FINANCIAL INSTITUTIONS AND MARKETS( LW-2316)

MODULE III: MONEY MARKET AND CAPITAL MARKET

3.1 Purpose of Money markets

3.2 Money Market Instruments: T-Bills, Repos and Reverse Repos
3.3 Banker’s Acceptance, Commercial Papers, Certificates of Deposits
3.4 Money Market Mutual Funds, Money Market Account
3.5 Money Market Index
3.6 Capital Markets Securities
3.7 Treasury Bonds, Corporate Bonds
3.8 Value of Coupon bonds

MONEY MARKET

The term ‘Money Market’, according to the Reserve Bank of India, is used to define a market
where short-term financial assets are traded. These assets are a near substitute for money and
they aid in the money exchange carried out in the primary and secondary market. So,
essentially, the money market is an apparatus which facilitates the lending and borrowing of
short-term funds, which are usually for a duration of under a year. Short maturity period and
high liquidity are two characteristic features of the instruments which are traded in the money
market. Institutions like commercial banks, non-banking finance corporations (NBFCs) and
acceptance houses are the components which make up the money market.

The money market is a part of the larger financial market and consists of numerous smaller
sub-markets like bill market, acceptance market, call money market, etc. Money market deals
are not carried out in money / cash, but other instruments like trade bills, government papers,
promissory notes, etc. Also, money market transactions cannot be done via brokers but have
to be carried out via mediums like formal documentation, oral or written communication.

Some Important Objectives Served By a Money Market

The money market serves several objectives in the overall economy. Listed below are some
important objectives:
 The money market doesn’t only help in the storage of short-term surplus funds but also
helps in lowering short term deficits.
 They help the central bank in regulating liquidity in the economy.
 Money markets help short-term fund users to fulfill their needs at reasonable costs.
 The money market helps in the development of the capital market, trade and industry.
 To help design effective monetary policies.
 To facilitate streamlined functioning of commercial banks.

Money Market Instruments

As the name suggests, Money Market Instruments are simply the instruments or tools which
can help one operate in the money market. These instruments serve a dual purpose of not only
allowing borrowers meet their short-term requirements but also provide easy liquidity to
lenders. Some of the common money market instruments include Banker’s Acceptance,
Treasury Bills, Repurchase Agreements, Certificate of Deposits and Commercial Papers.

Characteristics of Money Market Instruments

Money market instruments allow governments, financial organizations and businesses to
finance their short-term cash requirements. Some of the notable characteristics of money
market instruments are as follows.

Liquidity – Money market instruments are highly liquid because they are fixed-income
securities which carry short maturity periods of a year or less.

Safety – Issuers of money market instruments have strong credit ratings, which automatically
means that the money instruments issued by them will also be safe.

Discount Pricing – Another important characteristic feature of money market instruments is

that they are issued at a discount on their face value.

TYPES OF MONEY MARKET INSTRUMENTS

Treasury Bills (T-Bills)

When the government is going to the financial market to raise money, it can do it by issuing
two types of debt instruments – treasury bills and government bonds. Treasury bills are issued
when the government need money for a shorter period while bonds are issued when it need
debt for more than say five years.

Treasury bills generally shortened as T-bills, have a maximum maturity of a 364 days. Hence,
they are categorized as money market instruments (money market deals with funds with a
maturity of less than one year).

Issued by the Central Government, Treasury Bills are known to be one of the safest money
market instruments available. However, treasury bills carry zero risk. I.e. are zero risk
instruments. Therefore, the returns one gets on them are not attractive. Treasury bills come
with different maturity periods like 3-month, 6-month and 1 year and are circulated by
primary and secondary markets. Treasury bills are issued by the Central government at a
lesser price than their face value. The interest earned by the buyer will be the difference of the
maturity value of the instrument and the buying price of the bill, which is decided with the
help of bidding done via auctions. .

Treasury bills are presently issued in three maturities, namely, 91 day, 182 day and 364 day.
Treasury bills are zero coupon securities and pay no interest. Rather, they are issued at a
discount (at a reduced amount) and redeemed (given back money) at the face value at
maturity. For example, a 91 day Treasury bill of Rs.100/- (face value) may be issued at say Rs.
98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at the face value of
Rs.100/-. This means that you can get a hundred-rupee treasury bill at a lower price and can
get Rupees hundred at maturity.

The return to the investors is the difference between the maturity value or the face value (that
is Rs.100) and the issue price. The Reserve Bank of India conducts auctions usually every
Wednesday to issue T-bills. The rational is that since their maturity is lower, it is more
convenient to avoid intra period interest payments.

Treasury bills are usually held by financial institutions including banks. They have a very
important role in the financial market beyond investment instruments. Banks give treasury
bills to the RBI to get money under repo. Similarly, they can keep it as part of SLR.
Certificate of Deposits (CDs)

A Certificate of Deposit or CD, functions as a deposit receipt for money which is deposited
with a financial organization or bank. However, a Certificate of Deposit is different from a
Fixed Deposit Receipt in two aspects. The first aspect of difference is that a CD is only issued
for a larger sum of money. Secondly, a Certificate of Deposit is freely negotiable. First
announced in 1989 by RBI, Certificate of Deposits have become a preferred investment
choice for organizations in terms of short-term surplus investment as they carry low risk
while providing interest rates which are higher than those provided by Treasury bills and term
deposits. Certificate of Deposits are also relatively liquid, which is an added advantage,
especially for issuing banks. Like treasury bills, CDs are also issued at a discounted price and
their tenor ranges between a span of 7 days up to 1 year. However, banks issue Certificates of
Deposits for durations ranging from 3 months, 6 months and 12 months. They can be issued
to individuals (except minors), trusts, companies, corporations, associations, funds,
non-resident Indians, etc.

Commercial Papers (CPs)

Commercial Papers are can be compared to an unsecured short-term promissory note which is
issued by highly rated companies with the purpose of raising capital to meet requirements
directly from the market. CPs usually feature a fixed maturity period which can range
anywhere from 1 day up to 270 days. Highly popular in countries like Japan, UK, USA,
Australia and many others, Commercial Papers promise higher returns as compared to
treasury bills and are automatically not as secure in comparison. Commercial papers are
actively traded in secondary market.

Repurchase Agreements (Repo)

Repurchase Agreements, also known as Reverse Repo or simply as Repo, loans of a short
duration which are agreed upon by buyers and sellers for the purpose of selling and
repurchasing. These transactions can only be carried out between RBI approved parties Repo
/ Reverse Repo transactions can be done only between the parties approved by RBI.
Transactions are only permitted between securities approved by the RBI like treasury bills,
central or state government securities, corporate bonds and PSU bonds.

Banker's Acceptance (BA)

Banker's Acceptance or BA is basically a document promising future payment which is

guaranteed by a commercial bank. Similar to a treasury bill, Banker’s Acceptance is often
used in money market funds and specifies the details of the repayment like the amount to be
repaid, date of repayment and the details of the individual to which the repayment is due.
Banker’s Acceptance features maturity periods ranging between 30 days up to 180 days.

CAPITAL MARKETS IN INDIA

India has a fair share of the world economy and hence the capital markets or the share
markets of India form a considerable portion of the world economy. The capital market is
vital to the financial system.

The capital Markets are of two main types. The Primary markets and the secondary
markets. In a primary market, companies, governments or public sector institutions can raise
funds through bond issues. Alos, Corporations can sell new stock through an initial public
offering (IPO) and raise money through that. Thus in the primary market, the party directly
buys shares of a company. The process of selling new shares to investors is called
underwriting.

In the Secondary Markets, the stocks, shares, and bonds etc. are bought and sold by the
customers. Examples of the secondary capital markets include the stock exchanges like NSE,
BSE etc. In these markets, using the technology of the current time, the shares, and bonds etc.
are sold and purchased by parties or people.
Broad Constituents in the Indian Capital Markets

Fund Raisers

Fund Raisers are companies that raise funds from domestic and foreign sources, both public
and private. The following sources help companies raise funds.

Fund Providers

Fund Providers are the entities that invest in the capital markets. These can be categorized as
domestic and foreign investors, institutional and retail investors. The list includes subscribers
to primary market issues, investors who buy in the secondary market, traders, speculators,
FIIs/ sub-accounts, mutual funds, venture capital funds, NRIs, ADR/GDR investors, etc.

Intermediaries

Intermediaries are service providers in the market, including stock brokers, sub-brokers,
financiers, merchant bankers, underwriters, depository participants, registrar and transfer
agents, FIIs/ sub-accounts, mutual Funds, venture capital funds, portfolio managers,
custodians, etc.

Organizations

Organizations include various entities such as MCX-SX, BSE, NSE, other regional stock
exchanges, and the two depositories National Securities Depository Limited (NSDL) and
Central Securities Depository Limited (CSDL).

Market Regulators

Market Regulators include the Securities and Exchange Board of India (SEBI), the Reserve
Bank of India (RBI), and the Department of Company Affairs (DCA).

1.Corporate Bond

A bond is a debt instrument that provides a steady income stream to the investor in the form
of coupon payments. At the maturity date, the full face value of the bond is repaid to the
bondholder. The characteristics of a regular bond include:

Coupon rate: Some bonds have an interest rate, also known as the coupon rate, which is paid
to bondholders semi-annually. The coupon rate is the fixed return that an investor earns
periodically until it matures.

Maturity date: All bonds have maturity dates, some short-term, others long-term. When a
bond matures, the bond issuer repays the investor the full face value of the bond. For
corporate bonds, the face value of a bond is usually $1,000 and for government bonds, the
face value is $10,000. The face value is not necessarily the invested principal or purchase
price of the bond.
Current Price: Depending on the level of interest rate in the environment, the investor may
purchase a bond at par, below par, or above par. For example, if interest rates increase, the
value of a bond will decrease since the coupon rate will be lower than the interest rate in the
economy. When this occurs, the bond will trade at a discount, that is, below par. However, the
bondholder will be paid the full face value of the bond at maturity even though he purchased
it for less than the par value.

Bond Yield

A bond’s yield is the expected rate of return on a bond. The are three measures of bond yield:
nominal yield, current yield and yield to maturity.

In bond markets, a bond price movements are typically communicated by quoting their yields.
It is because it is a standardized measure which makes comparison between different bonds
easier. Unlike the bond price which depends on the denomination i.e. par value of the bond,
yield doesn’t depend on whether the par value is $100 or $1,000. It also helps us determine
the spread i.e. the yield difference between different types of bonds and associate the spreads
to different risks.

Relationship between Bond Yield and Bond Price

There is an interesting relationship between bond price and bond yield. As a bond’s price
drops, its yield rises and vice versa.

If a bond’s coupon rate is lower than the bond’s yield, it means that the bond is trading at
a discount to its par value i.e. it current market price is lower than its maturity value. If
someone purchases the bond at that lower market price and holds it till maturity, his ultimate
return will be higher than the coupon rate because it will comprise of the interest payments
and the capital gain that results from the difference between the purchase price of the bond
and the face value. The opposite is true if the bond’s yield is lower than its coupon rate i.e. the
bond sells at a premium.

Nominal Yield (i.e. Coupon Rate)

Nominal yield equals a bond's annual coupon rate. The coupon rate is the annual percentage
rate which is applied to the face value of the bond to work out the periodic coupon payment.

While the coupon rate is important in determining the periodic cash flow of the bond, it is not
a very comprehensive measure of the bond’s ultimate return. It is because it doesn’t take in to
consideration the difference between the current market price and the face value of the bond.
For example, a bond might pay a very high coupon rate, but its current price might be lower
than its face value due to high market interest rate. The nominal yield measure doesn’t
capture this price movement.

It also doesn’t include the effect of any initial discount or premium on the bond. Further,
since zero-coupon bonds have no coupon payments, there is no coupon rate to use as a yield
measure.

Current Yield

The current yield is a better measure than the nominal yield because it measures the return
with reference to the current market price of the bond. However, it is still doesn’t
accommodate the effect of price movement between the date the bond was purchased and the
date of valuation. Where c is the annual coupon rate, F is the face value of the bond and P is
its current market price. Current yield of a bond that trades below its face value is higher than
its nominal yield (i.e. coupon rate) and vice versa.

Yield to Maturity (Redemption Yield)

The most useful and theoretically-sound measure of bond yield is the yield to maturity of the
bond. There are other measures such as current yield, but they are less comprehensive.

The yield to maturity is the rate of return that a bondholder expects to earn if he purchases the
bond at its current price (P0) and holds its till maturity and receives all associated
future coupon payments and the maturity value. It is effectively the internal rate of return of
the bond. It is the periodic rate which causes the discounted value of bond cash flows (coupon
payments and face value) to equal the bond’s current market price.

CAPITAL MARKET INDICES

What Are Stock Indices

A stock market index is a statistical measure which shows changes taking place in the stock
market. To create an index, a few similar kinds of stocks are chosen from amongst the
securities already listed on the exchange and grouped together.

The criteria of stock selection could be the type of industry, market capitalisation or the size
of the company. The value of the stock market index is computed using values of the
underlying stocks. Any change taking place in the underlying stock prices impact the overall
value of the index. If the prices of most of the underlying securities rise, then the index will
rise and vice-versa.

In this way, a stock index reflects overall market sentiment and direction of price movements
of products in the financial, commodities or any other markets.Some of the notable indices in
India are as follows:

a. Benchmark indices like NSE Nifty and BSE Sensex

b. Broad-based indices like Nifty 50 and BSE 100

c. Indices based on market capitalization like the BSE Smallcap and BSE Midcap

d. Sectoral indices like Nifty FMCG Index and CNX IT

Why are stock indices required

The stock market index acts like a barometer which shows the overall conditions of the
market. They facilitate the investors in identifying the general pattern of the market. Investors
take the stock market as a reference to decide about which stocks to go for investing.
The following lists the importance of stock market index:

a. Aids in Stock-Picking

In a share market, you would thousands of companies listed on the exchange.

Broadly, picking the appropriate stock for investment may seem like a nightmare. Without a
benchmark, you may not be able to differentiate between the stocks. Simultaneously sorting
the stocks becomes a challenge. In this situation, a stock market acts like an instant
differentiator. It classifies the companies and their shares based on key characteristics like the
size of company, sector, industry type and so on.

b. Acts as a Representative

Investing in equities involves risk and you need to take an informed decision. Studying about
stocks individually may seem very impractical. Indices help to fill the knowledge gaps that
exist among the investors. They represent the trend of the whole market or a certain sector of
the market. In India, the NSE Nifty the BSE Sensex act as the benchmark indices. They are
believed to indicate the performance of the entire stock market. In the same manner, an index
which is made up of pharma stocks is assumed to portray the average price of stocks of
companies operating in the pharmaceutical industry.

c. The Parameter for Peer Comparison

Before including a stock in your portfolio, you have to assess whether it’s worth the money.
By comparing with the underlying index, you can easily judge the performance of a stock. If
the stock gives higher returns than the index, it’s said to have outperformed the index. If it
gives lower returns than the index, it’s said to have underperformed the index.

You would definitely want to invest in a multibagger so as to justify the risk assumed. Else
you can be better off investing in low-cost professionally managed index funds. You may also
compare the index with a set of stocks like the Information technology sector. As an investor,
you can know market trends easily.

d. Reflects Investor Sentiment

When you are participating in equity markets, amongst other things, knowing investor
sentiment becomes an important aspect. It is because the sentiment affects the demand for a
stock which in turn impacts the overall price. In order to invest in the right stock, you should
know the reason behind the rise/fall in its prices. At this juncture, indices help to gauge the
mood of investors. You may even recognize investor sentiment for a particular sector and
across market capitalizations.

e. Helps in Passive Investment

Passive investment refers to investing in a portfolio of securities which replicates the stocks
of an index. Investors who want to cut down on the cost of research and stock selection prefer
to invest in index portfolio. Consequently, the returns of the portfolio will resemble that of the
index. If an investor’s portfolio resembles the Sensex, then his portfolio is going to deliver
returns of around 8% when the Sensex earns 8% returns.

How are stock market indices developed

An index is made up of similar stocks based on market capitalization, industry or company

size. Upon selection of stocks, the index value is computed. Each stock will have a different
price and price change in one stock would not be proportionately equal to the price change in
another. So, the value of the index value cannot be arrived at as a simple sum of the prices of
all the stocks.

Here is when the importance of assigning weights to stocks comes into play. Each stock in the
index is assigned a particular weightage based on its market capitalization or price. The
weight represents the extent of the impact that the stock’s price change has on the value of the
index.
The two most commonly used stock market indices are as follows:

a. Market-cap weightage

Market capitalization refers to the total market value of the stock of a company. It is
calculated by multiplying the total number of outstanding stocks floated by the company with
the share price of a stock. It, therefore, considers both the price as well as the size of the stock.
In an index which uses market-cap weightage, the stocks are assigned weightage based on
their market capitalization as compared to the total market capitalization of the index.
Suppose a stock has a market capitalization of Rs. 50,000 whereas the underlying index has a
total market-cap of Rs. 1,00,000. Thus, the weightage given to the stock will be 50%.
It is important to note that market capitalization of a stock changes every day with the
fluctuation in its price. Due to this reason, weightage of the stock would change daily. But
usually such a change is marginal in nature. Moreover, the companies with higher
market-caps get more importance in this method.

In India, free-float market capitalization is used by most of the indices. Here, the total number
of shares listed by a company is not used to compute market capitalization. Instead, use only
the amount of shares available for trading publicly. Consequently, it gives a smaller number
than the market capitalization.

b. Price weightage

In this method, the value of an index value is computed based on the stock price of a company
rather than the market capitalization. Thus, the stocks which have higher prices receive
greater weightages in the index as compared to the stocks which have lower prices. This
method has been used in The Dow Jones Industrial Average in the US and the Nikkei 225 in
Japan.

What is NSE & BSE

Started in 1994, the National Stock Exchange (NSE) is the largest stock exchange in India in
terms of total and average daily turnover for equity shares. Being a pioneer in technology,
NSE has a fully-integrated business model to provide high-quality data and services to market
participants and clients. It includes trading services, exchange listings, indices, market data
feeds, clearing and settlement services, financial education offerings and technology solutions.
NSE ensures that trading and clearing members and listed companies follow the rules and
regulations of the exchange.

Founded in 1875, Bombay Stock Exchange Ltd. (BSE), is the fastest stock exchange in the
world which has the speed of 6 microseconds. It provides an efficient, integrated, transparent
and secure market for trading in equity, currencies, debt instruments, derivatives, mutual
funds. It provides an array of services like clearing, settlement, risk management, education
and market data services. It has a global reach with overseas customers and a nation-wide
presence. It provides depository services through its Central Depository Services Ltd. (CDSL)
arm. The S&P BSE SENSEX is India’s most widely tracked stock market benchmark index.
It is traded internationally on the EUREX as well as leading exchanges of the BRICS nations
(Brazil, Russia, China and South Africa).
Bond Valuation in Practice

Since bonds are an essential part of the capital markets, investors and analysts seek to
understand how the different features of a bond interact in order to determine its intrinsic
value. Like a stock, the value of a bond determines whether it is a suitable investment for a
portfolio and hence, is an integral step in bond investing.

Bond valuation, in effect, is calculating the present value of a bond’s expected future coupon
payments. The theoretical fair value of a bond is calculated by discounting the present value
of its coupon payments by an appropriate discount rate. The discount rate used is the yield to
maturity, which is the rate of return that an investor will get if s/he reinvested every coupon
payment from the bond at a fixed interest rate until the bond matures. It takes into account the
price of a bond, par value, coupon rate, and time to maturity.

1. The $1,000 face value ABC bond has a coupon rate of 6%, with interest paid
semi-annually, and matures in 5 years. If the bond is priced to yield 8%, what is the bond's
value today?
Ans: 918.89

Solution:

FV = $1,000
CF = $60/2 = $30
n = 5 x 2 = 10
r = 8%/2 = 4%
PV = 30*PVA(n=10,r=4%)+1000*PV((n=10,r=4%)=30*8.1109+1000*0.6756=918.927

2. The $1,000 face value EFG bond has a coupon of 10% (paid semi-annually), matures in 4
years, and has current price of $1,140. What is the EFG bond's yield to maturity?
Ans: 6%

Solution:

FV = $1,000
CF = $100/2 = $50
n=5x2=8
Current Price=PV=1140
1140=50*PVA(n=8,YTD)+1000*PV(n=8,YTD)
By trial and error , for YTD=3%
PV=50*PVA(n=8,r=3%)+1000*PV(n=8,r=3%)
PV=50*7.0197+1000*0.7894=1140.38
YTD(Annual)=2*3=6%

3. The KLM bond has a 8% coupon rate (with interest paid semi-annually), a maturity value
of $1,000, and matures in 5 years. If the bond is priced to yield 6%, what is the bond's current
price?
Ans: 1085

Solution:

FV = $1,000
CF = $80/2 = $40
n = 5 x 2 = 10
r = 6%/2 = 3%
PV = 40*PVA(n=10,r=3%)+1000*PV(n=10,r=3%)=40*8.5302+1000*0.7441=1085.30
4.Calculate the price of a Tata Corp. corporate bond which has a par value of Rs 1000 and
coupon payment is 6% and yield is 10%. The maturity of the bond is 6 years.
Ans: Rs 825.79

Solution:

FV = $1,000
CF = $60
n=6
r = 10%
PV = 60*PVA(n=6,r=10%)+1000*PV(n=6,r=10%)=60*4.3553+1000*0.5645=825.81

2.Zero-Coupon Bond

A zero-coupon bond is a bond that makes no periodic interest payments and is sold at a deep
discount from face value. The buyer of the bond receives a return by the
gradual appreciation of the security, which is redeemed at face value on a specified maturity
date.

The price of a zero-coupon bond can be calculated by using the following formula:

P = M / [(1+r)^n]

where:
P = price
M = maturity value
r = investor's required annual yield / 2
n = number of years until maturity x 2

For example, if you want to purchase a Company XYZ zero-coupon bond that has a
$1,000 face value and matures in three years, and you would like to earn 10% per year on
the investment, using the formula above you might be willing to pay:

$1,000 / (1+.05)6 = $746.22

When the bond matures, you would get $1,000. You would receive "interest" via the
gradual appreciation of the security.

The greater the length until a zero-coupon bond's maturity, the less the investor generally pays
for it. So if the $1,000 Company XYZ bond matured in 20 years instead of 3, you might only
pay:

$1,000 / (1+.05)40 = $142.05

Zero-coupon bonds are very common, and most trade on the major exchanges. Corporations,
state and local governments, and even the U.S. Treasury issue zero-coupon bonds. Corporate
zero-coupon bonds tend to be riskier than similar coupon-paying bonds because if
the issuer defaults on a zero-coupon bond, the investor has not even
received coupon payments -- there is more to lose.

2.Shares
A share or the proportion of interest of a shareholder is equal to the proportion of the amount
paid to the total capital payable to the company. Let us look at the various types of shares a
company can issue – equity shares and preferential shares.
Shares
A share in the share capital of the company, including stock, is the definition of the term
‘Share’. This is in accordance with Section 2(84) of the Companies Act, 2013. In other words,
a share is a measure of the interest in the company’s assets held by a shareholder. In this
article, we will look at the different types of shares like preferential and equity shares. Further,
we will understand certain definitions and regulations surrounding them.

The Memorandum and Articles of Association of the company prescribe the rights and
obligations of shareholders. Further, a shareholder must have certain contractual and other
rights as per the provisions of the Companies Act, 2013.

Section 44 of the Companies Act, 2013, states that shares or debentures or other interests of
any member in a company are movable properties. Also, they are transferable in the manner
prescribed in the Articles of the company. Further, Section 45 of the Act mandates the
numbering of every share. This number is distinctive. However, if a person is a holder of the
beneficial interest in the share, then this rule does not apply (example: share in the records of
a depository).

Kinds of Share Capital

According to Section 43 of the Companies Act, 2013, the share capital of a company is of two
types:

Preferential Share Capital

Equity Share Capital

Preferential Share Capital

The preferential share capital is that part of the Issued share capital of the company carrying a
preferential right for:

Dividend Payment – A fixed amount or amount calculated at a fixed rate. This might/might
not be subject to income tax.

Repayment – In case of a winding up or repayment of the amount of paid-up share capital,

there is a preferential right to the payment of any fixed premium or premium on any fixed
scale. The Memorandum or Articles of the company specifies the same.

Equity Share Capital – Equity Shares

All share capital which is NOT preferential share capital is Equity Share Capital. Equity
shares are of two types:

With voting rights

With differential rights to voting, dividends, etc., in accordance with the rules.

In 2008, Tata Motors introduced equity shares with differential voting rights – the ‘A’ equity
shares. According to the issue,

Every 10 ‘A’ equity shares have one voting right

‘A’ equity shares get 5 percentage points more dividend than the ordinary shares.
Due to the difference in voting rights, the ‘A’ equity shares traded at a discount to ordinary
shares with complete voting rights.