comply with the Know your Customer (KYC) norms.
This seeks to establish the identity and bona-fides of the investor.
Investors will also need to open a beneficiary account with a depository
participant (DP) to be able to trade in dematerialized securities. This
account will hold the shares which the investor will buy and sell.
Once the formality of account opening is done, investors can put through
their transactions through their brokers terminal. The trades have to be
settled, i.e. securities delivered/received and funds paid out/received,
according to the settlement schedule (currently T+2) decided by the
exchange. Investors have to give instructions to the DP to transfer
securities from their account to that of the broker who is also a clearing
member. Or give standing instructions to receive securities if they have
bought shares. Similarly, they have to ensure that funds are available in
their bank account to settle for shares they have bought.

18

2) Brokers
Intermediaries in the secondary market process include brokers and
depository participants. Brokers are members of a stock exchange who are
alone authorized to put through trades on the stock exchange. Brokers
may be individuals or institutions who are registered with SEBI and meet
the respective stock exchanges eligibility criteria for becoming a member of
the exchange.
The stock exchange will specify minimum eligibility requirements such as
base capital to be collected from the member brokers which are in line
with SEBIs regulations on the same. The exposure that a broker can take
in the market will be a multiple of the base capital that is deposited with
the exchange.
3) DPs
Depository participants are associates of a depository through whom the
investor will hold the beneficiary account of the investors to enable them to
trade in dematerialized shares.
The SEBI (Depository and Participants) regulations specify the eligibility
requirements for a DP. Banks, financial institutions, brokers, custodians,
R&T agents, NBFCs among others are eligible to become DPs. Apart from
this, the DPs are required to have minimum net worth as specified by the
regulations. This could range from Rs 10 Crore for R&T agents who are
DPs to Rs 50 Crore for NBFCs.
The DPs are responsible for executing the investors directions on delivery
and receipt of shares from their beneficiary account to settle the trades
done on the secondary markets.

19

CASE STUDY
Security Scam in India-1991
In April 1992, press reports indicated that there was a shortfall in the
Government Securities held by the State Bank of India. Investigations
uncovered the tip of an iceberg, later called the securities scam, involving
misappropriation of funds to the tune of over Rs. 3500 Crores8. The scam
engulfed top executives of large nationalized banks, foreign banks and
financial institutions, brokers, bureaucrats and politicians: The
functioning of the money market and the stock market was thrown in
disarray. The tainted shares were worthless as they could not be sold. This
created a panic among investors and brokers and led to a prolonged
closure of the stock exchanges along with a precipitous drop in the price of
shares. Soon after the discovery of the scam, the stock prices dropped by
over 40%, wiping out market value to the tune of Rs. 100,000 crores. TIle
normal settlement process in government securities was that the
transacting banks made payments and delivered the securities directly to
each other. The broker's only function was to bring the buyer and seller
together. During the scam, however, the banks or at least some banks
adopted an alternative settlement process similar to settlement of stock
market transactions. The deliveries of securities and payments were made
through the broker. That is, the seller handed' over the securities to the
broker who passed them on to the buyer, while the buyer gave the cheque
to the broker who then made the payment to the seller. There were two
important reasons why the broker intermediated settlement began to be
used in the government securities markets: The brokers instead of merely
bringing buyers and sellers together stfu1ed taking positions in the
market. They in a sense imparted greater liquidity to the markets.
When a bank wanted to conceal the fact. That it was doing a Ready
Forward deal, the broker came in handy. The broker provided contract
notes for this purpose with fictitious counterparties, but arranged for the
actual settlement to take place with the correct counterparty. This allowed
the broker to lay his hands on the cheque as it went from one bank to
another through him. The hurdle now was to find a way of crediting the
cheque to his account though it was drawn in favour of a bank and was
crossed account payee. It is purely a matter of banking custom that an
account payee cheque is paid only to the payee mentioned on the cheque.
In fact, privileged (Corporate) customers were routinely allowed to credit
account payee cheques in favour of a bank into their own accounts to
avoid clearing delays; thereby reducing the interest lost on the amount.
The brokers thus found a way of getting hold of the cheques as they went
from one bank to another and crediting the amounts to their accounts.
This effectively transformed an RF into a loan to a broker rather than to a
bank. But this, by itself, would not have led to the scam because the RF
after all is a secured. Loan and a secured loan to a broker is still secured.
20

What was necessary now was to find a way of eliminating the security
itself.
Three routes adopted for this purpose were:
Some banks (or rather their officials) were persuaded to part with
cheques without actually receiving securities in return. A simple
explanation of this is that the officials concerned were bribed and/or
negligent. Alternatively, as long as the scam lasted, the banks benefited
from such an arrangement. The management of banks might have been
sorely tempted to adopt this route to higher profitability.
The second route was to replace the actual securities by a worthless
piece of paper - a fake Bank Receipt (BR). A BR like an IOU has only the
borrower's assurance that the borrower has the securities which can/will
be delivered if/when the need arises.
The third method was simply to forge the securities themselves. In many
cases, PSU bonds were represented only by allotment letters rather than
certificates on security paper. However, it accounted for only a very small
part of the total funds misappropriated. During the scam, the brokers
perfected the art of using fake BRs to obtain unsecured loans from the
banking system. They persuaded some small and little known banks - the
Bank of Karad (BOK) and the Metropolitan Cooperative Bank (MCB) - to
issue BRs as and when required. These BRs could then be used to do RF
deals with other banks. The cheques in favour of BOK were, of course,
credited into the brokers' accounts. In effect, several large banks made
huge unsecured loans to the BOK/MCB which in turn made the money
available to the brokers.
Questions:
Q: 1).

Explain flaws in regulation which gives scope to scam-

1991 and how that scam helps in improvement of regulations.


Answer:
Some of the flaws in the regulation that gave the scope of 1991 scam are
as following:
a) Misappropriation of funds by top executives of large nationalized
banks, foreign banks and financial institutions, brokers,
bureaucrats and politicians.
b) Throwing in a disarray of the functioning of the money market and
the stock market
21

c) Tainting of shares that were worthless(they could not sold)


d) Creation of panic among investors and brokers leading to a
prolonged closure of stock exchanges, along with a sudden drop in
the price of shares.
e) Banks adopting an alternative settlement process similar to
settlement of stock market transactions.
f) Deliveries of securities and payments were made through the
brokers
Regulation improvement
1) Ensuring that an account payee cheque is paid only to the payee
mentioned on the cheque.
2) Allowing privileged (corporate) customers to credit account payee
cheques in favour of a bank into their own accounts to avoid
clearing delays (thus reducing interest lost on the amount).
Q: 2).

Explain roles and responsibilities of brokers and how that

was being violated in that scam and what actions should be taken by
regulatory bodies to avoid these kinds of frauds.
Answer:
Brokers are intermediaries in the secondary market process. They are
members of the stock exchange who are authorized to put through trades
on the stock exchange. Brokers may be individuals or institutions who are
registered with SEBI and meet the respective stock exchanges eligibility
criteria for becoming a member of the exchange.
The stock exchange will specify minimum eligibility requirements such as
base capital to be collected from the member brokers which are in line
with SEBIs regulations on the same. The exposure that a broker can take
in the market will be a multiple of the base capital that is deposited with
the exchange.
All brokers are regulated by the Securities and Exchange Commission
[SEC] and are required to meet certain standards when dealing with
customers. Specifically, the Securities and Exchange Act of 1934 puts
forth certain provisions that all brokers must adhere to. These provisions
are provided below:
Duty of Fair Dealing: This includes the duty to execute orders promptly,
disclosing material information (information that a brokers client would
22

consider relevant as an investor), and charge prices that are in line with
competitors.
Duty of Best Execution: The broker has a responsibility to complete
customer orders at the most favorable market prices possible.
Customer Confirmation Rule: The broker must provide the investor with
certain information, at or before the execution of the order (i.e. date, time,
price, and number of shares, commission and other information).
Disclosure of Credit Terms: At the time an account is opened, a broker
must provide the customer with the credit terms and, in addition, provide
credit customers with account statements quarterly.
Restriction of Short Sales: This rule bars an investor from selling an
exchange-listed security that they do not own (in other words, sell a stock
short) unless the sale is above the price of the last trade.
Trading During Offerings: the Rule 101 prohibits the broker from buying
a stock that is being offered during the "quiet period" one to five days
before and up to the offering.
Restrictions on Insider Trading: Brokers have to establish written
policies and procedures to ensure that employees do not misuse material
nonpublic (or inside) information.

23

Assignment C
Q: 1).
The organized financial system comprises the following subsystems:
I.
II.
III.
IV.
V.

Banking system
Cooperative system
Development Banking system
Money markets
Financial companies/institutions.

a)
b)
c)
d)
Q: 2).

I, II, and III above


I, II, III and IV above
I, III, IV and V above
I, II, III, IV, V ().
The formal financial system consists of segments:

a) Financial Institutions, Financial markets, financial


instruments and financial services ().
b) Financial Institutions, Financial markets and financial
instruments.
c) Financial markets, financial instruments and financial
services.
d) Financial markets, financial instruments, financial derivatives
and financial services.
Q: 3).
Financial institutions can be classified as banking and non
banking financial institutions.
a) True ().
b) False
Q: 4).
The main organized financial markets in a country are
normally:
a)
b)
c)
d)
Q: 5).

Money market and capital market ().


Money market and debt market.
Money market and equity market.
Money market and derivative market.
Examples of primary or direct securities include _________.

a)
b)
c)
d)

Mutual fund and Insurance policies


Insurance policies and Bank deposits
Bank deposits and Insurance policies
Equity shares and debentures ().

24

Q: 6).
The Reserve Bank of India regulates the _______ and Securities
and Exchange Board of India (SEBI) regulates _________.
a)
b)
c)
d)

Money market, capital market ().


Capital market, Money market
Money market and debt market.
Money market and derivative market.

Q: 7).
Secondary securities are also referred to as indirect securities,
as they are issued by financial intermediaries to the ultimate savers.
_______________ are secondary securities.
a)
b)
c)
d)

Mutual fund, equity shares and Insurance policies


Insurance policies, Bank deposits and Mutual fund ().
Bank deposits, equity shares and Insurance policies
Bank deposits, Mutual fund and debentures.

Q: 8).
Interest rates are typically determined by the supply of and
demand for ___________ in the economy.
a)
b)
c)
d)

Commodities
Money ()
Manpower
Technology

Q: 9).
If the economic growth of an economy picks up momentum,
then the demand for money tends to________, putting upward
pressure on interest rates.
a)
b)
c)
d)

Go down
Stabilize
Go up ()
None of the above

Q: 10). Inflation is a ______ in the general price level of goods and


services in an economy over a period of time.
a)
b)
c)
d)

Rise ()
Fall
Stabilization
None of the above

Q: 11). Which of the following are examples of a primary market


transaction?
a) A company issues new common stock ().
b) An investor asks his broker to purchase 1,000 shares of
Microsoft common stock.
c) An investor sells his shares.
25

d) All of the statements above are correct.


Q: 12).

When the price of a bond is above face value:

a)
b)
c)
d)
Q: 13).

The yield to maturity is below the coupon rate ().


The yield to maturity will be above the coupon rate.
The yield to maturity will equal the current yield.
The yield to maturity will equal the coupon rate.
Which of the following statements is most true?

a) Yield to maturity is equal to the coupon rate if the bond is held


to maturity.
b) Yield to maturity is the same as the coupon rate.
c) Yield to maturity is the same as the coupon rate if the bond is
purchased for face value.
d) Yield to maturity is the same as the coupon rate if the
bond is purchased for face value and held to maturity ().
Q: 14). ___________, __________ or _________ means the sum mentioned
in the capital clause of Memorandum of Association.
a)
b)
c)
d)

Nominal, issued or registered capital


Nominal, authorized or paid up capital
Nominal, paid up or registered capital
Nominal, authorized or registered capital ().

Q: 15). _____________ means that part of the issued capital at nominal


or face value which has been subscribed or taken up by purchaser of
shares in the company and which has been allotted.
a)
b)
c)
d)
Q: 16).
I.
II.
III.
IV.

Paid up capital
Issued capital
Subscribed Capital
Called Up Capital ().
Three theories about the determination of rate of Interest are:

The
The
The
The

a)
b)
c)
d)

classical theory
loanable funds theory
Keynesian theory
Vogels theory

I, II, and III ()


II, III and IV
I, III and IV
I, II, III, IV

26

Q: 17).
a)
b)
c)
d)

Financial markets and institutions


Involve the movement of huge quantities of money.
Affect the profits of businesses.
Affect the types of goods and services produced in an economy.
Do all of the above ().

Q: 18). The _____________ is the monetary authority of India, and also


acts as the regulator and supervisor of commercial banks.
a)
b)
c)
d)

SEBI (Securities and exchange board of India)


RBI (Reserve Bank of India) ()
SBI (State bank of India)
CBI (Central Bank of India)

Q: 19). Based on how interest is computed, interest rates are


classified into _____________ and ____________.
a)
b)
c)
d)
Q: 20).

Fixed, floating
Short term , Long term
Simple, compound ().
Long term, short term, medium term
Three theories about the determination of rate of Interest are:-

a) The classical theory, the loanable funds theory, The


Keynesian theory ().
b) The modern theory, the loanable funds theory, The Keynesian
theory.
c) The classical theory, the modern theory, The Keynesian theory.
d) The classical theory, the loanable funds theory, the modern
theory.
Q: 21).

Three theories about the term structure of Interest rates are:-

a) The Expectations Theory, Default Premium Theory, Market


Segmentation Theory
b) Default Premium Theory, Liquidity Premium Theory, Market
Segmentation Theory
c) The Expectations Theory, Liquidity Premium Theory, Default
Premium Theory
d) The Expectations Theory, Liquidity Premium Theory,
Market Segmentation Theory ()
Q: 22).

The RBI performs a wide range of functions; particularly, it:-

I. Acts as the currency authority


II. Controls money supply and credit
III. Manages foreign exchange
27

IV. Serves as a banker to the government


V. Builds up and strengthens the country's financial
infrastructure
a)
b)
c)
d)

I, II, III, IV
II, III, IV, V
I to V ()
I, II, III, V

Q: 23). By increasing ____________ , the RBI can reduce the funds


available with the banks for lending and thereby tighten liquidity in
the system.
a)
b)
c)
d)

Statutory Liquidity Ratio


Current Ratio
Cash Reserve Ratio ()
Bank ratio

Q: 24). ________________ banks cater to the financing needs of


agriculture, retail trade, small industry and self-employed
businessmen in urban, semi-urban and rural areas.
a)
b)
c)
d)

Co-operative ()
Scheduled commercial
Foreign
Private

Q: 25). Monetary policy is referred to as either being a _________ policy


or a ____________ policy.
a)
b)
c)
d)

Liberal, strict
Expansionary, contractionary ()
Inflationary, deflationary
Classical. Modern

Q: 26). Monetary policy is the process by which the central bank or


monetary authority of a country controls the ________________.
a)
b)
c)
d)

Supply of money ()
Demand of money
Inflation
Deflation

Q: 27). A monetary policy is referred to as __________ if it reduces the


size of the money supply or increases it only slowly, or if it raises the
interest rate.
a) Expansionary
b) Contractionary ()
28

c) Inflationary
d) Deflationary
Q: 28). The ____________ is a system in which the price of the national
currency is measured in units of gold bars and is kept constant by
the daily buying and selling of base currency to other countries and
nationals.
a)
b)
c)
d)

Stock trading
Gold standard ()
Discount window lending
Monetarism

Q: 29). Price level targeting is similar to ___________ except that CPI


growth in one year is offset in subsequent years such that over time
the price level on aggregate does not move.
a)
b)
c)
d)

Inflation targeting ()
Stock trading
Discount window lending
Monetarism

Q: 30). Money market is a very important segment of the financial


system of a country. It is the market dealing in monetary assets of
short term nature.
a)
b)
c)
d)

Long term nature


Medium term nature
Short term nature ()
All the above

Q: 31). Yield to maturity (YTM) is a popular and extensively used


method for computing the return on a _______ investment.
a)
b)
c)
d)

Share
Share & bond
Futures & options
Bond ()

Q: 32). Bonds that allow the issuer to alter the tenor of a bond, by
redeeming it prior to the original maturity date, are called ________
bonds.
a)
b)
c)
d)

Callable ()
Puttable
Amortising
Step up

29

Q: 33). An ________________ represents ownership in the shares of a


foreign company trading on US financial markets.
a)
b)
c)
d)
Q: 34).

Global Depositary Receipt (or GDR)


Treasury Bills
Government Security( G-sec)
American Depositary Receipt (or ADR) ()
External Commercial Borrowings (ECB) include:

I. Commercial Bank Loans


II. Buyers Credit
III. Suppliers Credit
IV. Securitized Instruments Such As Floating Rate Notes, Fixed
Rate Bonds Etc.
V. Credit From Official Export Credit Agencies
a)
b)
c)
d)
Q: 35).
a)
b)
c)
d)

I, II, III, IV
II, III, IV, V
I to V ()
I, II, III, V
The credit risk of a borrower is evaluated by ____________.
SEBI (Securities and exchange board of India)
Stock Exchange
RBI( Reserve Bank of India)
Credit rating agencies ()

Q: 36). _________ risk denotes the risk of the value of an investment


denominated in some other country's currency, coming down in
terms of the domestic currency.
a)
b)
c)
d)

Currency ()
Country
Hedging
Speculation

Q: 37). A _________is an entity which provides "trading" facilities for


stock brokers and traders, to trade stocks and other securities.
a)
b)
c)
d)

Stock exchange ()
Depository
Company
Credit rating agency

30

Q: 38). Various economic variables impact the movement in exchange


rates such as:
I.
II.
III.
IV.

Interest rates
Inflation figures
Balance of payment figures
GDP( Gross domestic product)

a)
b)
c)
d)
Q: 39).

I, II, III
I, II, III, IV ()
II, III, IV
I, III, IV
Benefits of trading through a stock exchange:

I. Best price
II. lack of any counter-party risk
III. Access to investor grievance and redressal mechanism
a)
b)
c)
d)

I, II
I, III
II, III
I, II, III ()

Q: 40). In a ____________ exchange, the three functions of ownership,


management and trading are concentrated into a single Group.
a)
b)
c)
d)

Mutual ()
Demutualised
Neither a nor b
Both a & b

31