1.

Krishna has recently joined an investment management company and his profile
consisted of money market instruments. His manager in order to estimate his
understanding of the market, asked him to prepare a report on the instruments of the
market. Suggest which instruments of the financial market should be included in his
report.

Answer: Money market

It is the place where transactions take place over a short period of time. Theperiod is
normally up to one year and substitutes to money are used todenote any financial asset. This
can be done quickly to convert substitutesinto money with less transaction cost.Money
market has become a component of the financial market for buying and selling of securities
of short-term maturities, of one year or less, such as treasury bills and commercial
papers.Over-the-counter trading is done in the money market and it is a wholesale process. It
is used by the participants as a way of borrowing and lending for the short term.

The money market is an unregulated and informal market and not structured like the capital
markets, where things are organised in a formal way. Money market gives lesser return to
investors who invest in it but provides a variety of products. Withdrawing money from the
money market is easier. Money markets are different from capital markets as they are for a
shorter period of time while capital markets are used for longer time periods.

Following money market instruments should be included in Krishna’s report:

Call/notice money: This is used for intraday transactions. Interveningholidays and/or
Sundays are excluded for this purpose. Thus, moneyborrowed on a day and returned on the
very next working day is called "CallMoney". When money is borrowed or lent for more than
a day and up to14 days, it is called "Notice Money". No collateral security is required tocover
these transactions.Banks who seeks to avail liquidity approaches the call market as borrowers
and the ones who have excess liquidity participate there as lenders. The CMM is functional
from Monday to Friday. Banks can access CMM to meet their reserve requirements (CRR
and SLR) or to cover a sudden shortfall in cash on any particular day.

Term money: If the deposits are made for more than 14 days in interbankmarkets, it is called
term money. The entry restrictions are the same asthose for call/notice money, except that as
per existing regulations, thespecified entities are not allowed to lend beyond 14 days.

Treasury bills: These are short-term (up to one year) borrowinginstruments of the
Government of India. It is an IOU (I owe you) of theGovernment. It is nothing but a promise
made by the government to pay astated sum from the date of issue after termination of the
stipulated period.Treasury bills are issued for a period of 14 days, 91 days, 182 days and 364
days. They are issued at a discount to the face value, and paid to the holderof such bills on
maturity. During the auction, the discount rate and issueprice are resolved and
ascertained.The treasuries bills have not developed as an active monetary instrument inthe
market as these bills of 91 days do not provide a yield which is positive.Due to their high
liquidity and safety, 182 days treasury bills despite lowrates represent the most important
instrument of money market and aversatile one in the hands of the effective fund managers of
firms,companies and banks. The market can be improved only by enhancing the nominal rate
of discountas compared to the expected rate in the price level.

Certificate of deposits (CDs): It is a negotiable money market instrumentand issued as

aUsance Promissory Note. These are given in lieu of thefunds deposited with a bank or other
financial institution for a stipulated timeperiod. The RBI directs the guidelines for issue of
CDs and these directionsare amended from time to time.Certificate of deposits can be issued
by:
 Scheduled commercial banks excluding Regional Rural Banks (RRBs)and Local Area
Banks (LABs); and
 Selected financial institutions in India, which are allowed by the RBI inorder to raise
short-term funds within the fixed umbrella limit. Scheduledbanks can issue CDs
according to their requirements.CDs can be issued by financial institutions within
their umbrella limit asdetermined by RBI. Issue of such CDs along with other
instruments, viz.term deposits, term money and commercial papers, etc. should not
exceed100 percent of its net owned funds, as per the latest audited balance sheet.

Commercial paper (CP): CP is a note in evidence of the debt obligation ofthe issuer. The
debt commitment on issuing the CP is changed as aninstrument. Therefore, a CP is an
unsecured promissory note given toinvestors at a discounted rate to face value determined by
market forces.CP is negotiable by making necessary endorsement in it, and can be issuedby
any company whose:
 Tangible net worth as per the latest audited balance sheet is not lessthan ` 4 crore.
 Has been sanctioned working capital limit by bank/s or all-India financialinstitution/s.
 Borrowable account is classified as a Standard Asset by the financingbank/s.
The minimum maturity period of CP is seven days. The minimum creditrating of such
companies shall be P-2 of CRISIL or such equivalent rating byother agencies.

Banker's acceptance: A banker's acceptance is also a short-term investment plan that comes
froma company or a firm backed by a guarantee from the bank. This guaranteestates that the
buyer will pay the seller at a future date. One who draws thebill should have a sound credit
rating. 90 days is the usual term for theseinstruments. The term for these instruments can also
vary between 30 and180 days. It is used as time draft to finance imports, exports.It depends
on the economic trends and market situation that RBI takes astep forward to ease out the
disparities in the market. Whenever there is aliquidity crunch, the RBI opts either to reduce
the Cash Reserve Ratio(CRR) or infuse more money in the economic system.

2. Nisha has completed her graduation and had started working in an MNC. She was
able to save good amount every month so she thought of making investments. She had
heard about capital market from her friend Alok. She decided to approach him to
understand the process to start investments in capital market. If you are Alok, mention
step by step process to Nisha, keeping in mind she doesn’t understand trading
mechanism.

Answer: The capital market is the place where transactions take place for more thana year.
Capital market instruments are equity shares, preference shares,convertible preference shares,
non-convertible preference shares etc. and inthe debt segment debentures, zero coupon bonds,
deep discount bonds etc.The primary market is that part of the capital markets thatdeals with
the issuance of new securities. Companies, governments orpublic sector institutions can
obtain funding through the sale of a new stockor bond issue.

Features of primary markets are:

 The primary market is the market where the securities are sold for thefirst time.
Therefore it is also called the new issue market.
  In a primary market securities are issued by the company directly toinvestors.
 Primary issues are used by companies for the purpose of setting up newbusiness or for
expanding or modernizing the existing business.
 The primary market performs the crucial function of facilitating capitalformation in
the economy.
 The financial assets sold can only be redeemed by the original holder.

Secondary market is the place where existingsecurities are bought and sold. The secondary
market for a variety of assetscan vary from loans to stocks, from fragmented to centralized,
and fromilliquid to very liquid. The major stock exchanges are the most visibleexample of
liquid secondary markets – in this case, for stocks of publiclytraded companies. Exchanges
such as the New York Stock Exchange,NASDAQ and the American Stock Exchange provide
a centralized, liquidsecondary market for the investors who own stocks that trade on
thoseexchanges. Most bonds and structured products trade “over the counter,” orby phoning
the bond desk of one’s broker-dealer.

Security brokers or dealers are intermediaries who help companies andinvestors find one
another. Many entrepreneurs hire brokers to help themraise money in the hope, that by doing
so, they will reduce the amount oftime they will have to spend in fund raising. In some cases,
brokers canprovide companies with valuable introductions that lead to financing.Leasing
represents a specialized financial institution that provides theaccess to productive assets such
as airplanes, automobiles, machinery, etc.The leased assets allow the businesses to use them
at a lower cost thanborrowing or owing them. Both the parties involved in the lease
agreement
will benefit through the arrangement.The trading platform of stock exchanges is accessible
only throughbrokers and trading of securities is confined only to stock exchanges.

Trading mechanism of the market

Trading on stock exchanges is done through brokers and dealers. Allmembers can act as
brokers and for this purpose they have to maintainsecurity deposits. Brokers act as agents,
buying and selling or others forwhich they receive brokerage commission at stipulated rates.
Dealers act asprincipals and sell securities on their own accounts.However, members cannot
enter into contract with any person other than amember without prior permission the
governing body. Given below are thekey members of the stock exchanges:
1. Commission Broker: The commission broker executes buying andselling on the floor of
the stock exchange.
2. Floor Broker: Floor brokers are not many. They execute orders forfellow members and
receives a share brokerage commission charged bya commission broker to his/her constituent.
3. Tataniwala: He/she is a jobber or specialist in selected shares he/she'makes the market' i.e.
brings continuity to dealings. They specialize instocks which are traded inactively.
4. Dealer in Non-cleared Securities: He/she deals in securities which arenot on the active
list.
5. Odd-lot Dealer: He/she specializes in buying and selling in amountswhich are less than
present trading units. They buy and sell odd lots,make them up into marketable trading units.
These dealers receivecommission.

Basic formalities before investing in stock market

KYC formalities: The need for KYC is to comply with the market regulator SEBI in
accordance with the Prevention of Money laundering Act, 2002 ('PMLA'), which undergo
changes from time to time.KYC process is investor friendly and is uniform across various
SEBI regulated intermediaries in the securities market such as Mutual Funds, Portfolio
Managers, Depository Participants, Stock Brokers, Venture Capital Funds, Collective
Investment Schemes and others. This way, a single KYC eliminates duplication of the KYC
process across these intermediaries and makes investing more investor friendly. KYC stands
for know your customer. As per the rules of SEBI an investor should be KYC complaint then
only he/she can make the investment in stock market or mutual funds. For KYC, we need to
provide our identity proof and address proof. PAN card is good proof of identity but these
days aadhar card is gaining importance so you should have aadhar card too.
Open demat account: After KYC verification, we need to open a demat account with any
stock broker who will help us to make investment in stock market. A cancelled cheque is also
required along with other documents. These days brokers are opening demat account free of
cost. You can take the advantage of online trading as well. Your broker will help you to
understand the procedure to trade online. India adopted the Demat System for electronic
storing, wherein shares and securities are represented and maintained electronically, thus
eliminating the troubles associated with paper shares. After the introduction of the depository
system by the Depository Act of 1996, the process for sales, purchases and transfers of shares
became significantly easier and most of the risks associated with paper certificates were
mitigated.
Savings account: Savings account is mandatory to invest in stock market, you will use this
account to buy shares or get the proceeds of selling the shares. In our case, Mr. Kripa Shankar
has savings account so this condition is already satisfied.
Computer with internet connection: If you wish to trade online then you need computer/
laptop and good internet connection. As online trading is quick and easy, you should use it.

3. Alok was working in the portfolio management department of Alpha Ltd and had
new recruits to whom he was supposed to provide training on the risks associated with
the financial market as apart from earning returns they should be well aware of the
risks that can be managed and which ones cannot be managed in a portfolio. He decided
to broadly classify the risks in two categories and explain the different types of risks
associated with each one. If you are Alok,
3a) Explain different types of risks associated with systematic risk.
3b) Explain different types of risks associated with unsystematic risk.

Answer: a) Systematic risk affects the entire market. Often we read in the newspaper thatthe
stock market is grappling in the a bear hug or a bull grip. This indicates thatthe entire market
is moving in a particular direction, either downward or upward.Economic conditions,
political situations and sociological changes affect thesecurity market. The recession in the
economy affects the profit prospect of theindustry and the stock market. The 1998 recession
experiencedby developedand developing countries has affected the stock markets all over the
world. The
South East Asian crisis has affected stock market worldwide. There the factorsare beyond the
control of the corporate and the investor. They cannot be entirelyavoided by the investor. It
drives home the point that systematic risk isunavoidable.

Different types of risks associated with systematic risk

Market risk: Market risk is the possibility of an investor experiencing losses due to factors
that affect the overall performance of the financial markets in which he or she is involved.
Market risk, also called "systematic risk," cannot be eliminated through diversification,
though it can be hedged against.
Interest Rate Risk: Interest rate risk is the variation in the single period rates of return
caused by thefluctuations in the market interest rate. Most commonly, interest rate risk
affectsthe price of bonds, debentures and stocks. The fluctuations in the interest ratesare
caused by changes in the government monetary policy and changes thatoccur in the interest
rates of treasury bills and the government bonds. The bondsissued by the government and
quasi-government are considered to be risk free.If higher interest rates are offered, investor
would like to switch his investmentsfrom private sector bonds to public sector bonds. If the
government to tide overthe deficit in the budget floats a new loan/bond of a higher rate of
interest, therewould be a definite shift in the funds from low yielding bonds to high
yieldingbonds and from stocks to bonds.

Purchasing Power Risk: Variations in the returns are caused also by the loss of purchasing
power ofcurrency. Inflation is the reason behind the loss of purchasing power. The levelof
inflation proceeds faster than the increase in capital value. Purchasing powerrisk is the
probable loss in the purchasing power of the returns to be received.The rise in price penalises
the returns to the investor and every potential rise inprice is a risk to the investor.Inflation
may be demand-pull or cost-push in nature. In the demand pullinflation, the demand for
goods and services are in excess of their supply. At fullemployment level of factors of
production, the economy would not be able tosupply more goods in the short run and the
demand for products pushes theprice upward. The supply cannot be increased unless there is
an expansion oflabour force or machinery for production. The equilibrium between demand
andsupply is attained at a higher price level.

b) Unsystematic risk is unique and peculiar to a firm or anindustry. It stems from managerial
inefficiency, technological change in theproduction process, availability of raw material,
changes in the consumerpreference and labour problems. The nature and magnitude of these
factorsdiffer from industry to industry, and company to company. They have to beanalysed
separately for each industry and firm. Technologicalchanges affect the information
technology industry more than that of consumerproduct industry. Thus, it differs from
industry to industry. Financial leverage ofthe companies that is debt-equity portion of the
companies differs from eachother. All these factors form unsystematic risk and contribute a
portionin the total variability of the return.

Different types of risks associated with unsystematic risk

Business Risk: Business risk is that portion of the unsystematic risk caused by the
operatingenvironment of the business. Business risk arises from the inability of a firm
tomaintain its competitive edge and the growth or stability of the earnings. Variationthat
occurs in the operating environment is reflected on the operating incomeand expected
dividends. The variation in the expected operating income indicatesthe business risk.
Consider two companies—Anu and Vinu companies. In Anucompany, operating income
could grow as much as 15 per cent and as low as7 per cent. In Vinu company, the operating
income can be either 12 per cent or9 per cent. When both the companies are compared, Anu
company’sbusinessrisk is higher because of its high variability in operating income compared
toVinu company. Thus, business risk is concerned with the difference betweenrevenue and
earnings before interest and tax. Business risk can be divided intoexternal business risk and
internal business risk.

Financial Risk: Financial risk refers to the variability of the income to the equity capital due
to thedebt capital. Financial risk in a company is associated with the capital structureof the
company. Capital structure of the company consists of equity funds andborrowed funds. The
presence of debt and preference capital results in acommitment of paying interest or pre fixed
rate of dividend. The residual incomealone would be available to the equity holders. The
interest payment affects thepayments that are due to the equity investors. Debt financing
increases thevariability of the returns to the common stock holders and affects
theirexpectations regarding the return. The use of debt with the owned funds toincrease the
return to the shareholders is known as financial leverage.Debt financing enables a corporate
to have funds at a low cost and lowfinancial leverage to the shareholders. As long as the
earnings of a companyare higher than the cost of borrowed funds, shareholders’ earnings are
increased.At the same time when the earnings are low, it may lead to bankruptcy to
equityholders.