FINANCIAL MANAGEMENT

Notes
CHAPTER 2

FINANCIAL SYSTEM

Learning Objectives
After reading this unit, you will be able to:
State the meaning and significance of financial system
Explain the meaning and significance of financial assets and market
Enumerate the components of financial market
Define the regulatory framework within which financial system
operates

Structure
2.1 Introduction
2.2 Meaning and significance of Financial System
2.3 Meaning and significance of Financial Assets
2.4 Meaning and significance of Financial Market
2.5 S.E.B.I. (Securities Exchange Board Of India)
2.6 Stock Exchange
2.7 Summary
2.8 Self-Assessment Questions
2.9 Model Answers

2.1 Introduction

Every finance manager is required to procure funds, use them wisely and give
appropriate returns to the stakeholders in business. Financial system provides
safety and security of funds both to the corporate, who procure funds and to
those who provide funds to corporate investment community.
This unit deals with understanding of financial system, its importance and
regulatory bodies and norms, which govern the operation of this system.

2.2 Meaning And Significance Of Financial System

Meaning:
Financial system is a set of- Financial Institutions, Financial Markets, Financial
Services and Instruments and Regulatory Frame Work. Comprises of Indian
Financial System.

Financial Institutions:
Ÿ Insurance Companies
Ÿ Credit rating agencies
Ÿ Merchant bankers
Ÿ Non Banking Financial Companies (NBFCs)

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Notes Financial Markets :

Ÿ Money market
Ÿ Capital market
Ÿ Foreign exchange market

Financial services and instruments :

Ÿ Mutual Funds
Ÿ Depositories
Ÿ Leasing
Ÿ Venture capital
Ÿ Factoring

Regulatory Framework :
Ÿ SEBI
Ÿ RBI
Ÿ Stock Exchange

Significance :
Financial system performs following functions
Ÿ It provides payment system for exchange of goods and services e.g.
banks and credit cards.
Ÿ Modern business enterprise requires large investments.
Mechanisms like financial markets. and financial intermediaries
facilitate pooling of household savings for financing business.
Ÿ It facilitates transfer of economic resources for most productive use in
the business sector.
Ÿ It offers variety of instruments that provide opportunities for risk
pooling and risk sharing for household and business, e.g. hedging,
diversification and insurance.
Ÿ It provides information that helps in coordinating and decision-
making of household as well as corporate sector.
Ÿ Financial intermediaries transmit complete information to all the
parties related to transaction, which is useful for developing healthy
financial market.
2.3 Meaning And Significance Of Financial Assets

Ÿ An asset is any right or property, which has a value in exchange.

Ÿ Assets are classified as tangible or intangible. Tangible assets can be
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Ÿ shown physically whereas intangible assets have no physical existence. Notes

Ÿ Financial assets have following features:
i) They are intangible assets
ii) They have claim on future benefit
iii) They are also known as financial instruments
Ÿ The person or entity who has promised to make future cash payments is
known as issuer of financial asset and the owner of financial asset is known
as investor, e.g. Rajesh has purchased 400 shares of Reliance Industries
Ltd. In this case, Reliance Industries Ltd. is an issuer. Rajesh is an investor.
400 shares is a financial asset.
Ÿ Examples of financial assets
i) Loans given by SBI to borrower to buy a house
ii) Bonds issued by Government of India
iii) Bonds issued by IDBI
iv) Shares of Tata Motors Ltd.

Ÿ Claim on financial asset may be fixed or variable.

Ÿ When claim is fixed, asset is called debt security and the claim is in the form
of fixed interest at a specific interval of time.
Returns on debt = Interest Amount x 100
Purchase price

For example, debenture having face value Rs. 100 is issued by the company
for Rs. 120. Coupon rate (i.e. interest rate) is 12%. Then,

Return on debt = Interest Amount x 100

Purchase Price

= 12 x 100
120

= 10%
Note: Interest is paid on face value and not on purchase price
Ÿ When claim is variable, it is known as equity security. Claim is in the form
of dividend, which is not fixed.
There are two components of returns :
- Dividend received at the end of year.
- Capital gain i.e. profit on sale of equity shares.
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Notes Returns on Equity= [Cash Dividend + End Price - Beginning Price] x 100
Beginning Price
For example, 200 shares with face value Rs. 10 of Hero Honda Ltd. purchased
@ Rs. 200 each. Dividend received is 20%. Shares sold for @ Rs. 250 each
then

Return on equity = [Cash dividend + End price - Beginning price]x 100

Beginning Price

Cash dividend = 2 x 200 = Rs. 400 [20% on face value Rs.10 each]
Beginning Price = 200 x 200 = Rs. 40,000
End Price = 250 x 200 = Rs. 50,000
Note: dividend is paid on face value and not on market value.

Return on Equity = [400 + 50,000 - 40,000] x 100

[40,000]
= 10,400 x 100
40,000

= 26%

Ÿ Financial assets have two economic functions :

i) To transfer funds from those having surplus funds to those who need funds
to invest in tangible assets.
ii) To reduce risk of both issuers and investors.

Ÿ Three types of risks are associated for investing funds in financial assets :
i) Purchasing power of expected cash flows is known as purchasing power
or inflation risk.
ii) Issuer may default on making payment to investor is known as default
risk.
iii) If financial assets are involving cash flow in foreign currency, then there is
a risk that exchange rate will change adversely; it is known as foreign
exchange risk.
2.4 Meaning And Significance Of Financial Market
It is a market for creation and exchange of financial assets. It is a channel
through which funds flow from one market participant to another. It plays
following three important functions
Ÿ Continuous interaction between numerous buyers and sellers help in
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Ÿ establishing prices of financial assets Notes

Ÿ It provides liquidity to financial assets. Individual can sell andbuy the
financial assets through mechanism of financial markets
Ÿ It is useful to reduce transaction costs.
Ÿ Two major costs associated with transacting are search costs and
information costs. Both these costs are reduced due to financial markets
Ÿ Following are the participants of financial market:
1. Ultimate Investors
2. Ultimate borrowers
3. Intermediaries such as - Brokers, Banks, F.Is, NBFCs, Insurance Cos., Unit
trusts.
Following are the two important segments of financial market:

(I) Money Market :

·It is a market where short term securities for a period one year or less are
traded.
Ÿ Money and highly liquid securities are bought and sold in this market.
Ÿ Main function of this market is to bridge gap of liquidity of different
companies.
Ÿ Volume of funds traded is very large (in crore).
Ÿ Controlled by R.B.I.
Following are money market instruments:
(I) T- bill:
These are the treasury bills issued by Govt. for duration 14 to 364 days.

(ii) Central Government Securities or Gilt edged Securities:

Securities issued by central Government.

(iii) Call or notice money market:

In this market, money can be borrowed or lent for period of 1day to 14 days.
When it is borrowed or lent for 1 day, it is called as call money.
When it is borrowed or lent for 2days to 14 days, it is called notice money.

(iv) Commercial paper:

It is a Usance Promissory Note issued by companies who fulfill norms set by
R.B.I. at discount. It is issued for minimum 15 days and maximum one year in
denomination of 5 lacs and multiples thereof.

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Notes Ÿ (v) Certificate of Deposit:

It is issued by any scheduled bank or co-op. bank for minimum 3 months and
maximum one year in the form of promissory note at a discount. They are
negotiable. There is lock-in period for 15 days. Minimum size of deposit is Rs. 1
lac and multiple thereof to single investor.

(vi) Repos (Repurchase of securities):

One party sells a security to another party with an agreement to buy it back at
specified time and price.

(II) Capital market :

Ÿ Market for long term funds (More than one year)
Ÿ It has two components : stock market and debt market
Ÿ In stock market, two instruments are traded viz.
(a) Equity shares
(b) Preference shares
Ÿ In debt market, debt instruments are bought and sold
This market is divided into two markets :
Ÿ Primary Market: securities are directly sold by company to investors
Ÿ Secondary Market: securities are sold by one investor to another investor
through stock exchange.

2.5 S.e.b.i. (securities Exchange Board Of India)

(A) Objectives of SEBI :

i. To protect interests of investors in securities
ii. To promote development of securities market
iii. To regulate securities market

(B) Functions of SEBI :

i) Regulate business in stock exchange and any other security market
ii) Register and regulate working of :
Ÿ Stock brokers
Ÿ Sub brokers
Ÿ Share transfer agents
Ÿ Bankers to issue
Ÿ Trustees of trust deeds
Ÿ Registrars to an issue
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Ÿ Merchant bankers Notes

Ÿ Underwriters
Ÿ Portfolio managers
Ÿ Investment advisors
Ÿ Any other intermediaries

i) Register and regulate working of collective investment schemes

including mutual funds.
ii) Promote and regulate self-regulatory organizations.
iii) Prohibit fraudulent and unfair trade practices in the securities market.
iv)Promote investors education and training of intermediaries in
securities market.
v) Prohibit insiders trading in securities.
vi)Regulate substantial acquisition of shares and takeover of
companies.
vii)Calling information, undertaking inspection.
viii) Conducting enquiries and audits of stock exchanges.
ix) Intermediaries and self-regulatory organizations in securities market.
(C) Role of SEBI in primary market :
SEBI has issued guidelines to tighten the entry norms for companies
assessing capital market, important norms are :
Ÿ Co. must have track record of dividend payment for minimum 3 years
preceding the issue.
Ÿ Co. making public issue must have at least 5 public shareholders for
every one lac of net capital offer made to the public.
Ÿ Promoters contribution should be 20% of issued capital and entire
contribution should be received before public issue.
Ÿ The draft prospectus filed with SEBI is made as a public document to
enhance transparency.
Ÿ Book building has been accepted as one of the modes of public issue
and SEBI has issued specific guidelines for book building process.
Ÿ Minimum application for shares is 200 shares
Ÿ Shares must be allotted on proportionate basis.
Ÿ Of the total issue, 50% should be offered to small investors (who have
applied for 100 or less shares.)
Ÿ Company must complete allotment process within 30 days of closure of
public issue.
Ÿ According to SEBI guidelines, merchant banker is one who handles
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Notes public issue and manages them.

Ÿ Merchant banker must have net worth of Rs. 5 crore.

(D) Role of SEBI in secondary market :

Ÿ Governing body of stock exchanges is constituted as per SEBI's
directives
Ÿ Infrastructure of stock exchanges and computer set up for screen based
trading must be as per directives of SEBI and must be approved by them.
Ÿ Settlement and cleaning of securities must as per norms set by SEBI
Ÿ SEBI has made it mandatory for all debts instruments to be rated from
any one of the authorized credit rating company.
Ÿ SEBI has asked stock exchanges to monitor the prices of newly listed
permitted scrips from the first day of trading.
Ÿ SEBI has issued strict guidelines for de-listing of securities from stock
exchanges.
Ÿ Every broker and sub-broker must be registered with SEBI and must
follow code of conduct laid down by SEBI.
Ÿ Insider trading is prohibited and SEBI is empowered to investigate cases
of insider trading.

2.6 Stock Exchange

Ÿ It is an organized market place where securities are traded.

Ÿ It is called as secondary market.
Ÿ Securities issued by Govt., Semi–Govt. Public sector undertaking and
limited Companies are traded in this market.
Ÿ As per Securities Contract (Regulations) Act 1956, trading insecurities is
regulated by Central Govt.
Ÿ Out of total transactions 80 to 90% are traded in BSE/NSE.
Ÿ Trading in approved contracts can only be done and through registered
members of stock exchange.
Ÿ Trading must be in normal trading hours (10 A.M. to 4 P.M.).
Ÿ In BSE Screen based trading called BOLT (BSES – on-line Trading) has
been introduced. At present BOLT is a nationwide network. Securities
traded in BSE are classified in various groups viz.
Group A: Specified shares i.e. Cos. with large outstanding shares, good track
record and large volume of business in the secondary market.
Group B1: Relatively liquid securities
Group B2: Remaining shares
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Group F: Debt securities Notes

Group Z: Companies not complying with listing requirements and not
responding to investors complaints.

Ÿ There is a separate surveillance department in the stock exchange to

ensure free and fair market.
Ÿ NSE was established in 1994. It has following main objectives :
- To establish nation-wide trading facilities for equities, debt
instruments and hybrids.
- To ensure equal access to investors all over the country through
appropriate communication network.
- To provide fair, efficient and transparent securities market to
investors using.
Ÿ Electronic communication network :
- To enable shorter settlement cycle.
- To meet current international standards of securities market.
Ÿ NSE ensures wider accessibility the satellite linked trading facility.
Computers terminals and links with VSAT help the traders to contact
their counterparts in other parts of the country quickly. The quick trading
system ensures better pricing.
Ÿ After establishing its operations in Mumbai. NSE had expanded its
operations to other cities.

Objective Stock Exchange :

I) To safeguard the interest of investing public having dealings on the

exchange.
ii) To establish and promote honorable and just practices in securities
transactions
iii) To promote, develop and maintain well-regulated market for dealing in
securities.
iv) To promote industrial development in the country through efficient
resource mobilization by way of investment in corporate securities.

2.7 Summary

Ÿ Every finance manager has to raise funds for his company. He must be
aware of meaning and significance of financial system, financial market
and financial assets.
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Notes Ÿ Financial system provides statutory framework for raising funds by

company and gives safety and security to investors.
Ÿ Financial assets are intangible assets, which have future claims. When
claim is fixed, it is called debt security and when variable it is called equity
security.
Ÿ Financial market provides liquidity and price fixing for financial assets.
Two main arms of this market are money market where funds required for
period less than one year can be procured by company. Other arm is
capital market. When funds are required for more than one year,
company approaches this market.
Ÿ S.E.B.I. is an apex regulatory authority, which controls financial market
and protects the interest of investors.
Ÿ Stock exchange is a place where financial assets are bought or sold.
Norms provided by stock exchange ensures that dealings in financial
assets are fair.

2.8 Self Assessment Questions

[A] Fill in the blanks.

1. When claim on financial asset is ________________________it is called

equity.

2. Financial market is a market for ___________and ______________of

financial assets.

3. T- bills have duration _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ t o

________________________days.

4. Money market is controlled by ________________________.

5. Stock exchange is called as ________________________ .

[B] Select the Correct Alternative

1. Financial system comprises of:
a. Financial Institutions and Financial Markets
b. Financial Institutions, Financial Market, Financial Instruments
and Regulators
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