CHPATER FOUR

Financial Markets in Financial Systems

4.1 Financial Market Structure
 Financial market is a mechanism allows people to easily buy and sell financial
securities, commodities, and other fungible items of value at low transaction costs
and at prices that reflect the efficient market hypothesis.
 Financial markets have evolved significantly over several hundred years and are
undergoing constant innovation to improve liquidity.
 Both general markets and specialized markets exist.
 Markets work by placing many interested sellers in one "place", thus making them
easier to find for prospective buyers.
 An economy which relies primarily on interactions between buyers and sellers to
allocate resources is known as a market economy in contrast either to a command
economy or to a non-market economy that is based, such as a gift economy.

 Financial Markets are the place where peoples and organization wanting to borrow
money are brought together with those having surplus funds”.
 The markets relay information, shift risk, set prices, and help move resource to their
most valued use.
 Smooth financial markets are key to an efficient economy.
 Financial markets are markets in which funds are transferred from people who have
an excess of available funds to people who have a shortage.
 Financial markets such as bond and stock markets are crucial to promoting greater
economic efficiency
 By channeling funds from people who do not have a productive use for them
to those who do. Indeed, well-functioning financial markets are a key factor
in producing high economic growth, and poorly performing financial markets
are one reason that many countries in the world remain desperately poor.
 In finance, financial markets facilitate:
• The raising of capital (in the capital market)
• The transfer of risk (in the derivative markets)
• International trade (in the currency market).
Functions of Financial Markets and institutions
Financial markets serve many functions. Some of these functions are briefly listed below:
 Borrowing and Lending: Financial markets permit the transfer of funds (purchasing
power) from one agent to another for either investment or consumption purposes.
Financial institutions allow individuals to transfer expenditures across time. If you
have more money now than you need and you wish to save for a rainy day, you can
(for example) put the money on deposit in a bank. If you wish to anticipate some of
your future income to buy a car, you can borrow money from the bank. Both the
lender and the borrower are happier than if they were forced to spend cash as it
arrived.
 Price Determination: Financial markets provide vehicles by which prices are set both
for newly issued financial assets and for the existing stock of financial assets.
 Information Aggregation and Coordination: Financial markets act as collectors and
aggregators of information about financial asset values and the flow of funds from

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 lenders to borrowers.
 Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments. Financial markets and
institutions allow individuals and firms to pool their risks. Insurance companies are an
obvious example.
 Liquidity: Financial markets provide the holders of financial assets with a chance to
resell or liquidate these assets.
 Efficiency: Financial markets reduce transaction costs and information costs.
 The Payment Mechanism: Think how inconvenient life would be if you had to pay
for every purchase in cash or if General Motors had to ship truckloads of hundred-
dollar bills round the country to pay its suppliers. Checking accounts, credit cards, and
electronic transfers allow individuals and firms to send and receive payments quickly
and safely over long distances. Banks are the obvious providers of payment services,
but they are not alone. For example, if you buy shares in a money-market mutual
fund, your money is pooled with that of other investors and used to buy safe, short-
term securities. You can then write checks on this mutual fund investment, just as if
you had a bank deposit.
In attempting to characterize the way financial markets operate, one must consider both the
various types of financial institutions that participate in such markets and the various ways in
which these markets are structured. In addition, financial markets all so make:
 to enabling exchange of previously issued financial assets,
 facilitate borrowing and lending by facilitating the sale of newly issued financial
assets.
 facilitating for the sale and buying of financial assets

4.2. PRIMARY AND SECONDARY MARKET

Financial markets is by whether the financial claims are newly issued. When an issuer
sells a new financial asset to the public, it is said to “issue” the financial asset. The market
for newly issued financial assets is called the primary market. After a certain period of
time, the financial asset is bought and sold (i.e., exchanged or traded) among investors.
The market where this activity takes place is referred to as the secondary market.

4.3 Money Markets

The term “money market” refers to the network of corporations, financial institutions,
investors and governments which deal with the flow of short-term capital. When a business
needs cash for a couple of months until a big payment arrives, or when a bank wants to invest
money that depositors may withdraw at any moment, or when a government tries to meet its
payroll in the face of big seasonal fluctuations in tax receipts, the short-term liquidity
transactions occur in the money market. The money markets have expanded significantly in
recent years as a result of the general outflow of money from the banking industry, a process
referred to as disintermediation. Until the start of the 1980s, financial markets in almost all
countries were centered on commercial banks.

Savers and investors kept most of their assets on deposit with banks, either as short-term
demand deposits, such as cheque-writing accounts, paying little or no interest, or in the form

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of certificates of deposit that tied up the money for years. Drawing on this reliable supply of
low-cost money, banks were the main source of credit for both businesses and consumers.

Financial deregulation has caused banks to lose market share in both deposit gathering and
lending. This trend has been encouraged by legislation, such as the Monetary Control Act of
1980 in the United States, which allowed market forces rather than regulators to determine
interest rates. Investors can place their money on deposit with investment companies that
offer competitive interest rates without requiring a long term commitment. Many borrowers
can sell short-term debt to the same sorts of entities, also at competitive rates, rather than
negotiating loans from bankers. The money markets are the mechanism that brings these
borrowers and investors together without the comparatively costly intermediation of banks.
They make it possible for borrowers to meet short-run liquidity needs and deal with irregular
cash flows without resorting to more costly means of raising money.

There is an identifiable money market for each currency, because interest rates vary from one
currency to another. These markets are not independent, and both investors and borrowers
will shift from one currency to another depending upon relative interest rates. However,
regulations limit the ability of some money-market investors to hold foreign-currency
instruments, and most money-market investors are concerned to minimize any risk of loss as
a result of exchange-rate fluctuations. For these reasons, most money-market transactions
occur in the investor’s home currency.

The money markets do not exist in a particular place or operate according to a single set of
rules. Nor do they offer a single set of posted prices, with one current interest rate for money.
Rather, they are webs of borrowers and lenders, all linked by telephones and computers. At
the center of each web is the central bank whose policies determine the short-term interest
rates for that currency. Arrayed around the central bankers are the treasurers of tens of
thousands of businesses and government agencies, whose job is to invest any unneeded cash
as safely and profitably as possible and, when necessary, to borrow at the lowest possible
cost. The connections among them are established by banks and investment companies that
trade securities as their main business.

The constant soundings among these diverse players for the best available rate at a particular
moment are the force that keeps the market competitive.

The Bank for International Settlements, which compiles statistics gathered by national central
banks, estimates that the total amount of money-market instruments in circulation worldwide
at December 2004 was $8.2 trillion, compared with $6 trillion in 2001 and $4 trillion at the
end of 1995.

What money markets do

There is no precise definition of the money markets, but the phrase is usually applied to the
buying and selling of debt instruments maturing in one year or less. The money markets are
thus related to the bond markets, in which corporations and governments borrow and lend
based on longer-term contracts. Similar to bond investors, money-market investors are

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extending credit, without taking any ownership in the borrowing entity or any control over
management.

Bond issuers typically raise money to finance investments that will generate profits – or, in
the case of government issuers, public benefits – for many years into the future.

Issuers of money-market instruments are usually more concerned with cash management or
with financing their portfolios of financial assets. A well-functioning money market
facilitates the development of a market for longer-term securities. Money markets attach a
price to liquidity, the availability of money for immediate investment. The interest rates for
extremely short-term use of money serve as benchmarks for longer-term financial
instruments. If the money markets are active, or “liquid”, borrowers and investors always
have the option of engaging in a series of short-term transactions rather than in longer-term
transactions, and this usually holds down longer-term rates. In the absence of active money
markets to set short-term rates, issuers and investors may have less confidence that longer-
term rates are reasonable and greater concern about being able to sell their securities should
they choose. For this reason, countries with less active money markets, on balance, also tend
to have less active bond markets.

Investing in money markets

Short-term instruments are often unattractive to investors, because the high cost of learning
about the financial status of a borrower can outweigh the benefits of acquiring a security with
a life span of six months. For this reason, investors typically purchase money-market
instruments through funds, rather than buying individual securities directly.

Money-market funds

The expansion of the money markets has been fuelled by a special type of entity, the money-
market fund, which pools money-market securities, allowing investors to diversify risk
among the various company securities in the fund. Retail money-market funds cater for
individuals, and institutional money-market funds serve corporations, foundations,
government agencies and other large investors. The funds are normally required by law or
regulation to invest only in cash equivalents, securities whose safety and liquidity make them
almost as good as cash. Money-market funds are a comparatively recent innovation. They
reduce investors’ search costs and risks. They are also able to perform the role of
intermediation at much lower cost than banks, because money-market funds do not need to
maintain branch offices, accept accounts with small balances and otherwise deal with the
diverse demands of bank customers. The spread between the rate money market funds pay
investors and the rate at which they lend out these investors’ money is normally a few tenths
of a percentage point, rather than the 2–4 percentage point spread between what banks pay
depositors and charge borrowers.

The shift of short-term capital into investment funds rather than banks is most advanced in
the United States, which began deregulating its financial sector earlier than most other
countries. The flow of assets into money-market funds is related to the gap between short

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term and long-term interest rates; assets in US money-market funds fell between 2001 and
2005, as extremely low short-term interest rates encouraged investors to put their money
elsewhere.
The investment companies that operate equity funds and bond funds usually provide money-
market funds to house the cash that investors wish to keep available for immediate
investment. People with large amounts of assets often invest in money-market instruments
through sweep accounts. These are multipurpose accounts at banks or stockbrokerage firms,
with the assets used for paying current bills, investing in shares and buying mutual funds.
Any uncommitted cash is automatically “swept” into money-market funds or overnight
investments at the end of each day, in order to earn the highest possible return.

Institutional investors

Money-market funds are by no means the only investors in money market instruments. All
sizeable banks maintain trading departments that actively speculate in short-term securities.
Investment trusts (mutual funds) that mainly hold bonds or equities normally keep a small
proportion of their assets in money-market instruments to provide flexibility, in part to meet
investors’ requests to redeem shares in the trust without having to dispose of long-term
holdings. Pension funds and insurers, which typically invest with extremely long time
horizons, also invest a proportion of their assets in money-market instruments in order to
have access to cash at any time without liquidating long-term positions. Businesses in the
United States owned $323 billion of money market instruments, including commercial paper
and shares in money market funds, in mid-2005. Certain types of money-market instruments,
particularly bank certificates of deposit, are often owned directly by individual investors.

Interest rates and prices

Borrowers in the money markets pay interest for the use of the money they have borrowed.
Most money-market securities pay interest at a fixed rate, which is determined by market
conditions at the time they are issued. Some issuers prefer to offer adjustable-rate
instruments, on which the rate will change from time to time according to procedures laid
down at the time the instruments are sold. Because of their short maturities, most money-
market instruments do not pay periodic interest during their lifetimes but rather are sold to
investors at a discount to their face value. The investor can redeem them at face value when
they mature, with the profit on the redemption serving in place of interest payments.

The value of money-market securities changes inversely to changes in short-term interest

rates. Because money-market instruments by nature are short term, their prices are much less
volatile than the prices of longer-term instruments, and any loss or gain from holding the
security in the short time until maturity rather than investing at current yields is small.

A. Economic Role of the money market

The most important economic function of the money market is to provide an efficient means

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for economic units to adjust their liquidity positions. Money markets help governments,
businesses, and individuals to manage their liquidity by temporarily bridging the gap between
cash receipts and cash expenditures. If a firm is temporarily short of cash, it can borrow in the
money market; or if it has temporary excess cash, it can invest in short-term money market
instruments. In doing so a money market performs a number of functions in an economy.

 It provides funds
 It helps to use surplus funds
 It eliminates the need to borrow from banks
 It helps government to borrow money at a lower interest rate
 It helps the implementation of the monetary policies of the central bank
 It facilitates the financial mobility from one sector to the other
 It promotes liquidity and safety of financial institutions
 It brings equilibrium between demand and supply of funds
 It economizes the use of cash.

B. Institutions of the Money Market

The various financial institutions which deal in short-term loans in the money market are:
1. The Central Bank: It does not itself enter into direct transactions. But control the
money market through variations in the bank rate and open market operation. It acts
as a guardian of the money market.

2. Commercial Banks: They deal in short-term loans which they lend to business and
trade. They discount bills of exchange and treasury bills. They lend against
promissory notes and through advances and overdrafts.

3. Non-bank Financial Intermediaries: This includes savings and loans associations,

mutual funds and credit unions. They deal in short term lending and advances.

4. Discount Houses and Bill Brokers: Discount houses’ primary function is to discount
bills on behalf of others. Bull brokers or dealers act as an intermediary between
borrowers and lenders by discounting bills of exchange at a nominal commission.
Dealers buy securities for their one position and sell from their security inventories,
when a trade takes place. Dealers and brokers specialize in one or more money market
instruments and they remain to be the main part of the money market.

5. Acceptance Houses: They act as agents between exporters and importers and lender and
borrower traders. They accept bills drawn on merchants whose financial standing is not
known in order to make the bills negotiable.

C. Sub Markets of the Money Market

The money market is a network of markets that are grouped together because they deal in

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financial instruments that have a similar function in the economy and are to some degree
substitutes from the point of view of holders. However, these markets use different credit
instruments. As the money market consists of varied types of institutions dealing in different
types of instruments, it operates through a number of sub-markets.

1. The call loan market: It is a market for marginal funds, for temporarily unemployed or
unemployable funds. For instance, commercial banks advance loans to bill brokers and
dealers in stock exchange so as to use the fund to discount or purchase bills or stocks for a
short period of time, one night, a week or not more than 14 days. The same thing is true
that central banks advance loans to commercial banks for a short period. The central bank
applies a rate called “call rate”, which is usually less than the normal rate but sometimes
it may be even greater than the normal rate.

2. The bill market: It is the short period loan market. In this market Commercial banks,
discount houses and brokers lend to businesspersons. The commercial banks discount
bills of exchange, lend against promissory notes, or through advances or overdrafts to the
businessperson and lend government through treasury bills.
The discount houses and bill brokers lend to businesspersons by discounting their bills of
exchange before they mature.

3. The collateral loan market: the commercial banks lend the discount houses and bill
brokers against collateral bonds, stocks; securities, etc. The commercial banks borrow
from big/large/ banks and the central bank on the basis of collateral securities.

4. The acceptance market: The merchant bankers accept bills drawn on domestic and
foreign traders whose financial standing is not known commercial banks have started the
acceptance business.

D. Characteristics of the Money Market

Money markets may be developed and undeveloped markets. Their characteristics can be
presented as follows.

i. Characteristics of an Undeveloped Money Market

The main characteristics of such a market are:

1. There is Personal Touch: The lender and borrower are known each other and decision
made in this market are not rational and objective.
2. There is flexibility in loans: The amount of the loan depends upon the nature of security
or the borrower’s good will with the money lender.
3. Multiplicity of Lending Activities: Money lending activity is combined with other
economic activities i.e., money lending is not the only activity of the money lender.
4. Varied Interest Rates are Applied: The rate depends on the need of the borrower, the
amount of the loan, the time for which it is required and the nature of security.
5. Defective Accounting System: The accounts of the moneylenders are not liable to
checking by any higher authority.

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6. Absence of link with the developed Market: There is no established channel to create a
link between the developed and undeveloped markets. The undeveloped money market
consists of the moneylenders, the indigenous bankers, traders, merchants, landlords,
brokers, etc.

ii. Characteristics of a Developed Money Market

The main characteristics of such a market are:
1. It is a well-developed market and consists of the central bank, the commercial bank,
bill brokers, discount houses, acceptance houses, etc.
2. The central bank controls, regulates and guides the entire money market
3. It consists of a number of specialized sub markets dealing in various types of credit
instruments such as the call loan market, the bill market, the treasury bill market, the
collateral loan market, the acceptance market and the foreign exchange market.
4. It has a large number of near money assets of various types such as: bills of exchange,
promissory notes, treasury bills, securities, bonds, etc.
5. It has an integrated interest rate structure. The change in the bank rate leads to
proportional changes in the interest rate prevailing in the sub-markets.
6. It has an adequate financial resources form both within and outside the country.
7. It provides easy and cheep remittance facilities for transferring funds from one market
to the other.
8. It is highly influenced by such factors as restrictions on international transactions,
crisis, boom, depression, war, political instability, etc.

Common Money Market Instruments

 Treasury Bills
 Bankers' acceptance - A draft issued by a bank that will be accepted for payment,
effectively the same as a cashier's check.
 Certificate of deposit - A time deposit at a bank with a specific maturity date; large-
denomination certificates of deposits can be sold before maturity.
 Repurchase agreements - Short-term loans—normally for less than two weeks and
frequently for one day—arranged by selling securities to an investor with an
agreement to repurchase them at a fixed price on a fixed date.
 Commercial paper - An unsecured promissory notes with a fixed maturity of one to
270 days; usually sold at a discount from face value.
 Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located
outside the United States.
 Federal Agency Short-Term Securities - (in the US). Short-term securities issued by
government sponsored enterprises such as the Farm Credit System, the Federal Home
Loan Banks and the Federal National Mortgage Association.
 Federal funds - (in the US). Interest-bearing deposits held by banks and other
depository institutions at the Federal Reserve; these are immediately available funds
that institutions borrow or lend, usually on an overnight basis. They are lent for the
federal funds rate.
 Municipal notes - (in the US). Short-term notes issued by municipalities in
anticipation of tax receipts or other revenues.

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  Treasury bills - Short-term debt obligations of a national government that are issued
to mature in 3 to 12 months. For the U.S., see Treasury bills.
 Money market mutual funds - Pooled short maturity, high quality investments which
buy money market securities on behalf of retail or institutional investors.
 Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the
reversal of the exchange of currencies at a predetermined time in the future.

Treasury Bills

Treasury bills (T-bills) are very safe short-term investments issued by the federal government
and some provinces. Like zero-coupon bonds, they do not pay interest prior to maturity;
instead they are sold at a discount of the par value to create a positive yield to maturity.

Governments issue T-bills in very large denominations of $1 million or so. Banks and
investment dealers break these up and sell them to investors. You always buy a T-bill at a
discount to its face value

General calculation for yield on Treasury bills is

Other types of treasury

a) Treasury note

Treasury notes (or T-Notes) mature in two to ten years. They have a coupon payment every
six months, and are commonly issued with maturities dates of 2, 5 or 10 years, for
denominations from $1,000 to $1,000,000.

b) Treasury bond

Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from ten years to
thirty years. They have coupon payment every six months like T-Notes, and are commonly
issued with maturity of thirty years. The secondary market is highly liquid, so the yield on the
most recent T-Bond offering was commonly used as a proxy for long-term interest rates in
general.

c) Zero-Percent Certificate of Indebtedness

The "Certificate of Indebtedness" is a Treasury security that does not earn any interest and
has no fixed maturity. It can only be held in a Treasury Direct account and bought or sold
directly through the Treasury. It is intended to be used as a source of funds for traditional
Treasury security purchases. Purchases and redemptions can be made at any time.

1. Bankers' acceptance

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A banker's acceptance, or BA, is a time draft drawn on and accepted by a bank. Before
acceptance, the draft is not an obligation of the bank; it is merely an order by the drawer to
the bank to pay a specified sum of money on a specified date to a named person or to the
bearer of the draft. Upon acceptance, which occurs when an authorized bank accepts and
signs it, the draft becomes a primary and unconditional liability of the bank. If the bank is
well known and enjoys a good reputation, the accepted draft may be readily sold in an active
market. A banker's acceptance is also a money market instrument – a short-term discount
instrument that usually arises in the course of international trade.

Bankers' acceptances are considered very safe assets, as they allow traders to substitute the
banks' credit standing for their own

2. Certificate of deposit

A certificate of deposit or CD is a time deposit, a financial product commonly offered to

consumers by banks, thrift institutions, and credit unions.

Such CDs are similar to savings accounts in that they are insured and thus virtually risk-free;
they are "money in the bank". They are different from savings accounts in that the CD has a
specific, fixed term (often three months, six months, or one to five years), and, usually, a
fixed interest rate. It is intended that the CD be held until maturity, at which time the money
may be withdrawn together with the accrued interest.

3. Repurchase agreement

Better known as Repurchase agreements (RPs or repos), a Sale and Repurchase Agreement
has a borrower (seller/cash receiver) sell securities for cash to a lender (buyer/cash provider)
and agrees to repurchase those securities at a later date for more cash. The repo rate is the
difference between borrowed and paid back cash expressed as a percentage.

A repo is economically similar to a secured loan, with the buyer receiving securities as
collateral to protect against default. There is little that prevents any security from being
employed in a repo; so, Treasury or Government bills, corporate and Treasury / Government
bonds, and stocks / shares, may all be used as securities involved in a repo.

Types of repo and related products

There are three types of repo maturities: overnight, term, and open repo. Overnight refers to a
one-day maturity transaction. Term refers to a repo with a specified end date. Open simply
has no end date. Although repos are typically short-term, it is not unusual to see repos with a
maturity as long as two years

4. Eurodollar

Eurodollars are deposits denominated in United States dollars at banks outside the United
States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such
deposits are subject to much less regulation than similar deposits within the United States,

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allowing for higher margins. There is nothing "European" about Eurodollar deposits; a US
dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar
deposits. Neither is there any connection with the euro currency.

More generally, the "euro" prefix can be used to indicate any currency held in a country
where it is not the official currency: for example, euro yen or even euro euro.

5. Commercial paper

Commercial paper is a money-market security issued by large banks and corporations. It is

generally not used to finance long-term investments but rather to purchase inventory or to
manage working capital. It is commonly bought by money funds (the issuing amounts are
often too high for individual investors), and is generally regarded as a very safe investment.
As a relatively low-risk investment, commercial paper returns are not large. There are four
basic kinds of commercial paper: promissory notes, drafts, checks, and certificates of deposit.

6. Municipal bond

In the United States, a municipal bond (or muni) is a bond issued by a state, city or other
local government, or their agencies. Potential issuers of municipal bonds include cities,
counties, redevelopment agencies, school districts, publicly owned airports and seaports, and
any other governmental entity (or group of governments) below the state level

7. Federal funds

In the United States, federal funds are overnight borrowings by banks to maintain their bank
reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their
reserve requirements and to clear financial transactions

4.4 The Capital Market

The capital market is a market which deals in long-term loans. It functions through the stock
exchange market. A stock exchange market is a market which facilitates buying and selling
of shares, stocks, bonds, securities and debentures for both new and old ones.

It supplies industry with fixed and working capital and finances medium-term and long-term
borrowings of the central, state and local governments. It deals in ordinary stocks, shares and
debentures of corporations and bonds and securities of governments. The funds which flow in
to the capital market come from individuals who have savings to invest, the merchant banks,
the commercial banks, and non-bank financial intermediaries, such as insurance companies,
finance houses, unit trusts, investment trusts, venture capital, leasing finance, mutual funds,
building societies, and underwriting companies.

Importance or Functions of Capital Market

The capital market helps in capital formation and economic growth of the county. The
functions/importance are discussed as follows:
1. It acts as an important link between savers and investors

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 The savers are called the “surplus units” and they are lenders of funds. Whereas the
investors are called the “deficit units” and they are borrowers of funds. Hence, the capital
market is the transmission mechanism between surplus units and deficit units. It is a
conduct through which surplus units lend their surplus funds to the deficit units. Surplus
units buy securities with their surplus funds and deficit units sell securities to raise funds
they need. This fund flow may be directly or indirectly.

2. It gives incentives to savers and investors

Savers or surplus spending units will be rewarded in a form of interest, if they deposit
their money in a bank and buy interest bearing financial assets or in a form of dividend, if
they buy shares and stocks, for their postponement of present consumption. This leads to
capital formation which is used by investors or deficit spending units. Investors of DSUs
will be also rewarded in a form of profit from their investment activity. By doing so, it
diverts resources from wasteful and unproductive channels to productive investments.

3. It brings stability in the value of stocks and securities

It does so by providing capital to the needy at reasonable interest rates and helps in
minimizing speculative activities.
4. It encourages economic growth
The various institutions which operate in the capital market give quantitative and
qualitative direction to the flow of funds and bring rational allocation of resources. They
do so by converting financial assets in to productive physical assets. Business firms invest
in the projects offering the highest rates of return and that households invest in direct or
indirect financial claims offering the highest yields for given levels of risk.
Distinction between Money and Capital Markets
The money market differs from the capital market on several grounds.
1. The money market deals in short-term funds, whereas, the capital market deals in long-
term funds.
2. The money market uses short-term instruments, such as promissory notes, bills of
exchange, treasury bills, certificates of deposits, commercial papers, etc. whereas; the
capital market uses long-term securities such as shares, debentures, bonds of industrial
concerns and bonds and securities of the government.
3. Institutions operating in the two markets differ. In the money market: the central bank,
commercial banks, non-bank financial intermediaries and bill brokers operate. In the
capital market, stock exchange, mutual funds, insurance companies, leasing companies,
investment banks, investment trust, etc, operate.
Inter-relation between Money and Capital Markets
These markets are closely interrelated because most corporations and financial institutions
are active in both. Their interrelation is discussed as follows:
1. Lenders may choose to direct their funds to either or both markets depending on the
availability of funds, the rates of return and their investment policies.
2. Borrowers may obtain their funds from either or both markets according to their
requirements.
3. Some corporations and financial institutions serve both markets by buying and selling

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 short-term and long-term securities.
4. All long-term securities become short-term instruments at the time of maturity. So some
capital markets instruments also become money market instruments.
5. Funds flow back and forth between the two markets whenever the treasury finances
maturing bills with treasury securities or whenever a bank lends the proceeds of a
maturing loan to a firm on a short-term basis.
6. Yields in the money market are related to those of the capital market. As the long-term
interest rates fall, the short-term interest rate will fall. However, money market interest
rates are more sensitive than are long-term interest rates in the capital market.

4.3.1 Debt Market

Bond market

Bonds generally can trade anywhere in the world that a buyer and seller can strike a deal.
There is no central place or exchange for bond trading, as there is for publicly traded stocks.
The bond market is known as an "over-the-counter" market, rather than an exchange market.
There are some exceptions to this. For example, some corporate bonds in the United States
are listed on an exchange. Also, bond futures, and some types of bond options, are traded on
exchanges. But the overwhelming majority of bonds do not trade on exchanges. (This article
refers to marketable bonds where trading is permitted. Trading is sometimes not permitted for
government savings bonds.)

Bond Dealers

While investors can trade marketable bonds among themselves whenever they want, trading
is usually done with bond dealers, more specifically, the bond trading desks of major
investment dealers. The dealers occupy center stage in the vast network of telephone and
computer links that connect the interested players. Bond dealers usually "make a market" for
bonds. What this means is that the dealer has traders whose responsibility is to know all about
a group of bonds and to be prepared to quote a price to buy or sell them. The role of the
dealers is to provide "liquidity" for bond investors, thereby allowing investors to buy and sell
bonds more easily and with a limited concession on the price. Dealers also buy and sell
amongst themselves, either directly or anonymously via bond brokers. The name of the
trading game is to take a spread between the price the bonds are bought at and the price they
are sold at. This is the main way that bond dealers make (or lose) money. Dealers often have
bond traders located in the major financial centers and are able to trade bonds 24 hours a day
(although not usually on weekends).

Bond Investors

The major bond investors are financial institutions, pension funds, mutual funds and
governments, from around the world. These bond investors, along with the dealers, comprise
the "institutional market", where large blocks of bonds are traded. A trade of $1-million-
worth of bonds would be considered a small ticket. There is no size limit, and trades
involving $500 million or $1 billion at a time can take place. There similarly is no size
restriction in the "retail market," which essentially involves individual investors buying and

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selling bonds with the bond trading desks of investment dealers. However, the size of trades
is usually under $1 million.

Types of bond markets

The Securities Industry and Financial Markets Association classify the broader bond market
into five specific bond markets.

 Corporate
 Government & Agency
 Municipal
 Mortgage Backed, Asset Backed, and Collateralized Debt Obligation
 Funding

Bond market participants

Bond market participants are similar to participants in most financial markets and are
essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both.

Participants include:

 Institutional investors;
 Governments;
 Traders; and
 Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many smaller
issues, the majority of outstanding bonds are held by institutions like pension funds, banks
and mutual funds. In the United States, approximately 10% of the market is currently held by
private individuals.

Corporate bond

A Corporate Bond is a bond issued by a corporation. The term is usually applied to longer-
term debt instruments, generally with a maturity date falling at least a year after their issue
date. (The term "commercial paper" is sometimes used for instruments with a shorter
maturity.)

Types

Corporate debt falls into several broad categories:

 secured debt vs unsecured debt

 senior debt vs subordinated debt

Generally, the higher one's position in the company's capital structure, the stronger one's
claims to the company's assets in the event of a default.

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Subordinated debt
In finance, subordinated debt (also known as subordinated loan, subordinated bond,
subordinated debenture or junior debt) is debt which ranks after other debts should a
company fall into receivership or be closed.
Senior debt
In finance, senior debt, frequently issued the form of a senior note, is debt that takes priority
over other debt securities sold by the issuer. Senior debt has greater seniority in the issuer's
capital structure than subordinated debt. In the event the issuer goes bankrupt, senior debt
must be repaid before other creditors receive any payment.
Secured loan
A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as
collateral for the loan, which then becomes a secured debt owed to the creditor who gives the
loan.

Government bond

A government bond is a bond issued by a national government denominated in the country's

own currency. Bonds issued by national governments in foreign currencies are normally
referred to as sovereign bonds.

Risk

Governments bonds are usually referred to as risk-free bonds, because the government can
raise taxes or simply print more money to redeem the bond at maturity. Some counter
examples do exist where a government has defaulted on its domestic currency debt, such as
Russia in 1998- the "ruble crisis", though this is very rare.

Types of Government Bonds

Supranational Agencies
A supranational agency, such as the World Bank, levies assessments or fees against its
member governments. Ultimately, it is this support and the taxation power of the underlying
national governments that allow these organizations to make payments on their debts.

National Governments
The "central" or national governments also have the power to print money to pay their debts,
as they control the money supply and currency of their countries. This is why most investors
consider the national governments of most modern industrial countries to be almost "risk-
free" from a default point of view.
Provincial or State Governments
Provincial or state governments also issue debt, depending on their constitutional ability to do
this. Canadian provinces, notably Ontario, borrow more than many smaller countries. Most
investors consider provincial or state issuers to be very strong credits because they have the
power to levy income and sales taxes to support their debt payments. Since they can’t control

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monetary policy like national governments, they are considered lesser credits than national
governments.
Municipal and Regional Governments
Cities, towns, counties and regional municipalities issue bonds supported by their property
taxes. School boards also issue bonds, supported by their ability to levy a portion of property
taxes for education.
Quasi-Government Issuers
Many governments related institutions issue bonds, some supported by the revenues of the
specific institution and some guaranteed by a government sponsor. In Canada, Federal
government agencies and Crown corporations issue bonds. For example, The Federal
Business Development Bank (FBDB) and the Canadian Mortgage and Housing Corporation
(CMHC) bonds are directly guaranteed by the Federal government. Provincial crown
corporations such as Ontario Hydro and Hydro Quebec are guaranteed by the Provinces of
Ontario and Quebec respectively
Municipal bonds are issued by state and local governments, often to finance specific projects
such as highways, schools, recreational facilities, and the like. While they typically pay lower
interest rates than corporate bonds, the interest income is generally exempt from federal
income tax and frequently from state and local taxes, as well. Thus, a lower-yield municipal
bond could actually be more attractive than a higher-paying taxable instrument when the
relative tax consequences are figured into the comparison, especially in the higher income tax
brackets.
Foreign Currency Bonds
A "foreign currency" bond is a bond that is issued by an issuer in a currency other than its
national currency. Issuers make bond issues in foreign currencies to make them more
attractive to buyers and to take advantage of international interest rate differentials. Foreign
currency bonds can "swapped" or converted in the swap market into the home currency of the
issuer. Bonds issued by foreign issuers in the United States market in U.S. dollars are known
as "Yankee" bonds. Bonds issued in British pounds in the British bond market are known as
"Bulldogs". Yen denominated bonds by foreign issuers are known as "Samurai" bonds.
Foreign currency bonds have a vocabulary all their own. Bonds issued in foreign currencies
are given the names listed beside the currencies below:
 "Yankee Bonds" for U.S. dollars;
 "Samurai Bonds" for Japanese Yen;
 "Bulldog Bonds" for British pounds; and
 "Kiwi Bonds" for New Zealand dollars.

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Mortgage-Backed Securities
A mortgage-backed security (MBS) is a security that is based on a pool of underlying
mortgages. MBS are usually based on mortgages that are guaranteed by a government agency
for payment of principal and a guarantee of timely payment. The analysis of MBS
concentrates on the nature of the underlying payment stream, particularly the prepayments of
principal prior to maturity.

4.3.2 Equity Market

A stock market or (equity market) is a private or public market for the trading of company
stock and derivatives of company stock at an agreed price; both of these are securities listed
on a stock exchange as well as those only traded privately. The expression 'stock market'
refers to the market that enables the trading of company stocks (collective shares), other
securities, and derivatives. Bonds are still traditionally traded in an informal, over-the-counter
market known as the bond market. Commodities are traded in commodities markets, and
derivatives are traded in a variety of markets (but, like bonds, mostly 'over-the-counter').

Participants in the stock market range from small individual stock investors to large hedge
fund traders, who can be based anywhere. Their orders usually end up with a professional at a
stock exchange, who executes the order.

Some exchanges are physical locations where transactions are carried out on a trading floor,
by a method known as open outcry. This type of auction is used in stock exchanges and
commodity exchanges where traders may enter "verbal" bids and offers simultaneously. The
other type of exchange is a virtual kind, composed of a network of computers where trades
are made electronically via traders.

Actual trades are based on an auction market paradigm where a potential buyer bids a
specific price for a stock and a potential seller asks a specific price for the stock. (Buying or
selling at market means you will accept any ask price or bid price for the stock, respectively.)
When the bid and ask prices match, a sale takes place on a first come first served basis if
there are multiple bidders or askers at a given price.

The purpose of a stock exchange is to facilitate the exchange of securities between buyers
and sellers, thus providing a marketplace (virtual or real). The exchanges provide real-time
trading information on the listed securities, facilitating price discovery.

Market participants

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Many years ago, worldwide, buyers and sellers were individual investors, such as wealthy
businessmen, with long family histories (and emotional ties) to particular corporations. Over
time, markets have become more "institutionalized"; buyers and sellers are largely
institutions (e.g., pension funds, insurance companies, mutual funds, hedge funds, investor
groups, and banks). The rise of the institutional investor has brought with it some
improvements in market operations. Thus, the government was responsible for "fixed" (and
exorbitant) fees being markedly reduced for the 'small' investor, but only after the large
institutions had managed to break the brokers' solid front on fees (they then went to
'negotiated' fees, but only for large institutions)

The role of stock exchanges

 Raising capital for businesses

The Stock Exchange provides companies with the facility to raise capital for expansion
through selling shares to the investing public.

 Mobilizing savings for investment

When people draw their savings and invest in shares, it leads to a more rational allocation of
resources because funds, which could have been consumed, or kept in idle deposits with
banks, are mobilized and redirected to promote business activity with benefits for several
economic sectors such as agriculture, commerce and industry, resulting in a stronger
economic growth and higher productivity levels and firms.

 Facilitating company growth

Companies view acquisitions as an opportunity to expand product lines, increase distribution

channels, hedge against volatility, increase its market share, or acquire other necessary
business assets. A take overbid or a merger agreement through the stock market is one of the
simplest and most common ways for a company to grow by acquisition or fusion.

 Redistribution of wealth

Stocks exchanges do not exist to redistribute wealth. However, both casual and professional
stock investors, through dividends and stock price increases that may result in capital gains,
will share in the wealth of profitable businesses.

 Creating investment opportunities for small investors

As opposed to other businesses that require huge capital outlay, investing in shares is open to
both the large and small stock investors because a person buys the number of shares they can
afford. Therefore the Stock Exchange provides the opportunity for small investors to own
shares of the same companies as large investors.

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  Government capital-raising for development projects

Governments at various levels may decide to borrow money in order to finance infrastructure
projects such as sewage and water treatment works or housing estates by selling another
category of securities known as bonds. These bonds can be raised through the Stock
Exchange whereby members of the public buy them, thus loaning money to the government.
The issuance of such bonds can obviate the need to directly tax the citizens in order to
finance development, although by securing such bonds with the full faith and credit of the
government instead of with collateral, the result is that the government must tax the citizens
or otherwise raise additional funds to make any regular coupon payments and refund the
principal when the bonds mature.

 Barometer of the economy

At the stock exchange, share prices rise and fall depending, largely, on market forces. Share
prices tend to rise or remain stable when companies and the economy in general show signs
of stability and growth. An economic recession, depression, or financial crisis could
eventually lead to a stock market crash. Therefore the movement of share prices and in
general of the stock indexes can be an indicator of the general trend in the economy.

2.5 DERIVATIVE MARKET (INSTRUMENTS)

Derivative market is a market for which different financial are traded and their values are
depends on the underlying assets. Basically there are four types of derivative instruments.
These are forward contracts, future contracts, options and swaps. Let as discuss one by one.

FUTURES AND FORWARD CONTRACTS

A futures contract is an agreement that requires a party to the agreement either to buy or sell
something at a designated future date at a predetermined price. Futures contracts are products
created by exchanges. To create a particular futures contract, an exchange must obtain
approval from the Commodity Futures Trading Commission (CFTC), a government
regulatory agency. When applying to the CFTC for approval to create a futures contract, the
exchange must demonstrate that there is an economic purpose for the contract. Futures
contracts are categorized as either commodity futures or financial futures. Commodity futures
involve traditional agricultural commodities (such as grain and livestock), imported
foodstuffs (such as coffee, cocoa, and sugar), and industrial commodities. Futures contracts
based on a financial instrument or a financial index are known as financial futures.

A party to a futures contract has two choices on liquidation of the position. First, the position
can be liquidated prior to the settlement date. For this purpose, the party must take an
offsetting position in the same contract. For the buyer of a futures contract, this means selling
the same number of identical futures contracts; for the seller of a futures contract, this means
buying the same number of identical futures contracts. The alternative is to wait until the
settlement date. At that time the party purchasing a futures contract accepts delivery of the
underlying (financial instrument, currency, or commodity) at the agreed-upon price; the party
that sells a futures contract liquidates the position by delivering the underlying at the agreed-

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upon price. For some futures contracts settlement is made in cash only. Such contracts are
referred to as cash-settlement contracts.

Associated with every futures exchange is a clearinghouse, which performs two key
functions. First, the clearinghouse guarantees that the two parties to the transaction will
perform. It does so as follows. When an investor takes a position in the futures market, the
clearinghouse takes the opposite position and agrees to satisfy the terms set forth in the
contract. Because of the clearinghouse, the investor need not worry about the financial
strength and integrity of the party taking the opposite side of the contract. After initial
execution of an order, the relationship between the two parties ends. The clearinghouse
interposes itself as the buyer for every sale and the seller for every purchase. Thus investors
are free to liquidate their positions without involving the other party in the original contract,
and without worry that the other party may default. In addition to the guarantee function, the
clearinghouse makes it simple for parties to a futures contract to unwind their positions prior
to the settlement date.

When a position is first taken in a futures contract, the investor must deposit a minimum
dollar amount per contract as specified by the exchange. This amount is called the initial
margin and is required as deposit for the contract. The initial margin may be in the form of an
interest-bearing security such as a Treasury bill. As the price of the futures contract
fluctuates, the value of the investor’s equity in the position changes. At the end of each
trading day, the exchange determines the settlement price for the futures contract. This price
is used to mark to market the investor’s position, so that any gain or loss from the position is
reflected in the investor’s equity account. Maintenance margin is the minimum level
(specified by the exchange) by which an investor’s equity position may fall as a result of an
unfavorable price movement before the investor is required to deposit additional margin. The
additional margin deposited is called variation margin, and it is an amount necessary to bring
the equity in the account back to its initial margin level. Unlike initial margin, variation
margin must be in cash not interest-bearing instruments. Any excess margin in the account
may be withdrawn by the investor. If a party to a futures contract who is required to deposit
variation margin fails to do so within 24 hours, the futures position is closed out. Although
there are initial and maintenance margin requirements for buying securities on margin, the
concept of margin differs for securities and futures. When securities are acquired on margin,
the difference between the price of the security and the initial margin is borrowed from the
broker. The security purchased serves as collateral for the loan, and the investor pays interest.
For futures contracts, the initial margin, in effect, serves as “good faith” money, an indication
that the investor will satisfy the obligation of the contract. Normally no money is borrowed
by the investor.
Futures versus Forward Contracts
A forward contract, just like a futures contract, is an agreement for the future delivery of
something at a specified price at the end of a designated period of time. Futures contracts are
standardized agreements as to the delivery date (or month) and quality of the deliverable, and
are traded on organized exchanges. A forward contract differs in that it is usually non
standardized (that is, the terms of each contract are negotiated individually between buyer
and seller), there is no clearinghouse, and secondary markets are often nonexistent or

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extremely thin. Unlike a futures contract, which is an exchange-traded product, a forward
con-tract is an over-the-counter instrument.
Futures contracts are marked to market at the end of each trading day. Consequently, futures
contracts are subject to interim cash flows as additional margin may be required in the case of
adverse price movements, or as cash is withdrawn in the case of favorable price movements.
A forward contract may or may not be marked to market, depending on the wishes of the two
parties. For a forward contract that is not marked to market, there are no interim cash flow
effects because no additional margin is required. Finally, the parties in a forward contract are
exposed to credit risk because either party may default on the obligation. Credit risk is
minimal in the case of futures contracts because the clearinghouse associated with the
exchange guarantees the other side of the transaction. Other than these differences, most of
what we say about futures contracts applies equally to forward contracts.

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