Financial Markets and Institutions (HUL463)

2019

(2nd Semester)

Batch: 2016

Department of Humanities & Social Sciences IIT, Ropar

Dr. Samaresh Bardhan

Why Study Financial Markets?

What is the Structure of Financial

Markets?
Special Role of Banks and Financial
Institutions.

Role of money market, bond market,

stock market.
 Financial Markets and Institutions

• Financial markets → exist to facilitate the most efficient

allocation of capital: Financial markets are markets in
which funds are transferred from those who have excess
funds (savers, lenders) to those who have a shortages
(investors, borrowers).

• Players→ Households, Firms, Government, Rest of the

World.

• How they play and what motivates them to play is critical

to the role of financial markets and well-being of society.
Source: Mishkin, Frederic S. and Stanley G. Eakins, (2008) Financial Markets and
Institutions
Direct Finance (first route)→ Borrowers borrow funds directly from lenders in
financial markets by selling them securities (financial instruments), claims on
borrower’s future income or assets.

Securities are assets to buyers of financial instruments but liabilities to sellers.

Example, (a) Bond (debt security) that promises to make payments periodically
for a specified period of time. (b) Stock refers to a security that entitles the owner
to a share of the company’s profits and assets.

Indirect Finance (second route) → It involves a financial intermediary that stands

between Lender-saver and Borrowers-Spenders and helps in transfer of funds.
Example, a bank might acquire funds by issuing a liability (asset to public) in the form
of savings deposits and then use these funds to acquire an asset by making a loan.

Process leads to funds transfer from lenders-savers (public) to borrowers-investors

through the bank (financial intermediary).
 Asymmetric Information
one party to a transaction has better
information to make decisions than the other
party

asymmetric information in financial market

causes two main problems
adverse selection
moral hazard

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 Adverse Selection
asymmetric information problem that occurs
prior to a transaction

examples of adverse selection:

Lenders may decide not to make loans if they

can not distinguish between “good” and “bad”
credit risks.
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 Moral Hazard
asymmetric information problem that occurs
after a transaction
risk that borrower will undertake risky
activities that will increase the probability of
default
result of moral hazard is that lenders may
decide not to make a loan.

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 Lemons Problem
The Market for "Lemons": Quality Uncertainty and the Market
Mechanism (George Akerlof, 1970)

 idea presented by George Akerlof in terms of lemons in

used car market

 used car buyers are unable to determine quality of car -

good car or lemon?

 What amount is buyer willing to pay for this used car of

unknown quality?

 How can buyer improve information on quality?

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 Lemons Problem in Stock and Bond Market

 asymmetric information prevents investors from

identifying good and bad firms (Capital market)

 What price will these investors pay for stock?

 Who has better information about the firm?

 Which firms will “come to the market” for financing

under these conditions?

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 Solutions to Financing Puzzles
lemons or adverse selection problem tells why
marketable securities are not the primary
source of financing

tells why stocks are not the most important

source of external financing

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 More Solutions to Financial Structure Puzzles

 importance of financial intermediaries explains

importance of indirect financing

 explains why banks are most important source of

external financing

 explains why markets are only available to large,

well-known firms.

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 Structure of Financial Markets
Financial Market

Capital Market Money Market

Primary Market Secondary Market Call Money Bill Mkt CDs

(New Issues Market (Existing Issues Mkt) Market
Brokers, Dealers CP(firms,
Investment Bank) Commercial
Ex, NYSE, NASDAQ Treasury 1 yr)
Bills (30d/60d/90d) Bills (govt)
Foreign exchange mkt, future
Market, option market etc. (91d/182d/364d)

Call money
Market for 24 hours Short notice
Repayable on demand) Market(<14 days)
Reqd for maintaining CRR
Structure of capital Market
Money market: India
• Characteristics of Money Market instruments
• Money Market→ It deals with short-term financial instruments, generally with
original maturity of less than one year.
 It does not deal with money or cash but close substitutes of money viz. CP, T-
bill, promissory notes that can be quickly converted to cash with low
transactions cost and quickly.
 These are more widely traded than longer term securities and so tend to be
more liquid. Moreover, short-term securities are subject to smaller
fluctuations in prices than long-term securities.
 It constitutes of central bank, commercial banks, NBFC.
 Transactions in these markets take place via oral communication without the
help of brokers.
Objectives of Money Markets:
 To make available a parking place in order to make use of short term surplus.
 To offer room to overcome short term deficits.
 To allow the central bank to influence and control liquidity in the economy by
means of intervention in this market.
 To provide access to users of short-term funds so that they can meet their
requirements quickly, adequately, and at reasonable costs.
 Short-term Financial Instruments
• Commercial Paper :
 It is an unsecured short-term debt instrument issued by a corporation typically for
financing liabilities, inventories, accounts receivables etc.
 Maturity period of CP is less than one year.
 It is not backed by any collateral.
Commercial Bill :
 It is a bill of exchange that a merchant Investment bank or a company issues in
 order to borrow money.
 It is unsecured, short-term debt instrument.
 It is risky and has comparatively higher yield than TBs.
 Reputation of the issuing firm acts a collateral.
 Maturity period of CBs varies between 30 days to 90 days.
 Example, Trade Bills, Demand Bill (payable on demand) , Issuance Bill (payable at a
 specified later date.
 Inland Bill (Hundi), drawn on and payable on India only (for example).
 Foreign Bill, Export Bill, Import Bill.
• Treasury bills - Short-term debt obligations of a
national government that are issued to mature in
three to twelve months.
• Certificate of deposit - Time deposit, commonly
offered to consumers by banks, thrift institutions,
and credit unions.
• Call money market
• The call money market deals in short term
finance repayable on demand, with a maturity
period varying from one day to 14 days
Capital Market → Deals with longer-term debts
(generally with original maturity of one year or more)
and equity instruments. For example, stocks and
long-term bonds are held by insurance companies,
pension funds.
Example: (i) Government Securities market
(ii) Industrial Securities market
(iii) DFIs
(iv) Financial Intermediaries
 Capital Market: Regulatory Framework

• Department of Economic Affairs, Ministry of Finance:

Capital Markets Division formulate policies related to
the orderly growth and development of the securities
markets (i.e. share, debt and derivatives) as well as
protecting the interest of the investors.
(i) institutional reforms in the securities markets,
(ii) building regulatory and market institutions,
(iii) strengthening investor protection mechanism, and
(iv) providing efficient legislative framework for securities
markets such as SEBI Act 1992, Securities Contracts
(Regulation) Act, 1956; and the Depositories Act,
1996.
• A mutual fund is a type of professionally managed collective investment
scheme that pools money from many investors to purchase securities.

• Mutual funds have both advantages and disadvantages compared to direct

investing in individual securities. They have a long history in the United
States. Today they play an important role in household finances, most
notably in retirement planning.

• The fund manager trades (buys and sells) the fund's investments in
accordance with the fund's investment objective. A fund manager must be
a registered investment advisor.

• Examples: The four main categories of funds are money market funds,
bond or fixed income funds, stock or equity funds and hybrid funds.
• Mutual funds have advantages compared to direct investing in individual
securities. These include:
• Increased diversification: A fund must hold many securities. Diversifying reduces
risks compared to holding a single stock, bond, other available instruments.

• Daily liquidity: Shareholders may trade their holdings with the fund manager at
the close of a trading day based on the closing net asset value of the fund's
holdings. However, there may be fees and restrictions as stated in the fund
prospectus. For holders of individual stocks, bonds, closed-end funds, ETFs, and
other available instruments, there may not be a buyer/seller for that instrument
every day, making such investments less liquid.

• Professional investment management: A highly variable aspect of a fund discussed

in the prospectus. Actively managed funds may have large staffs of analysts who
actively trade the fund holdings.

• Ease of comparison: Since mutual funds are available from many providers, it is
generally easy to find similar funds and compare features such as expenses.
• Mutual funds have disadvantages as well,
which include:
• Fees
• Less control over timing of recognition of
gains.
• Less predictable income.
• No opportunity to customize.
 Future Markets

• It deals with buying and selling of future contracts at a certain date at a

certain price. It is a contractual agreement that takes place at the trading
floor of future exchange to buy and sell a specified asset of standardised
quality and quantity. These are negotiable instruments.

• Buyers of the contract are called long and sellers are called short referring to
a kind of expectations formed by the agents. The buyer hopes or expects that
the asset price is going to increase, while the seller hopes or expects that it
will decrease in near future.

• It helps reduce volatility and minimises the risks of default in markets.

• These can be traded in secondary markets→ future secondary future

markets.

• Example : stock future, bond future, currency future.

• A closely related contract is a forward contract. A forward is like a future in

that it specifies the exchange of goods for a specified price at a specified
future date. However, it is not traded in exchange and not standardised.
Options Markets
Options are contracts that confer buyer of the
contract certain rights (to buy or sell a contract) at
a predetermined price on or before pre-specified date.

The person granting the option is called the optioner

and the person who has the benefit of the option is
called the beneficiary (optionee).
Sellers are obligated to buy or sell the contract to the
purchaser if the owner of the option exercises the right
to sell or buy.
Owner of the option is not obligated to take any action
but has the right to exercise the contract if he or she
so chooses → the owner of option pays premium.
(contd..)
• Types.
• Call Options give the beneficiary the right to require grantor to sell or
convey the property to them at the agreed price.

• Put Options, give the beneficiary the right to require the grantor to buy or
receive the property at the agreed price.

• American options→ can be exercised at any time.

• European Options → can be exercised only on expiration.

• Examples : stock options, future options, insurance options etc. Players in

option market are corporates, FIs. Options traded through OTCs,
exchanges.

• Regulatory bodies: Securities and Exchange commission(SEC-US), SEBI

(INDIA)
 Money markets vs Capital markets
Money market Capital market

Duration Deals with financial instruments It deals with is instruments of

of short-term maturity long-term maturity
Nature of Funds Meets working capital Supplies Capital for Fixed Capital
reqirements
requirements

Instruments T-Bills, Commercial papers,

certificates of Deposits, call money Shares, Debentures, Bonds etc.
etc.
Amt of Instruments Each single instrument is of Each single instrument is of
large amount small amount
Institutions Central banks, SCBS, NBFIs etc. Stock Exchanges, OTCs, SCBS,
NBFIs viz. LIC

Risks Less due to smaller maturity, Higher

probability of default is less

Contd..
 Money markets vs Capital markets
Money market
Transactios Transactions take place over
phone, fax, internet
Broker Meets working capital
Reqirements
Role To ease the liquidity constraints in
the economy
Relation with central bank Closely and directly linked with
central bank of the country
Market Regulation COMMERCIAL BANKS ARE
CLOSELY REGULATED BY
THE CENTRAL BANK
Capital Market
It takes place in formal markets
e.g. stock market
Supplies Capital for Fixed Capital
requirements
Helps in mobilisation of LT funds
Capital mkt. feels central bank’s
intervention, but mainly
indirectly through money
market.
SEBI