Financial Markets

UNIVERSITY OF CALICUT
SCHOOL OF DISTANCE EDUCATION
Core Course
MA ECONOMICS
IV SEMESTER
ECO4 C13
FINANCIAL MARKETS
2019 Admission onwards

CBCSS
190314
FINANCIAL MARKETS
IV SEMESTER
Core Course
MA ECONOMICS
(2019 Admission onwards)
(CBCSS)
UNIVERSITY OF CALICUT
SCHOOL OF DISTANCE EDUCATION
Calicut University (P.O), Malappuram, Kerala, India 673635
Prepared by
Dr. Shiji O.
(Assistant Professor, SDE, University of Calicut)
Scrutinised by
Dr. YC. Ibrahim
(Associate Professor & Vice Principal, Government
College Kodenchery, Kozhikode)
190314: MA Economics - IV SEMESTER
Contents
Module I Financial Markets
Module II Money Market
Module III Capital Market
Module IV Derivatives Market
Module V Global Financial Markets
School of Distance Education, University of Calicut 4

Detailed Syllabus
Module I: Financial Markets
Functions of financial markets-Types of financial markets-

Participants in financial markets- Role of financial intermediaries-
Financial Innovation-Financial inclusion and inclusive growth.
Module II: Money Market
Functions of money market-Instruments of the money market-

Call money-Bill of exchange- Commercial Bills-Treasury bills-
Commercial Paper-Interbank market-Federal funds- Negotiable
certificate of deposits- Banker’s acceptance-Repurchase agreements-
Money market mutual funds- Features of a developed money market-
Structure of Indian money market- Money market reforms in India
since 1991.
Module III: Capital Market
Functions of capital market-Primary market-Instruments of the

primary market- Secondary market-Functions- Instruments of the
secondary market-Demutualisation of stock exchanges- Trading
mechanism of the stock exchanges- Liquidity products (margin trading,
short sales, securities lending and borrowing)-Foreign institutional
investment-Participatory notes (P- notes)-Insider trading-Investor
protection- Credit rating-Capital market institutions- Depositories-
Discount and Finance House of India-Stock Holding Corporation of
India- Securities Trading Corporation of India-SEBI-Functions and
powers- Capital market reforms in India since 1991.
5 School of Distance Education, University of Calicut
Module IV: Derivatives Market
Types of derivatives-Participants in the derivative markets-Uses

of derivatives- Options- Types of options-Uses of options-Platforms
for options trade-Trading mechanics-Option premium-
Profits and losses with options-Stock options and stock index options
in India -Futures- Types of futures (stock index futures-foreign currency
futures-interest rate futures commodity futures)-Uses of futures-Market
mechanics-Market participants- The clearing process- Stock futures
and stock index futures in India-Difference between options and futures-
Swaps-Interest rate swaps-Foreign currency swaps.
Module V: Global Financial Markets
Instruments- American Depository Receipts (ADR)-Global

Depository Receipts (GDR)- Foreign Currency Convertible Bonds
(FCCB)-External commercial borrowings-International bonds-
Eurobonds-Euro notes-Euro commercial papers-Eurodollars-
Eurocurrency market- Reasons for the growth-Features-Effects of the
eurocurrency market.

Module I
FINANCIAL MARKETS
Financial System
Financial system is an integral part of modern economy.

Economic development of any economy depends upon the existence
of a well organised financial system. It is defined as ‘a set of institutions,
instruments and markets which encourage saving and channelize them
to their effective use.’ It is the financial system that supplies necessary
financial inputs for the production of goods and services, which in turn
promote the wellbeing and standard of living of the people of the country.
It mobilizes the savings in the form of money and monetary assets and
invests them to productive ventures. It facilitates the free flow of funds
to more productive activities and promote investment. Financial system
intermediate between savers and investors and promote faster economic
development.
Functions of the Financial System
1. Provision of liquidity
The major function of the financial system is the provision of money
and monetary assets for the production of goods and services.
There should not be any shortage of money for productive ventures.
In financial language, the money and monetary assets are referred
to as liquidity. Hence, all activities in a financial system are related
to liquidity i.e., either provision of liquidity or trading in liquidity.

2. Mobilisation of savings
Another important activity of the financial system is to mobilise
savings and channelise them into productive activities. The financial
system should offer appropriate incentives to attract savings and
make them available for more productive ventures. Thus, the
financial system facilitates the transformation of savings into
investment and consumption. The financial intermediaries have to
play a dominant role in this activity.
3. Size transformation function
Generally, the savings of millions of small investors are in the nature
of a small unit of capital which cannot find any fruitful avenue for
investment unless it is transformed into a perceptible size of credit
unit. Banks and other financial intermediaries perform this size
transformation function by collecting deposits from a vast majority
of small customers and giving them as loan of a sizeable quantity.
Thus, this size transformation function is considered to be one of
the very important functions of the financial system.
4. Maturity transformation function
Another function of the financial system is the maturity
transformation function. The financial intermediaries accept deposits
from public in different maturities according to their liquidity
preference and lend them to the borrowers in different maturities
according to their need and promote the economic activities of a
country.
5. Risk transformation function
Most of the small investors are risk-averse with their small holding
of savings. So, they hesitate to invest directly in stock market. On

the other hand, the financial intermediaries collect the savings from
individual savers and distribute them over different investment units
with their high knowledge and expertise. Thus, the risks of individual
investors get distributed. This risk transformation function promotes
industrial development. Moreover, various risk mitigating tools are
available in the financial system like hedging, insurance, use of
derivatives, etc.
Structure of Financial System
• Financial Institutions
• Financial Markets
• Financial Instruments/Assets/Securities
• Financial Services.
Financial System is a combination of financial institutions,
financial markets, financial instruments and financial services to facilitate
the transfer of funds. Financial system provides a payment mechanism
for the exchange of goods and services. So, the four major components
that comprise the Financial System are:
The structure of the financial system is shown in the figure 1.1:
Figure 1.1: Financial System
Private Bank
Commercial
Banks
Public Bank
Co-operative
Banking Banks
Institutions Regional Rural
Financial Institutions Banks
Non-banking
Institutions Foreign Bank
Financial System
Secondary
Unorganized Market
Financial Markets Capital Market
Organized Primary Market
Financial Money Market
Assets/Instruments
Fund-Bases Leasing, Hire Purchase, Consumer Credit, Bill
Service Discounting, Factoring, Insurance etc..
Financial Services
Fee-Bases Issue Management, Merchant Banking, Credit
Service Rating, Debt Restructuring Stocks Broking etc..

I. Financial Institutions/Intermediaries
Financial Institutions or Intermediaries are all kinds of

organisations which intermediate and facilitate financial transactions of
both the individuals and corporate customers. Business organisations
that act as mobilisers and depositories of savings and as suppliers of
credit or finance. They deal financial assets such as deposits, loans,
securities etc.
They may be in the organised sector or in the unorganised sector.

This may also be classified into two:
(i) Capital market intermediaries.
(ii) Money market intermediaries.
Capital market intermediaries

These intermediaries mainly provide long-term funds to
individuals and corporate customers. They consist of term lending
institutions like financial corporations and investing institutions like LIC.
Money market intermediaries

Money market intermediaries supply only short-term funds to
individuals and corporate customers. They consist of commercial
banks, co-operative banks, etc
Financial institutions may be Regulatory, Intermediaries,

Non-Intermediaries and Others.

(i). Regulatory
Regulatory institutions are those which regulate the Financial
Institutions. For example, RBI is the regulatory institution of money
market and SEBI is the regulatory institution of capital market in
India.
(ii). Intermediaries
Intermediaries are those institutions which intermediate between
savers and investors. They are classified into Banking Financial
Intermediary (BFI) and Non-Banking Financial Intermediary
(NBFI).
Banking Financial Intermediaries are the creators of credit. They
accept deposit and give loans and advances.
E.g. Commercial Banks (Public and Private), Co-op. Banks, RRBs.
On the other hand, Non-Banking Financial Intermediaries are
mere suppliers of credit. They have no credit creation capacity-
E.g., LIC, GIC, UTI
(iii). Non-Intermediaries
Non-Intermediaries do the loan business but their resources are
not directly obtained from savers. They came into exist because
of governmental effort to provide for specific purposes, sections
and regions-E.g., IDBI, IFC, NABARD
(iv). Others
Other intermediaries are unorganised financial institutions. They
include Money Lenders, Indigenous bankers, Traders, Pawn
Brokers, Land Lords etc.

II. Financial Instruments
The stages of development of the Financial System can be judged

from the diversity of financial instruments that exist in the system.
It is the written legal obligation of one party to transfer something
of value, usually money, to another party at some future date,
under certain conditions. The enforceability of the obligation is
important. Financial instruments obligate one party (person,
company, or government) to transfer something to another party.
Financial instruments specify payment will be made at some future
date. Financial instruments specify certain conditions under which
a payment will be made.
Can be classified generally as -

1. Equity based, representing ownership of the asset,
2. Debt based, representing a loan made by an investor to the

owner of the asset.
3. Foreign exchange instruments comprise a third, unique type of

instrument
Features of Financial instruments

1. Easily transferable
2. Have a ready market
3. Possess liquidity
4. Can be used as a security for raising loan
5. Some have tax saving

6. Have specified maturity period

7. Facilitate further trading to cover risk
Classification
Financial instruments can also be called financial securities.
Financial securities can be classified into:
(i) Primary or direct securities.
(ii) Secondary or indirect securities.
Primary securities
These are securities directly issued by the ultimate investors to
the ultimate savers, e.g., shares and debentures issued directly to the
public.
Secondary securities
These are securities issued by some intermediaries called
financial intermediaries to the ultimate savers, e.g., Unit Trust of India
and Mutual Funds issue securities in the form of units to the public and
the money pooled is invested in companies.
Again, these securities may be classified on the basis of duration
as follows:
(i) Short-term securities.
(ii) Medium-term securities.
(iii) Long-term securities.

Short-term securities are those which mature within a period

of one year, e.g., Bill of Exchange, Treasury Bill, etc. Medium-term
securities are those which have a maturity period ranging between one
to five years, e.g., Debentures maturing within a period of five years.
Long-term securities are those which have a maturity period of more
than five years, e.g., Government Bonds maturing after ten years.
III. Financial Services
Financial service is part of financial system that provides different

types of finance through various credit instruments, financial products
and services. Financial Services is also the term used to describe
organizations that deal with the management of money. Examples are
the Banks, investment banks, insurance companies, credit card
companies and stock brokerages.
In financial instruments, we come across cheques, bills,
promissory notes, debt instruments, letter of credit, etc. While in financial
products, we deal different types of mutual funds which extending various
types of investment opportunities. In addition, there are also products
such as credit cards, debit cards, etc.
But in services we have leasing, factory, hire purchase finance
etc., through which various types of assets can be acquired either for
ownership or on lease. There are different types of leases as well as
factoring too. Thus, financial services enable the user to obtain any
asset on credit, according to his convenience and at a reasonable interest
rate.
Financial Services are generally not limited to the field of
deposit-taking, loan and investment services, but is also present in the
fields of insurance, estate, trust and agency services, securities, and all

forms of financial or market inter mediation including the distribution of

financial products. That is the financial services include all activities
connected with the transformation of savings into investment. The
important financial services include lease financing, hire purchase,
instalment payment systems, merchant banking, factoring, forfaiting etc.
IV. Financial Markets
The financial system encompasses the financial infrastructure

and all financial intermediaries and financial markets, and their
relationships with respect to the flow of funds to and from households,
governments, business firms, and foreigners. Financial infrastructure is
the set of institutions that enables the effective operation of financial
intermediaries and financial markets, including payment systems, credit
information bureaus, and collateral registries. The main task of the
financial system is to channel funds from sectors that have a surplus to
those with a shortage of funds.
The structure of the world’s financial markets and institutions

has experienced revolutionary changes over the last 30 years. Some
financial markets have become obsolete, while new ones have emerged.
Similarly, some financial institutions have gone bankrupt, while new
entrants have emerged. However, the functions of the financial system
have been more stable than the markets and institutions used to
accomplish these functions. If sectors with surplus funds cannot channel
their money to sectors with good investment opportunities, many
productive investments will never take place. Indeed, cross-country,
case-study, industry- and firm-level analyses suggest that the functioning
of financial systems is vitally linked to economic growth. Countries with
larger banks and more active stock markets have higher growth rates,
even after controlling for many other factors underlying economic

growth. Furthermore, several recent studies conclude that the

relationship between financial and economic development may be non-
linear. For instance, Arcand et al. (2015) report that at intermediate
levels of financial depth, there is a positive relationship between the size
of the financial system and economic growth, but at high levels of financial
depth, more finance is associated with less growth. In fact, the marginal
effect of financial depth on output growth becomes negative when credit
to the private sector reaches 80–100 per cent of GDP. This reflects the
fact that higher levels of financing increase the likelihood of financial
crises, which may depress economic growth. In addition, a large financial
sector may lead to a misallocation of resources, as the financial sector
may attract talent from more productive sectors of the economy, which
may be inefficient from society’s point of view. Finally, some types of
finance, like mortgage credit, are considerably less conducive to
sustainable economic development than other types.
Functions of Financial Markets

Financial Market serve the following basic functions
a) Borrowing and Lending:
Financial markets perform the essential economic function of
channelling funds from households, firms, and governments that
have saved surplus funds by spending less than their income to
those that have a shortage of funds because they wish to spend
more than their income. Those who have saved and are lending
funds, the lender-savers, are at the left, and those who must
borrow funds to finance their spending, the borrower- spenders,
are at the right.

b) Price Determination:
The financial commodities traded in a financial market get their prices
from the rules of demand and supply. The investors or the household
are the suppliers of the funds, and the industries are the ones demanding
them. The interaction between the two and other market factors will
help determine the prices.
c) Information aggregation and Coordination:
FM acts as collectors and aggregators of information about
financial asset values and the flow of funds from lenders to
borrowers.
d) Risk Sharing:
FM allow a transfer of risk from those who undertake investment
to those who provide fund for investment.
e) Liquidity:
The instruments sold in the financial market tend to have high liquidity.
This means at any given time the investors can sell their financial
commodities and convert them to cash in a very short period. This
is an important factor for investors who do not want to invest long
term.
f) Efficiency:
Channelling of funds from savers to spenders so important to the
economy because the people who save are frequently not the
same people who have profitable investment opportunities
available to them, the entrepreneurs. Without financial markets, it
is hard to transfer funds from a person who has no investment
opportunities to one who has them. Financial markets are thus

essential to promoting economic efficiency. Financial Markets

reduce the transaction cost and information cost.
g) Easy Access:
Both investors and industries need each other. The financial market
provides a platform where both the buyers and sellers can find
each other easily without spending too much time, money or effort.
h) Saves time and Money:
Financial markets serve as a platform where buyers and sellers
can easily find each other without making too much efforts or
wasting time. Also, since these markets handle so many
transactions it helps them to achieve economies of scale. This
results in lower transaction cost and fees for the investors.
Types of Financial Markets
1. Primary and Secondary Markets
A primary market is a financial market in which new issues of a

security, such as a bond or a stock, are sold to initial buyers by the
corporation or government agency borrowing the funds. A secondary
market is a financial market in which securities that have been previously
issued can be resold. The primary markets for securities are not well
known to the public because the selling of securities to initial buyers
often takes place behind closed doors. An important financial institution
that assists in the initial sale of securities in the primary market is the
investment bank. It does this by underwriting securities: It guarantees a
price for a corporation’s securities and then sells them to the public.

The New York Stock Exchange, NASDAQ (National

Association of Securities Dealers Automated Quotation System),
Bombay Stock Exchange (BSE) and National Stock Exchange (NSE)
in which previously issued stocks are traded, are the best-known
examples of secondary markets, although the bond markets, in which
previously issued bonds of major corporations and the government are
bought and sold, actually have a larger trading volume. Other examples
of secondary markets are foreign exchange markets, futures markets,
and options markets. Securities brokers and dealers are crucial to a
well-functioning secondary market. Brokers are agents of investors who
match buyers with sellers of securities; dealers link buyers and sellers
by buying and selling securities at stated prices.
When an individual buys a security in the secondary market,

the person who has sold the security receives money in exchange for
the security, but the corporation that issued the security acquires no
new funds. A corporation acquires new funds only when its securities
are first sold in the primary market. Nonetheless, secondary markets
serve two important functions. First, they make it easier and quicker to
sell these financial instruments to raise cash; that is, they make the
financial instruments more liquid. The increased liquidity of these
instruments then makes them more desirable and thus easier for the
issuing firm to sell in the primary market. Second, they determine the
price of the security that the issuing firm sells in the primary market. The
investors who buy securities in the primary market will pay the issuing
corporation no more than the price they think the secondary market
will set for this security. The higher the security’s price in the secondary
market, the higher the price that the issuing firm will receive for a new
security in the primary market, and hence the greater the amount of

financial capital it can raise. Conditions in the secondary market are

therefore the most relevant to corporations issuing securities. It is for
this reason that books like this one, which deal with financial markets,
focus on the behaviour of secondary markets rather than primary
markets.
2. Money and Capital Markets
Another way of distinguishing between markets is on the basis

of the maturity of the securities traded in each market. The money market
is a financial market in which only short-term debt instruments (generally
those with original maturity of less than one year) are traded; the capital
market is the market in which longer term debt (generally with original
maturity of one year or greater) and equity instruments are traded. Money
market securities are usually more widely traded than longer-term
securities and so tend to be more liquid. In addition, short-term securities
have smaller fluctuations in prices than long-term securities, making
them safer investments. As a result, corporations and banks actively
use the money market to earn interest on surplus funds that they expect
to have only temporarily. Capital market securities, such as stocks and
long-term bonds, are often held by financial intermediaries such as
insurance companies and pension funds, which have little uncertainty
about the amount of funds they will have available in the future.
3. Organized Market and Unorganized market
Organized market is that part of the financial markets, which

operates under a defined set of rules, regulations and legal provisions
and the statutory authorities such as the Central Government, the Central
Bank the Exchange Commission (such as SEBI in India), etc. The
organized market may also be called the official or formal market.

Unorganized is that part of the financial markets, which is not

standardized and is outside the preview of government control. In India,
the rural money lenders and traders form the unorganized market. The
basic feature of unorganized market are high interest rates, fluctuating
and varying interest rates, absence of precise rules, upfront payment of
interest, unsystematic arrangements etc.
Participants in Financial Markets
Following are some of the Major Participants in Financial Markets

1. Banks:
Banks participate in the capital market and money market. Within

the capital market, banks take active part in bond markets. Banks
may invest in equity and mutual funds as a part of their fund
management. Banks take active trading interest in the bond market
and have certain exposures to the equity market also. Banks also
participate in the market as clearing houses.
2. Primary Dealers (PDs):
PDs deal in government securities both in primary and secondary

markets. Their basic responsibility is to provide two-way quotes
and act as market makers for government securities and strengthen
the government securities market.
3. Financial Institutions (FIs):
FIs provide/lend long term funds for industry and agriculture. FIs
raise their resources through long-term bonds from financial system
and borrowings from international financial institutions like
International Finance Corporation (IFC), Asian Development Bank

(ADB) International Development Association (IDA), International

Bank for Reconstruction and Development (IBRD), etc.
4. Stock Exchanges:
A Stock exchange is duly approved by the Regulators to provide

sale and purchase of securities by “open cry” or “on-line” on
behalf of investors through brokers. The stock exchanges provide
clearing house facilities for netting of payments and securities
delivery. Such clearing houses guarantee all payments and
deliveries. Securities traded in stock exchanges include equities,
debt, and derivatives.
Currently, in India, only dematerialized securities are allowed to
be traded on the stock exchanges. Settlement in securities account
is made by depositories through participants’ accounts. It is
essential that stock exchanges are corporatised and de-mutualised
so that there can be greater transparency in the trades and better
governance in markets.
5. Brokers:
Only brokers approved by Capital Market Regulator can operate
on stock exchange. Brokers perform the job of intermediating
between buyers and seller of securities. They help build up order
book, price discovery, and are responsible for a contract being
honoured. For their services brokers earn a fee known as
brokerage.
6. Investment Bankers (Merchant Bankers):
These are agencies/organisations regulated and licensed by SEBI,
the Capital Markets Regulator. They arrange raising of funds

through equity and debt route and assist companies in completing

various formalities like filing of the prescribed document and other
compliances with the Regulator and Regulators.
They advise the issuing company on book building, pricing of issue,
arranging registrars, bankers to the issue and other support
services. They can underwrite the issue and also function as issue
managers. They may also buy and sell on their account.
As per regulatory stipulations, such own account business should
be separately booked and confined to scrip’s where insider
information is not available to the investment/merchant banker.
Investment/Merchant banking can be an exclusive business. A
bank can also undertake these activities.
7. Foreign Institutional Investors (FIIs):
Foreign Institutional Investors are foreign based funds authorized

by Capital Market Regulator to invest in countries’ equity and
debt market through stock exchanges. They are allowed to
repatriate sale proceeds of their holdings, provided sales have
been made through an authorized stock exchange and taxes have
been paid. Foreign Institutional Investors enjoy de-facto capital
account convertibility.
Foreign Institutional Investors operations provide depth to equity
and debt markets and result in increased turnover. In India, these
activities have brought in technological advancements and foreign
funds in equity and debt market.
8. Custodians:
Custodians are organizations which are allowed to hold securities
on behalf of customers and carry out operations on their behalf.
They handle both funds and securities of Qualified Institutional

Borrowers (QIBs) including Foreign Institutional Investors.
Custodians are supervised by the Capital Market Regulator. In
view of their position and as they handle the payment and
settlements, banks are able to play the role of custodians effectively.
Thus, most banks perform the role of custodians.
9. Depositories:
Depositories hold securities in demat (electronic) form, maintain

accounts of depository participants who, in turn, maintain accounts
of their customers. On instructions of stock exchange clearing
house, supported by documentation, a depository transfer security
from buyers to sellers’ accounts in electronic form.
Role of Financial Intermediaries
Unlike brokers, dealers, and investment banks, financial

intermediaries are financial institutions that engage in financial asset
transformation. That is, financial intermediaries purchase one kind of
financial asset from borrowers generally some kind of long-term loan
contract whose terms are adapted to the specific circumstances of the
borrower (e.g., a mortgage) and sell a different kind of financial asset
to savers, generally some kind of relatively liquid claim against the
financial intermediary (e.g., a deposit account). In addition, unlike
brokers and dealers, financial intermediaries typically hold financial
assets as part of an investment portfolio rather than as an inventory for
resale. In addition to making profits on their investment portfolios,
financial intermediaries make profits by charging relatively high interest
rates to borrowers and paying relatively low interest rates to savers.

Types of financial intermediaries include:

Depository Institutions (commercial banks, savings and loan
associations, mutual savings banks, credit unions);
Contractual Savings Institutions (life insurance companies, fire and
casualty insurance companies, pension funds, government retirement
funds); and
Investment Intermediaries (finance companies, stock and bond
mutual funds, money market mutual funds).
These can be grouped as follows:
The individuals: These are net savers and purchase the securities
issued by corporates. Individuals provide funds by subscribing to these
securities or by making other investments.
The Firms or corporates: The corporates are net borrowers. They
require funds for different projects from time to time. They offer different
types of securities to suit the risk preferences of investors Sometimes,
the corporates invest excess funds, as individuals do. The funds raised
by issue of securities are invested in real assets like plant and machinery.
The income generated by these real assets is distributed as interest or
dividends to the investors who own the securities.
Government: Government may borrow funds to take care of the
budget deficit or as a measure of controlling the liquidity, etc.
Government may require funds for long terms (which are raised by
issue of Government loans) or for short-terms (for maintaining liquidity)
in the money market. Government makes initial investments in public
sector enterprises by subscribing to the shares, however, these
investments (shares) may be sold to public through the process of
disinvestments.

Regulators: Financial system is regulated by different government

agencies. The relationships among other participants, the trading
mechanism and the overall flow of funds are managed, supervised and
controlled by these statutory agencies. In India, two basic agencies
regulating the financial market are the Reserve Bank of India (RBI)
and Securities and Exchange Board of India (SEBI). Reserve Bank of
India, being the Central Bank, has the primary responsibility of
maintaining liquidity in the money market It undertakes the sale and
purchase of T-Bills on behalf of the Government of India. SEBI has a
primary responsibility of regulating and supervising the capital market.
It has issued a number of Guidelines and Rules for the control and
supervision of capital market and investors protection. Besides, there
is an array of legislations and government departments also to regulate
the operations in the financial system.
Market Intermediaries: There are a number of market
intermediaries known as financial intermediaries or merchant bankers,
operating in financial system. These are also known as investment
managers or investment bankers. The objective of these intermediaries
is to smoothen the process of investment and to establish a link between
the investors and the users of funds. Corporations and Governments
do not market their securities directly to the investors. Instead, they
hire the services of the market intermediaries to represent them to the
investors. Investors, particularly small investors, find it difficult to make
direct investment. A small investor desiring to invest may not find a
willing and desirable borrower. He may not be able to diversify across
borrowers to reduce risk. He may not be equipped to assess and monitor
the credit risk of borrowers. Market intermediaries help investors to
select investments by providing investment consultancy, market analysis
and credit rating of investment instruments. In order to operate in

secondary market, the investors have to transact through share brokers.

Mutual funds and investment companies pool the funds (savings) of
investors and invest the corpus in different investment alternatives. Some
of the market intermediaries are:
1) Lead Managers
2) Bankers to the Issue
3) Registrar and Share Transfer Agents
4) Depositories
5) Clearing Corporations
6) Share brokers
7) Credit Rating Agencies
8) Underwriters
9) Custodians
10) Portfolio Managers
11) Mutual Funds

12) Investment Companies
These market intermediaries provide different types of financial services

to the investors. They provide expertise to the securities issuers. They
are constantly operating in the financial market. Small investors in
particular and other investors too, rely on them. It is in their (market
intermediaries) own interest to behave rationally, maintain integrity and
to protect and maintain reputation, otherwise the investors would not

be trusting them next time. In principle, these intermediaries bring

efficiency to corporate fund raising by developing expertise in pricing
new issues and marketing them to the investors.
Role of Financial Intermediaries in Economic Development
1.Self-employment programme:
Employment growth is a sign of economic development. Financial
Intermediaries, by providing finance for starting self-employment
programmes are generating more production and income in the country.
2. Entrepreneurial Development Programmes (EDPs):

EDPs have been successfully launched by various banks.
Initially through Lead Bank Scheme, banks were developing
employment opportunities at the district level. Later on, certain specific
areas were allotted to the banks for launching different economic
programmes for the development of such areas.
3. Integrated Rural development scheme:

Under this scheme, financial intermediaries were financing socially
and economically depressed people by providing loans to them for
various economic activities. One third of the loan will be a subsidy and
the remaining two-thirds of the loan will carry a lower rate of interest
under the interest subsidy scheme of RBI. In this way, various economic
programmes aimed at improving rural economic conditions were
undertaken.
4. Housing Finance:
As a part of improving dwelling houses, financial intermediaries
are providing housing loans. They are also providing refinancing facility
to agencies such as HUDCO (Housing and Urban Development
Corporation). This has enabled many fixed income group people to

avail the housing loan. Normally, to a borrower under this facility, a
bank provides 3-year aggregate net income as a maximum amount or
the cost of the house, whichever is less.
5. Priority Sector:
As per RBI guidelines, commercial banks have to provide
certain percentage of their lending to priority sector which consists of
agriculture and its allied activities, such as poultry, dairy, etc, cottage
industries, small scale industries, small industry and business.
6. Backward area Development:

In order to prevent regional disparities, financial intermediaries
have been advancing loans to industries which are started in backward
areas. Government has given certain concessions in the form of tax
benefits to such industries and banks provide cheap loans so that the
backward areas could attract more industries.
7. Introduction of Electronic system:

Computer is being used by financial intermediaries for most of
their activities now and they are able to link their branches through a
network. This has resulted in quicker transfer of funds between centres
and this has helped customers in realizing their cheques in a speedy
manner. It is for this purpose, that Magnetic Ink Character Recognition
(MICR) cheques have been introduced. The customer can also make
use of Home banking facility by linking their computer system with the
bank and instructions can be provided for transfer of funds. This facility,
if developed throughout the country, will not only help in the movement
of funds but also reduce the disparity in the interest rate.

Financial Innovation
Financial innovation is the process of creating new products,
services, or processes related to the finance sector. Recent financial
innovations include hedge funds, private equity, weather derivatives,
retail-structured products, exchange-traded funds, multi-family offices,
and Islamic bonds (Sukuk). The shadow banking system has spawned
an array of financial innovations including mortgage-backed securities
products and collateralized debt obligations (CDOs). There are
three categories of innovation: institutional, product, and process.
Institutional innovations relate to the creation of new types of
financial firms such as specialist credit card firms like Capital One,
electronic trading platforms such as Charles Schwab Corporation, and
direct banks. Product innovation relates to new products such as
derivatives, securitization, and foreign currency mortgages. Process
innovations relate to new ways of doing financial business, including
online banking and telephone banking.
They occur with the advancement in financial instruments and
payment systems with time. Financial innovation is a general term and
can be broken down into specific categories based on updates to
various spheres of the financial system.
They are made in the lending and borrowing of funds. The term
can be seen in the light of various spheres of the financial system such
as equity capital, remittances, mobile banking, and many more.
Financial innovation has come via advances over time in financial
instruments and payment systems used in the lending and borrowing of
funds. These changes – which include updates in technology, risk
transfer, and credit and equity generation – have increased available
credit for borrowers and given banks new and less costly ways to raise
equity capital.

Investment crowdfunding has begun to open up and make the

process of raising equity capital more democratic. While investing in
early and growth-stage companies used to be reserved for a privileged
few (generally institutional investors), new infrastructure has allowed
individual retail investors to invest in projects they are passionate about
and/or have other connections to for a small sum. Individuals receive
shares of the new company commensurate with the amount they have
invested. Two popular platforms for equity crowdfunding are Seed
Invest and Funders Club. In addition, micro-lending platforms such as
Lending Club and Prosper allow for crowdfunded debt financing. In
this asset class, instead of owning part of the company, individuals
become creditors and receive regular interest payments until the loan is
eventually paid back in full.
Remittances are another area that financial innovation is
transforming. Remittances are funds that expatriates send back to his
or her country of origin via wire, mail, or online transfer. Given the
volume of these transfers worldwide, remittances are economically
significant for many of the countries that receive them. In the early 2000s,
the World Bank established a database, where people could compare
prices of different transfer services. The Gates Foundation subsequently
began tracking remittances in 2011. Western Union and MoneyGram
once monopolized remittances; however, in recent years start-ups such
as TransferWise and Wave have competed with their lower cost apps.
Finally, mobile banking has made major innovations for retail
customers. Today, many banks like T.D. Bank offer comprehensive
apps with options to deposit checks, pay for merchandise, transfer
money to a friend, or find an ATM instantly. It is still important for
customers to establish a secure connection before logging into a mobile

banking app in order to avoid his or her personal information being

compromised.
Financial inclusion and inclusive growth.
By financial inclusion, we mean the delivery of financial services,

including banking services and credit, at an affordable cost to the vast
sections of disadvantaged and low-income groups who tend to be
excluded. The various financial services include access to savings, loans,
insurance, payments and remittance facilities offered by the formal
financial system. Among the key financial services that are of great
relevance here are risk management or risk mitigation services vis-à-
vis economic shocks. Such shocks may be an income shock due to
adverse weather conditions or natural disasters, or an expenditure shock
due to health emergencies or accidents, leading to a high level of
unexpected expenditure. This aspect of financial inclusion is of vital
importance in providing economic security to individuals and families.
There is growing evidence that a well-functioning financial

system fosters faster and more equitable growth. Access to financial
services allows the poor to save money outside the house safely, prevents
concentration of economic power with a few individuals and helps in
mitigating the risks that the poor face as a result of economic shocks.
Providing access to financial services is increasingly becoming an area
of concern for policy-makers for the obvious reason that it has far-
reaching economic and social implications. Increasingly, in developing
countries, access to finance is positioned as a public good, which is as
important and basic as access to safe water or primary education.
There are a number of positive externalities of financial inclusion.

One of the important effects is that one is able to reap the advantages

of network externality of financial inclusion as the value of the entire

national financial system increases.Another reason why financial inclusion
is a quasi-public good is that the consequent fuller participation by all in
the financial system makes monetary policy more effective and thus
enhances the prospects of non-inflationary growth. Once it is agreed
that financial inclusion is indeed a quasi-public good, we are in the
realm of public policy. Hence, it is incumbent upon the government to
provide it in partnership with other agencies (including private agencies).
The system needs to be reformed to ensure that everyone can

access financial goods and services. The promotion of financial inclusion
can be done in two major ways: First, by expanding the role of the
formal financial system, including banking. Second, through the growth
of micro-finance institutions in rural and urban areas. First and foremost,
enhanced financial inclusion will drastically reduce the farmers’
indebtedness, which is one of the main causes of farmers’ suicides. Yet
another benefit will be increased growth, as well as more equitable
growth, in both rural and urban areas because financial growth will
mobilize what
Prof. C. K. Prahalad calls “the bottom of the pyramid”. By

providing greater access to educational loans for all sections of society,
improved financial inclusion will also mean India becoming a more equal
opportunity nation a pre-condition for promoting inclusive growth. Finally,
a very positive impact of promoting financial inclusion will be the boost
given to grass- roots innovations and entrepreneurship. Greater financial
inclusion will promote micro-venture capital funds and thus reward and
mobilize creativity from segments of our society that remain completely
untapped.

Module II
MONEY MARKET
The money market deals with near substitutions for money or

near money like trade bills, promissory notes and government papers
drawn for a short period not exceeding one year. It is a mechanism
which makes it possible for borrowers and lenders who meet together
to deal in short term funds. It does not refer a particular place where
short term funds are dealt with. It includes all individuals, institutions
and intermediaries dealing with short term funds. It meets the short-
term requirements of the borrowers and provides liquidity or cash to
lenders. According to Madden and Nadler, “a money market is a
mechanism through which short term funds are loaned and borrowed
and through which a large part of the financial transaction of a particular
country or of the world are cleared.” The Reserve Bank of India defines
money market as, the centre for dealing, mainly of short-term character,
in monetary assets, it meets the short-term requirements of borrowers
and provides liquidity or cash the lenders.”
Functions of Money Market
• It facilitates economic development through provision of short-
term funds to industrial and other sectors.
• It provides a mechanism to achieve equilibrium between
demand and supply of short- term funds.
• It facilitates effective implementation of RBIs monetary policy.
• It provides ample avenues for short-term funds with fair
returns to investors.

• It instils financial discipline in commercial banks.

• It provides funds to meet short-term needs.
• It enhances capital formation through savings and investment.
• Short-term allocation of funds is made possible through inter-
banking transactions and money market instruments.
• It helps employment generation.
• It provides funds to government to meet its deficits.
• It helps to control inflation.
• It provides a stable source of funds to banks in addition to
deposits, allowing alternative financing structures and
competition.
• It encourages the development of non-bank intermediaries thus
increasing the competition for funds.
• Savers get a wide range of savings instruments to select from
and invest their savings.
Instruments of the Money Market
A variety of money market instruments are available to meet
the diverse needs of market participants. One security will be perfect
for one investor; a different security may be best for another. Money
market securities are debt securities with a maturity of one year or less.
They are issued in the primary market through a telecommunications
network by the Treasury, corporations, and financial intermediaries that
wish to obtain short-term financing. The U.S. Treasury issues money
market securities (Treasury bills) and uses the proceeds to finance the
budget deficit. Corporations issue money market securities and use the
proceeds to support their existing operations or to expand their
operations. Financial institutions issue money market securities and

bundle the proceeds to make loans to households or corporations.
Thus, the funds are channelled to support household purchases, such
as cars and homes, and to support corporate investment in buildings
and machinery.
The Treasury and some corporations commonly pay off their
debt from maturing money market securities with the proceeds from
issuing new money market securities. In this way, they are able to finance
expenditures for long periods of time even though money market
securities have short-term maturities. Overall, money markets allow
households, corporations, and the U.S. government to increase their
expenditures; thus, the markets finance economic growth. Money market
securities are commonly purchased by households, corporations
(including financial institutions), and government agencies that have funds
available for a short-term period. Because money market securities
have a short-term maturity and can typically be sold in the secondary
market, they provide liquidity to investors. Most firms and financial
institutions maintain some holdings of money market securities for this
reason.
The more popular money market securities are:
Treasury bills (T-bills)
Commercial paper
Negotiable certificates of deposit
Repurchase agreements
Federal funds
Banker’s acceptances

Call Money
Call Money Market is sometimes referred as “loans or money
at call and short notice’’. The rate at which funds are borrowed and
lend in this market is called the call money rate. The borrowers and
lenders contact each other through telephone in the call market. After
negotiation the lender issues cheques in favour of the borrower. After
receiving the cheques, the borrower issues a receipt. On payment of
loan and interest the receipt is returned to the lender.
Bill of Exchange/Commercial Bills
A commercial bill or a bill of exchange is a short-term,
negotiable, and self-liquidating money market instrument which
evidences the liability to make a payment on a fixed date when goods
are bought on credit. It is an asset with high degree of liquidity and a
low degree of risk. The two main types of bills are demand bill and
usance bill. A demand bill is payable ‘at sight’ or ‘on presentation’ to
the drawee. Usance or time bill is payable at a specified later date.
Bills can also be classified as clean bills, documentary bills, inland bills,
foreign bills, accommodation bills and supply bills. Commercial bills
are used to finance the movement and storage of agricultural and
industrial goods in domestic and foreign trade. The Normal maturity
period of bills varies considerably as follows: a) usuance hundi-30 to
120 days b) export bills- 90 days c) import bills-60 days d) internal
trade bills-90 to 180 days.
A bill of exchange is transferable, so the drawee may find
itself paying an entirely different party than it initially agreed to pay.
The payee can transfer the bill to another party by endorsing the
back of the document. A payee may sell a bill of exchange to another
party for a discounted price in order to obtain funds prior to the

payment date specified on the bill. The discount represents the

interest cost associated with being paid early. A bill of exchange
does not usually include a requirement to pay interest. If interest is
to be paid, then the percentage interest rate is stated on the
document. If a bill does not pay interest, then it is effectively a post-
dated check. If an entity accepts a bill of exchange, its risk is that
the drawee may not pay. This is a particular concern if the drawee is
a person or non- bank business. No matter who the drawee is, the
payee should investigate the creditworthiness of the issuer before
accepting the bill. If the drawee refuses to pay on the due date of the
bill, then the bill is said to be dishonoured.
Important features are:
• Preference for cash to bills.
• Lack of uniform practices with regards to bills.
• Excessive stamp duty.
• Preference for cash credit and overdraft arrangements as a
means of borrowing from commercial banks.
• Lack of specialized discount houses.
Treasury Bills
When the government needs to borrow funds, the Treasury
frequently issues short-term securities known as Treasury bills. The
Treasury issues T-bills with 4-week, 13-week, and 26- week maturities
on a weekly basis. It periodically issues T-bills with terms shorter than
four weeks, which are called cash management bills. It also issues T-
bills with a one-year maturity on a monthly basis. Treasury bills were
formerly issued in paper form but are now maintained electronically.

Investors in Treasury Bills

Depository institutions commonly invest in T-bills so that they
can retain a portion of their funds in assets that can easily be liquidated
if they suddenly need to accommodate deposit withdrawals. Other
financial institutions also invest in T-bills in the event that they need cash
because cash outflows exceed cash inflows. Individuals with substantial
savings invest in T- bills for liquidity purposes. Many individuals invest
in T-bills indirectly by investing in money market funds, which in turn
purchase large amounts of T-bills. Corporations invest in T-bills so
that they have easy access to funding if they suddenly incur unanticipated
expenses.
Credit Risk
Treasury bills are attractive to investors because they are
backed by the federal government and are therefore virtually free of
credit (default) risk. This is a very desirable feature, because investors
do not have to use their time to assess the risk of the issuer, as they do
with other issuers of debt securities.
Liquidity
Another attractive feature of T-bills is their liquidity, which is
due to their short maturity and strong secondary market. At any given
time, many institutional investors are participating in the secondary
market by purchasing or selling existing T-bills. Thus, investors can
easily obtain cash by selling their T-bills in the secondary market.
Government securities dealers serve as intermediaries in the secondary
market by buying existing T-bills from investors who want to sell them,
or selling them to investors who want to buy them. These dealers’ profit
by purchasing the bills at a slightly lower price than the price at which
they sell them.

Pricing Treasury Bills

The par value (amount received by investors at maturity) of T-
bills is Rs.1,000 and multiples of Rs.1,000. Since T-bills do not pay
interest, they are sold at a discount from par value, and the gain to the
investor holding a T-bill until maturity is the difference between par
value and the price paid. The price that an investor will pay for a T-bill
with a particular maturity depends on the investor’s required rate of
return on that T-bill. That price is determined as the present value of the
future cash flows to be received. The value of a T-bill is the present
value of the par value. Thus, investors are willing to pay a price for a
one-year T-bill that ensures that the amount they receive a year later
will generate their desired return.
Commercial Paper
Commercial paper is a short-term debt instrument issued only
by well-known, creditworthy firms that is typically unsecured. It is
normally issued to provide liquidity or to finance a firm’s investment in
inventory and accounts receivable. The issuance of commercial paper
is an alternative to short-term bank loans. Some large firms prefer to
issue commercial paper rather than borrow from a bank because it is
usually a cheaper source of funds. Nevertheless, even the large
creditworthy firms that are able to issue commercial paper normally
obtain some short-term loans from commercial banks in order to maintain
a business relationship with them. Financial institutions such as finance
companies and bank holding companies are major issuers of commercial
paper.
Denomination
The minimum denomination of commercial paper is usually
Rs.100,000, and typical denominations are in multiples of Rs.1 million.

Maturities are normally between 20 and 45 days but can be as short

as 1 day or as long as 270 days. The 270-day maximum is due to a
Securities and Exchange Commission ruling that paper with a maturity
exceeding 270 days must be registered. Because of the high minimum
denomination, individual investors rarely purchase commercial paper
directly, although they may invest in it indirectly by investing in money
market funds that have pooled the funds of many individuals. Money
market funds are major investors in commercial paper. Although the
secondary market for commercial paper is very limited, it is sometimes
possible to sell the paper back to the dealer who initially helped to
place it. However, in most cases, investors hold commercial paper until
maturity.
Credit Risk
Because commercial paper is issued by corporations that are
susceptible to business failure, commercial paper is subject to credit
risk. The risk of default is affected by the issuer’s financial condition
and cash flow. Investors can attempt to assess the probability that
commercial paper will default by monitoring the issuer’s financial
condition. The focus is on the issuer’s ability to repay its debt over the
short term because the payments must be completed within a short-
term period. Although issuers of commercial paper are subject to
possible default, historically the percentage of issues that have defaulted
is very low, as most issuers of commercial paper are very strong
financially. In addition, the short time period of the credit reduces the
chance that an issuer will suffer financial problems before repaying
the funds borrowed. However, during the credit crisis in 2008, Lehman
Brothers (a large securities firm) failed. This made investors more
cautious before purchasing securities.

Credit Risk Ratings

Commercial paper is commonly rated by rating agencies such
as Moody’s Investors Service, Standard & Poor’s Corporation, and
Fitch Investor Service. The rating serves as an indicator of the potential
risk of default. Some investors rely heavily on the rating to assess credit
risk, rather than assess the risk of the issuer themselves. A money market
fund can invest only in commercial paper that has a top-tier or second-
tier rating, and second-tier paper cannot represent more than 5 per
cent of the fund’s assets. Thus, corporations can more easily place
commercial paper that is assigned a top-tier rating. Some commercial
paper (called junk commercial paper) is rated low or not rated at all.
Placement
Some firms place commercial paper directly with investors.
Other firms rely on commercial paper dealers to sell their commercial
paper at a transaction cost of about one-eighth of 1 per cent of the face
value. This transaction cost is generally less than it would cost to establish
a department within the firm to place commercial paper directly.
However, companies that frequently issue commercial paper may reduce
expenses by creating such an in-house department. Most nonfinancial
companies use commercial paper dealers rather than in-house resources
to place their commercial paper. Their liquidity needs, and therefore
their commercial paper issues, are cyclical, so they would use an in-
house, direct placement department only a few times during the year.
Finance companies typically maintain an in-house department because
they frequently borrow in this manner.
Backing Commercial Paper
Some commercial paper is backed by assets of the issuer.
Commercial paper that is backed by assets should offer a lower yield
than if it were not secured by assets. However, the issuers of asset-

backed commercial paper tend to have more risk of default than the
well-known firms that can successfully issue unsecured commercial
paper, and the value of assets used as collateral may be questionable.
Thus, yields offered on asset-backed commercial paper are often higher
than the yields offered on unsecured commercial paper. Some issuers
of asset- backed commercial paper obtain credit guarantees from a
sponsoring institution in the event that they cannot cover their payments
on commercial paper. This allows them to more easily sell their
commercial paper to investors. Issuers of commercial paper typically
maintain backup lines of credit in case they cannot roll over (reissue)
commercial paper at a reasonable rate because, for example, their
assigned rating has been lowered. A backup line of credit provided by
a commercial bank gives the company the right (but not the obligation)
to borrow a specified maximum amount of funds over a specified period
of time. The fee for the credit line can either be a direct percentage
(e.g., 0.5 per cent) of the total accessible credit or be in the form of
required compensating balances (e.g., 10 per cent of the credit line).
Interbank Market
Some international banks periodically have an excess of funds

beyond the amount that other corporations want to borrow. Other
international banks may be short of funds because their client
corporations want to borrow more funds than the banks have available.
An international interbank market facilitates the transfer of funds from
banks with excess funds to those with deficient funds. This market is
similar to the federal funds market in the United States, but it is
worldwide and conducts transactions in a wide variety of currencies.
Some of the transactions are direct from one bank to another, while
others are channelled through large banks that serve as intermediaries

between the lending bank and the borrowing bank. Historically,

international banks in London carried out many of these transactions.
The rate charged for a loan from one bank to another in the
international interbank market is the LIBOR, which is similar to the
federal funds rate in the United States. Several banks report the interest
rate that they offer in the interbank market and their rates may vary
slightly. The LIBOR is the average of the reported rates at a given point
in time. The LIBOR varies among currencies and is usually in line with
the prevailing money market rates in the currency. It varies over time in
response to changes in money market rates in a particular currency,
which are driven by changes in the demand and supply conditions for
short-term money in that currency. The term LIBOR is still frequently
used, even though many international interbank transactions do not pass-
through London.
LIBOR Scandal
In 2012, some banks that periodically report the interest rate
they offer in the interbank market falsely reported their rates. These
banks have some investment or loan positions whose performance is
dependent on the prevailing LIBOR. For example, some banks provide
loans with rates that adjust periodically in accordance with LIBOR,
and therefore would benefit from inflating the reported rate they charge
on interbank loans in order to push LIBOR higher. Some banks were
charged with colluding to manipulate LIBOR in order to boost their
trading profits. In particular, many banks have large positions in
derivative securities, and manipulating LIBOR by just 0.1 per cent
could generate millions of rupees in profits from their positions.
Federal Funds
The federal funds market enables depository institutions to lend
or borrow short-term funds from each other at the so-called federal

funds rate. This rate is charged on federal funds transactions, and it is

influenced by the supply of and demand for funds in the federal funds
market. The Federal Reserve adjusts the amount of funds in depository
institutions in order to influence the federal funds rate and several other
short-term interest rates. All types of firms closely monitor the federal
funds rate because the Federal Reserve manipulates it to affect general
economic conditions. For this reason, many market participants view
changes in the federal funds rate as an indicator of potential changes in
other money market rates.
The federal funds rate is normally slightly higher than the T-bill
rate at any given time. A lender in the federal funds market is subject to
credit risk, since it is possible that the financial institution borrowing the
funds could default on the loan. Once a loan transaction is agreed upon,
the lending institution can instruct its Federal Reserve district bank to
debit its reserve account and to credit the borrowing institution’s reserve
account by the amount of the loan. If the loan is for just one day, it will
likely be based on an oral agreement between the parties, especially if
the institutions commonly do business with each other.
Commercial banks are the most active participants in the federal
funds market. Federal funds brokers serve as financial intermediaries
in the market, matching up institutions that wish to sell (lend) funds with
those that wish to purchase (borrow) them. The brokers receive a
commission for their service. The transactions are negotiated through a
telecommunications network that links federal funds brokers with
participating institutions. Most loan transactions are for Rs.5 million or
more and usually have a maturity of one to seven days (although the
loans may often be extended by the lender if the borrower requests
more time).

The volume of interbank loans on commercial bank balance

sheets over time is an indication of the importance of lending between
depository institutions. The interbank loan volume outstanding now
exceeds Rs.200 billion.
Negotiable Certificate of Deposits
Negotiable certificates of deposit (NCDs) are certificates
issued by large commercial banks and other depository institutions as
a short-term source of funds. The minimum denomination is Rs.100,000,
although a Rs.1 million denomination is more common. Nonfinancial
corporations often purchase NCDs. Although NCD denominations are
typically too large for individual investors, they are sometimes purchased
by money market funds that have pooled individual investors’ funds.
Thus, money market funds allow individuals to be indirect investors in
NCDs, creating a more active NCD market.
Maturities on NCDs normally range from two weeks to one
year. A secondary market for NCDs exists, providing investors with
some liquidity. However, institutions prefer not to have their newly issued
NCDs compete with their previously issued NCDs being resold in the
secondary market. An oversupply of NCDs for sale could force
institutions to sell their newly issued NCDs at a lower price.
Placement
Some issuers place their NCDs directly; others use a
correspondent institution that specializes in placing NCDs. Another
alternative is to sell NCDs to securities dealers who in turn resell them.
A portion of unusually large issues is commonly sold to NCD dealers.
Normally, however, NCDs can be sold to investors directly at a higher
price.

Yield
Negotiable certificates of deposit provide a return in the form
of interest along with the difference between the price at which the
NCD is redeemed (or sold in the secondary market) and the purchase
price. Given that an institution issues an NCD at par value, the annualized
yield that it will pay is the annualized interest rate on the NCD. If investors
purchase this NCD and hold it until maturity, their annualized yield is
the interest rate. However, the annualized yield can differ from the
annualized interest rate for investors who either purchase or sell the
NCD in the secondary market instead of holding it from inception until
maturity.
Banker’s Acceptance
A banker’s acceptance indicates that a bank accepts
responsibility for a future payment. Banker’s acceptances are commonly
used for international trade transactions. An exporter that is sending
goods to an importer whose credit rating is not known will often prefer
that a bank act as a guarantor. The bank therefore facilitates the
transaction by stamping ACCEPTED on a draft, which obligates
payment at a specified point in time. In turn, the importer will pay the
bank what is owed to the exporter along with a fee to the bank for
guaranteeing the payment. Exporters can hold a banker’s acceptance
until the date at which payment is to be made, but they frequently sell
the acceptance before then at a discount to obtain cash immediately.
The investor who purchases the acceptance then receives the
payment guaranteed by the bank in the future. The investor’s return on
a banker’s acceptance, like that on commercial paper, is derived from
the difference between the discounted price paid for the acceptance
and the amount to be received in the future. Maturities on banker’s
acceptances typically range from 30 to 270 days. Because there is a
possibility that a bank will default on payment, investors are exposed
to a slight degree of credit risk. Thus, they deserve a return above the
T-bill yield in compensation. Because acceptances are often discounted
and sold by the exporting firm prior to maturity, an active secondary
market exists. Dealers match up companies that wish to sell acceptances
with other companies that wish to purchase them. A dealer’s bid price
is less than its ask price, and this creates the spread (or the dealer’s
reward for doing business). The spread is normally between one-eighth
and seven-eighths of 1 per cent.
Steps Involved in Banker’s Acceptances
The sequence of steps involved in a banker’s acceptance is
illustrated in figure 2.1.
Figure 2.1
1 Purchase Order
Importer 5 Shipment of Goods Exporter
Shipping Documents & Time Draft

L/C (Letter of Credit) Application
L/C Notification
2 4 6
3 L/C
American Bank
7 Shipping Documents & Time Draft Japanese Bank
(Import’s Bank
Draft Accepted (B/A Created) (Export’s Bank
To understand these steps, consider the example of a U.S. importer of

Japanese goods. First, the importer places a purchase order for the
goods (Step 1). If the Japanese exporter is unfamiliar with the U.S.
importer, it may demand payment before delivery of goods, which the
U.S. importer may be unwilling to make. A compromise can be reached

by creating a banker’s acceptance. The importer asks its bank to issue
a letter of credit (L/C) on its behalf (Step 2). The L/C represents a
commitment by that bank to back the payment owed to the Japanese
exporter. Then the L/C is presented to the exporter’s bank (Step 3),
which informs the exporter that the L/C has been received (Step 4).
The exporter then sends the goods to the importer (Step
5) and sends the shipping documents to its bank (Step 6), which
passes them along to the importer’s bank (Step 7). At this point, the
banker’s acceptance (B/A) is created, which obligates the importer’s
bank to make payment to the holder of the banker’s acceptance at a
specified future date. The banker’s acceptance may be sold to a money
market investor at a discount. Potential purchasers of acceptances are
short term investors. When the acceptance matures, the importer pays
its bank, which in turn pays the money market investor who presents
the acceptance.
The creation of a banker’s acceptance allows the importer to
receive goods from an exporter without sending immediate payment.
The selling of the acceptance creates financing for the exporter. Even
though banker’s acceptances are often created to facilitate international
transactions, they are not limited to money market investors with
international experience. Investors who purchase acceptances are more
concerned with the credit of the bank that guarantees payment than
with the credit of the exporter or importer. For this reason, the credit
risk on a banker’s acceptance is somewhat similar to that of NCDs
issued by commercial banks. Yet because it has the backing not only of
the bank but also of the importing firm, a banker’s acceptance may be
perceived as having slightly less credit risk than an NCD.

Repurchase Agreements
With a repurchase agreement (or repo), one party sells securities
to another with an agreement to repurchase the securities at a specified
date and price. In essence, the repo transaction represents a loan backed
by the securities. If the borrower defaults on the loan, the lender has
claim to the securities. Most repo transactions use government securities,
although some involve other securities such as commercial paper or
NCDs. A reverse repo refers to the purchase of securities by one party
from another with an agreement to sell them. Thus, a repo and a reverse
repo refer to the same transaction but from different perspectives. These
two terms are sometimes used interchangeably, so a transaction
described as a repo may actually be a reverse repo.
Financial institutions such as banks, savings and loan
associations, and money market funds often participate in repurchase
agreements. Many nonfinancial institutions are also active participants.
The size of the repo market is about Rs.4.5 trillion, and transaction
amounts are usually for Rs.10 million or more. The most common
maturities are from 1 to 15 days and for one, three, and six months. A
secondary market for repos does not exist. Some firms in need of
funds will set the maturity on a repo to be the minimum time period for
which they need temporary financing. If they still need funds when the
repo is about to mature, they will borrow additional funds through new
repos and use these funds to fulfil their obligation on maturing repos.
Placement
Repo transactions are negotiated through a telecommunications
network. Dealers and repo brokers act as financial intermediaries to
create repos for firms with deficient or excess funds, receiving a
commission for their services.

When the borrowing firm can find a counterparty to the repo

transaction, it avoids the transaction fee involved in having a government
securities dealer find the counterparty. Some companies that commonly
engage in repo transactions have an in-house department for finding
counterparties and executing the transactions. A company that borrows
through repos may, from time to time, serve as the lender. That is, it
may purchase the government securities and agree to sell them back in
the near future. Because the cash flow of any large company changes
on a daily basis, it is not unusual for a firm to act as an investor one day
(when it has excess funds) and a borrower the next (when it has a cash
shortage). Impact of the Credit Crisis During the credit crisis in 2008,
the values of mortgage securities declined and so financial institutions
participating in the housing market were exposed to more risk.
Consequently, many financial institutions that relied on the repo market
for funding were not able to obtain funds. Investors became more
concerned about the securities that were posted as collateral. Bear
Stearns, a large securities firm, relied heavily on repos for funding and
used mortgage securities as collateral. But the valuation of these types
of securities was subject to much uncertainty because of the credit
crisis. Consequently, investors were unwilling to provide funding, and
Bear Stearns could not obtain sufficient financing. It avoided bankruptcy
only with the aid of the federal government. The lesson of this example
is that repo market funding requires collateral that is trusted by investors.
When economic conditions are weak, some securities may not serve
as adequate collateral to obtain funding.
Money Market Mutual Funds
A money market mutual fund often referred to as a money market
fund is a low-risk investment vehicle that provides both a modest return on
your money and a high degree of liquidity. That means you can easily and

quickly move cash in and out of a money market fund without fees or
penalties.
Money market mutual funds were first developed in the 1970s
before bank money market accounts came on the scene, as an alternative
to low-yielding savings accounts. As its name suggests, a money market
fund is a type of mutual fund, which invests its shareholders’ money in
short-term, high-quality debt. This makes a money market fund much less
risky than mutual funds that buy stocks or even longer-term bonds.
Money market funds can be categorized into three groups:
prime, government and tax-free.
• Prime money market funds are typically invested in short-term
corporate and bank debt securities.
• Government money market funds invest at least 99.5 per cent of their
funds in government- backed securities, making them extremely safe
investments.
• Tax-free money market funds are invested primarily in municipal bonds
or debt issued by other entities whose interest payments are exempt
from federal income taxes.
Money market funds can be a highly useful tool for holding the
cash component of your investment portfolio. The key advantage of money
market funds is the fact that they are highly liquid investments. Money market
funds offer higher liquidity than certificates of deposit (CDs) and Treasury
bills while also offering ultra-low risk. Unlike CDs, which you generally
need to hold to maturity to cash out without penalty, money market funds
don’t have maturities and can be liquidated on demand. You can sell Treasury
bills on the secondary market with ease, but it’s also possible to take a loss
on the sale.

Money market funds may be appropriate for customers who:

• Have an investment goal with a short time horizon
• Have a low tolerance for volatility, or are looking to diversify with
a more conservative investment
• Need the investment to be extremely liquid While the returns on
money market funds are generally not as high as those of other
types of fixed income funds, such as bond funds, they do seek to
provide stability, and can therefore play an important role in your
portfolio. Investors can use money market funds in a few ways:
• To offset the typically greater volatility of bond and equity
investments
• As short-duration investments for assets that may be needed in the
near term (such as an emergency fund)
• As a holding place for assets while waiting for other investment
opportunities to arise (such as in the core position for your brokerage
account)
Features of a Developed Money Market
The developed money market is a well organised market which
has the following main features:
1. A Central Bank:
The presence of a strong Central bank is an indispensable factor
for a well-developed money market. The leader of the money
market is the Central bank. So, it has to guide the money market
by providing funds and also maintain a reasonable interest rate
according to the prevailing conditions in the economy. If there is
inflationary trend, the Central bank, by increasing the interest rate

can bring down the prices. This will be possible only when all the
economic activities in the country are carried through the banking
sector.
The Central bank can help the commercial banks in undertaking
various activities so that the entire economic activities are financed
by the commercial banks. The commercial banks must have a better
cordial relationship with Central bank so that they can always
depend on Central bank for assistance. This position can be attained
by the Central bank only when it is strong enough to assist the
commercial bank.
2. Organised Banking System:
An organised and integrated banking system is the second feature
of a developed money market. In fact, it is the pivot around which
the whole money market revolves. It is the commercial banks which
supply short-term loans, and discount bills of exchange. They form
an important link between the borrowers, brokers, discount houses
and acceptance houses and the central bank in the money market.
3. Specialised Sub-Markets:
A developed money market consists of a number of specialised
sub-markets dealing in various types of credit instruments. There
is the call loan market, the bill market, the Treasury bill market, the
collateral loan market and the acceptance market, and the foreign
exchange market. The larger the number of sub-markets, the more
developed is the money market. But the mere number of sub-
markets is not enough. What is required is that the various sub-
markets should have a number of dealers in each market and the
sub-markets should be properly integrated with each other.

4. Existence of Large Near-Money Assets:

A developed money market has a large number of near-money
assets of various types such a bill of exchange, promissory notes,
treasury bills, securities, bonds, etc. The larger the number of near-
money assets, the more developed is the money market.
5. Integrated Interest-Rate Structure:
Another important characteristic of a developed money market is
that it has an integrated interest-rate structure. The interest rates
prevailing in the various sub-markets are integrated to each other.
A change in the bank rate leads to proportional changes in the
interest rate prevailing in the sub-markets.
6. Adequate Financial Resources:
A developed money market has easy access to financial sources
from both within and outside the country. In fact, such a market
attracts adequate funds from both sources, as is the case with the
London Money Market.
7. Remittance Facilities:
A developed money market provides cash and cheap emittance
facilities for transferring funds from one market to the other. The
London Money Market provides such remittance facilities
throughout the world.
8. Free movement of funds among the various constituents of
well-developed money market
When commercial banks are dealing in various credit instruments
and sub markets, they ensure that equal amount of resources are
distributed among the various sub markets. This will not only ensure
uniform interest rate, but will help in the uniform growth of the
economy. Agriculture as well as industry will get adequate resources.

Similarly, both domestic and foreign trade will get adequate
resources.
9. Better industrial relations in a well-developed money market
If there are more strikes and lock-outs in the country, they will
affect production and there will be less demand for short-term
funds. So, a congenial industrial atmosphere is a per-requisite for
a well-developed money market.
10. Integrated monetary and fiscal policies of money market
The monetary policy is framed by the Central bank while the fiscal
policy is framed by the Government. In the monetary policy, the
Central bank tries to control price level while in the fiscal policy
the government tries to maximize the revenue. If these policies are
contradictory to each other, it will affect the working of a well-
developed money market.
11. Promotion of Foreign Trade in a well-developed money
market
When there is more foreign trade, there will be more foreign bills
and foreign exchange transactions in a well-developed money
market. The foreign bills will also be discounted. Exchange
rate will be streamlined.
12. Miscellaneous Factors:
Besides the above noted features, a developed money market is
highly influenced by such factors as restrictions on international
transactions, crisis, boom, depression, war, political instability, etc.

Indian Money Market

The money market provides a mechanism for evening out short-
term liquidity imbalances within an economy. The development of the
money market is thus, a prerequisite for the growth and development
of the economy of a country.
The main components of Indian money market are:
a. Organized money market: these markets have standardized and
systematic rules, regulations and procedures to govern the
financial dealings. Organized money markets are governed and
regulated by Government and Reserve Bank of India. It consists
of Reserve Bank of India and other banks, financial institutions,
specialized financial institutions, non-banking financial
institutions, quasi government bodies and government bodies
who supply funds through money market.
b. Unorganized money market: unorganized market consists of
indigenous bankers and money lenders. They collect deposits
and lend money. A part from them there are certain private
finance companies or non-banking companies, chit funds etc.
Reserve Bank of India has taken a number of steps to regulate
such type of institutions and bring them in the organized sector.
One of such steps is issuing of non-banking Financial Companies
Act, 1998.
c. Sub market: it consists of call money market and bill market.
Bill market consists of commercial bill market and Treasury bills
market, certificates of deposits, and commercial papers.
Structure of Indian Money Market
The main components of Indian money market re unorganized
banking sector, organized banking sector with several sub markets which
deals with borrowing and lending of short-term credits.
A. Unorganised Banking Sector

It consists of indigenous bankers and moneylenders in all the country
who pursue banking business on traditional lines.
1. Indigenous bankers: the Indian Central Banking Enquiry Committee
defined Indigenous banks as “an individual or private firm receiving
deposits and dealing in hundies or lending money”. They accept
deposits on current accounts and fixed deposits. They lend money
to small farmers and traders. Along with this they deal in hundies.
They charge exorbitant rate of interest on loans. Certain
communities such as Marwaris, Bengalese, Gujarathies, Chettiars
and Kallida Kurichi Brahmins do indigenous banking business in
India. The main limitation of indigenous bankers is that they follow
conservative practices and are not governed by Reserve Bank of
India.
2. Money lenders: money lenders constitute one of the components
of the organized money market of our country. Money lenders are
those persons who do not accept deposits from public, but merely
lend their own funds. They lend money mainly for consumption
and other domestic purposes. They are mainly two categories of
money lenders. 1) Professional money lenders: they are those
persons whose main business is to lend money. It may be of two
types- Resident money lenders (Maharaja, Sahukars, Seths or
Banias) and Itinerant money lenders (Pathans, Kabulis and
Qustwalas).
3. Non-professional money lenders: these are those persons who
combine money lending with other activities.

Defects:
1) Their resources are limited to meet the requirement of the rural

people.
2) They charge high rate of interest.
3) They grant loans for consumption and unproductive purposes.
4) They provide loans against crops. In this way they compel the
consumers to supply the crops to them.
B. Organised Banking Sector
It consists of Reserve Bank of India, the State Bank of India
and its seven subsidiaries, 19 nationalized banks, the other joint stock
banks including commercial banks, co-operative banks, regional Rural
Banks, special institutions like LIC, UTI, IDBI, SFCs, NABARD, Exim
bank etc. DFHI, non-banking companies and quasi-Government bodies
and large companies which supply funds in the money market through
banks. Reserve Bank of India (RBI) is the central bank and monitory
authority of our country. So, RBI is the leader of Indian money market.
Participants in Money Market:
1. Lenders: These are the entities with surplus lendable funds like
Banks (commercial, co- operative and Private) Mutual Funds
Corporate Entities with bulk lendable resources of minimum of
Rs.3 crores per transaction and Financial Institutions.
2. Borrowers: these are entities with deficit funds and include the
ones as above.
Players or Organisations in Money Market:
Money market is dominated by a small number of large players.
The Reserve bank of India is the most important constituent of Indian

Money market. Some important players in the money market are:

1. Government.
2. Reserve Bank of India.
3. Discount and finance House of India.
4. Banks.
5. Financial Institution.
6. Corporate firms.
7. Mutual funds.
8. Non- banking financial companies.
9. Primary Dealers.
10. Securities Trading Corporation of India. 11.Provident Funds.
12. Public sector undertakings (PSU).
Reserve Bank of India
It is the nerve centre of the financial and monetary system. RBI
possesses special status in our country. It is the authority to regulate
and control the monetary system of our country. The preamble to the
Reserve Bank of India Act states that the object of establishing Reserve
Bank of India is, “to regulate the issue of bank notes and keeping of
reserves with a view to securing monetary stability in India and generally
to operate the currency and credit system of the country to its
advantage.” The main function of RBI is to maintain monetary stability
and to maintain stable payment system. The other important function of
RBI is to regulate overall volume of money and credits in the economy
with a view to ensure a reasonable degree of price stability. RBI
influences liquidity and interest rates through a number of operating

instruments such as cash reserve requirement of banks, conduct of open

market operations, repos, change in bank rates, and at times of foreign
exchange swap operations. The roles RBI plays in Indian financial system
as a regulator relate to,
• Note issue authority.
• Government banker.
• Banker’s bank.
• Supervising authority.
• Exchange control Authority.
• Promoter of the financial system and,
• Regulator of money and credit.
1. Note Issuing Authority
According to section 22 of the Reserve Banks of India Act, the
Reserve Bank has given the sole right to issue currency notes other
than one-rupee coins and notes and subsidiary coins in our country.
Currency notes of rupee one and other subsidiary coins are issued
by the Ministry of Finance of the Government of India through
Reserve Bank.
2. Government Banker
The reserve bank acts as a Banker, agent and advisor to the
Government as per the obligations created under the section 20,
21, and 21(a) of the Reserve Bank of India Act.
As A Banker: The Reserve Bank have statutory obligation of
keeping money of the Central and State Government and provide
other services free of charge. It makes payments on behalf of the

central Government through its branches and the branches of the

State Bank of India all over the country.
As A Financial Advisor: the bank acts a financial advisor to the central
and state Governments. It assists them generally to formulate
financial and economic policies. As A Financial Agent: the bank is
the representative of Government of India in the World Bank and
International Monetary fund. It sells treasury bills on behalf of the
Central Government. It acts as the agent of the central and state
governments in the matter of floatation of loans.
3. Banker’s bank and Lender of the Last Resort
RBI has the right to control and supervise the activities of all banks
in the country by way of issuing license, giving permission etc. it
controls the volume of their reserve and determines their deposit
credit creation ability.
4. Supervising and Regulating Authority
RBI is the regulator and supervisor of monetary system. It provides
broad parameters with in which the banking and financial system
of our country functions It regulates the money market according
to the provisions of the RBI act and the banking regulation act.
5. Exchange Control Authority
RBI develops and regulates the foreign exchange market. Its role
is to facilitate external trade and payment and provide or orderly
development and maintenance of foreign exchange market within
the frame work of FEMA.
6. Promoter of the Financial System
RBI has taken a number of steps to promote financial system. It

created certain financial institutions and helped other financial

institutions to develop. Example: IDBI, IFCI, SFCs, IIBI, EXIM
BANK, UTI, SIDBI, NABARD etc.
7. Regulator of Money and Credit
RBI formulates and conducts the monetary policy. Monetary policy
refers to the use of the techniques of monetary control to achieve
the broad objectives of maintaining price stability and to ensure
adequate flow of credit to productive sectors for helping economic
growth. The following are the important monetary techniques used
for monetary control.
Open Market Operations
Bank Rate
Refinance
Cash Reserve Ratio
Statutory Liquidity Ratio
Liquidity Adjustment Facility
REPOS/ Reserve REPOS
Financial Institutions
They undertake lending and borrowing of short-term funds, they
also lend money to banks by rediscounting Bills of Exchange.
a. Corporate Firms
Corporate firms operate in money market to raise short-term funds
to meet their working capital requirements. They issue commercial
papers with a maturity period of 7 days to 1year.

b. Institutional Players
They consist of Mutual funds, foreign Institutional players,
insurance Firms, etc. Their participation depends on the regulations.
For instance, the level of participation of the FIIs in the Indian money
market is restricted to investment in Government Securities.
c. Discount Houses and Primary Dealers
Discount houses discount and rediscount commercial bill and
treasury bills. Primary dealers were introduced by RBI for developing
an active secondary market for Government securities.
Importance of Money Market
The money market is an integral part of a country’s economy. The
money market is an indispensable necessity for the economic
development of a country. A developed money market helps the
development of country in a number of ways.
1. Development of Capital Market: capital market deals with medium-
and long-term lending and borrowing of funds. The short-term
interest rates and the conditions prevailed in the money market
influences the interest on long term lending and resource mobilization
in the market.
2. Financing Trade: Money market plays crucial role in financing both
internal as well as international trade. The acceptance houses and
discount market help in financing foreign trade.
3. Financing Industry: money market contributes to the growth in two
ways:
• Money market helps the industries in securing short-term loans
to meet their working capital requirements through the system of
financial bills, commercial papers etc.

• Money markets help to grow industries by providing short-term

loans to meet working capital requirements through discounting
operations and commercial papers.
4. Formulation of Suitable Monetary Policy: Conditions prevailing in
a money market serve as a true indicator of the monetary state of
an economy. Hence, it serves as a guide to the Government in
formulating and revising the monetary policy then and there
depending upon the monetary conditions prevailing in the market.
5. Non-Inflationary Source of Finance to Government: A developed
money market helps the Government to raise short-term funds
through the treasury bills floated in the market. In the absence of a
developed money market, the Government would be forced to
print and issue more money or borrow from the central bank. Both
ways would lead to an increase in prices and the consequent
inflationary trend in the economy.
6. Helps Commercial Banks: money market enables the commercial
banks to use their excess reserves in profitable investment. The
main objective of the commercial banks is to earn income from its
reserves as well as maintain liquidity to meet the uncertain cash
demand of the depositors.
7. Helps Central Bank: it acts as a guide to central bank for adopting
an appropriate banking policy. Money market helps the central
bank in two ways:
- The short run interest rates of the money market serves as
an indicator of the monetary and banking conditions in the
country.
- The sensitive and integrated money market helps the Central
bank to secure quick and widespread influence on the sub-

markets and thus achieve effective implementation of its

policy.
8. Guide and Help to Government
9. Encourages Savings and Investment
Money Market Organisation
Money market is a Heterogeneous Market which consist of
sub markets. It consists of:
1. Call Money Market
It is sometimes referred as “loans or money at call and short
notice’’. The call money markets are mainly located in developed,
industrial centres like Mumbai, Kolkata, Ahmadabad, Delhi, Chennai
etc. The banks that are in need of temporary funds will take this loan
from the banks that have excess funds. So, this is called interbank call
money market. The borrowers and lenders contact each other through
telephone in the call market. After negotiation the lender issues cheques
in favour of the borrower. After receiving the cheques, the borrower
issues a receipt. On payment of loan and interest the receipt is returned
to the lender.
The important features of call money market are:
1. The call market enables the banks and institutions to even out their
day-to-day deficits and surpluses of money.
2. Commercial banks, co-operative Banks and primary dealers are
allowed to borrow and lend in this market for adjusting their cash
reserve requirements.
3. Specified All Indian Financial Institutions, Mutual Funds and certain
specified entities are allowed to access call/ Notice money only as
lenders.

4. It is a complete inter-bank market hence non-bank entities are not

allowed access to this market.
5. Interest rates in the call and notice money markets are market
determined.
6. The borrowers and the lenders are required to have current accounts
with Reserve Bank of India.
7. It serves as an outlet for deploying funds on short-term basis to the
lenders having steady inflow of funds.
Call loans are provided for the following purposes:
It is given to commercial banks to meet huge payments, bulky
remittances and to maintain statutory requirements with RBI.
It is provided to the stockbrokers and speculators to deal in stock
exchanges and bullion markets.
It is allowed to high status individuals for trade purposes to save
interest on overdraft or cash credit.
It is provided to the Discount and Finance Houses of India (DFHI)
and Securities Trading Corporation of India to activate the call
money.
It is given to bill markets to meet matured bills. Merits of Call Money
Market
• Profitability.
• High Liquidity.
• Helps to Maintain Statutory Reserve Requirements.
• Safe.
• Helps the Central Bank.

Demerits of Call Money Market

• Confined to big cities.
• Lack of integration.
• Call money rates volatile in nature.
• Small size.
• Commercial banks are not inclined to offer loans to brokers and
dealers in bills and securities.
2. Commercial Bill Market or Discount Market
Commercial bill or the bills of exchange popularly known as
bill is a written instrument containing an unconditional order. The bill is
signed by the drawer directing a certain person to pay a certain sum of
money only to or order of a certain person or to bearer of the instrument
at a fixed time in future or on demand. A
well-organized bill market or discount market forshort term bill is essential
for establishing an effective link between credit agencies and Reserve
Bank of India. Reserve bank of India started making efforts in this
direction in 1952. However, a new bill market was introduced in 1970.
There has been substantial improvement since then.
3. Treasury Bills
Treasury bill is a short-term government security usually of the
duration of 91 days sold by the central bank on behalf of the government.
There is no fixed rate of interest payable on the treasury bills. These are
sold by the central bank on the basis of competitive bidding. They are
highly secured and liquid because of guarantee of repayment assured
by the RBI who is always willing to purchase or discount them. Treasury
bills are basically classified into two types. Ordinary treasury bill and

Adhoc treasury bills. Ordinary/Regular Treasury Bills are issued to the

public and the RBI by a process of auction or bidding. The objective is
to meet the additional short term financial needs of the government.
Bids are invited usually for 14 days, 182 days, 91 days and 364 days
treasury bills. On the other hand, Adhoc Treasury Bills are issued in
favour of RBI with a view to replenish Government’s cash balances by
employing temporary surpluses of state government and semi government
departments. Banks are the main subscribers to such treasury bills
because they offer a stable and attractive returns, high liquidity and can
be encashed at a very short notice with RBI.
4. Call and Short Notice Money
Call money refers to a money given for a very short period. It
may be taken for a day or overnight but not exceeding seven days in
any circumstances. Surplus funds of the commercial banks and other
institutions are usually given as call money.
5. Cetificate of Deposits
As per the Reserve Bank of India Certificate of Deposit is a
negotiable money market instrument and issued in dematerialized form
or as a Usance Promissory Note against funds deposited at a bank or
other eligible financial institutions for a specified time period. Certificate
of Deposits are marketable receipts in bearer or registered form of
funds deposited in a bank or other eligible financial institution for a
specified period at a specified rate of interest. They are different from
the fixed deposits in the sense that they are freely transferable can be
sold to someone else and can be traded on the secondary market.
Reserve Bank of India launched a scheme in June 1989 permitting
banks to issue CDs. The Reserve Bank of India has modified its
guidelines from time to time. At present the minimum amount of a CD
should be Rs.1 lakh and in multiples of Rs. 1 lakh thereafter. The maturity
period of certificate of deposit at present should not be less than 7 days
and not more than one year from the date of issue in case of CD issued
by a bank. The financial institutions can issue CDs for a period not less
than one year and not exceeding three years from the date of issue.
6. Commercial Papers
CPs are short term promissory notes issued by reputed
companies with good credit standing and having sufficient tangible
assets. CPs are unsecured and are negotiable by endorsement and
delivery. CPs are normally issued by banks, public utilities, insurance
and non-banking financial institutions. CPs in India were launched by
the RBI’s notification in January 1990. With a view to enable highly
reputed companies to diversify their sources of short-term borrowings
and also to provide an additional instrument to investors. The issuing
company is required to meet the stamp duty, credit rating agency fees,
stand by facility charges etc. the maturity period of CPs was 30 days.
7. Repurchase agreement [REPO]
It is very important instrument of the money market. It enables
smooth adjustment of short- term liquidity among varied categories of
market participants. As it is a market-based instrument it serves the
purpose of an indirect instrument of monetary control in a liberalized
financial market. The monetary policy of 1999-2000 recognised that
the Repo rates are being increasingly accepted by the market as signals
for movement in the market rate of interests especially the call money
rates.
It is a money market instrument which enables collateralized
short-term borrowing and lending through sale/ purchase operations in
debt instruments. Repo rates is the annualized rate for the funds

transferred by the lender to the borrower. Repo is also called ready

forward transaction as it involves selling a security on spot basis and
repurchasing the same on forward basis. An active Repo market leads
to increase in the money market turnover and the central bank of the
country can use it as an integral part of open market operations.
The following are some of the important advantages that Repos
can provide to the financial and debt markets of a country.
An active repo market leads to increase in the turnover of the
money market.
It improves liquidity and depth of the money market.
It enables smooth adjustment of short-term liquidity among
varied categories of market participants.
Repo is a tool for funding transactions. It provides a
cheaper and most efficient way of improving liquidity in the
secondary markets.
Repos are a source of inexpensive finance for institutions.
Reserve Bank of India can use repos as a tool of open
market operations for injecting or withdrawing liquidity from
the market.
It can be used as indirect instruments of monetary control in
the financial market.
8. Inter Bank Participation Certificates (IBPCs)
The interbank participation certificates are the interbank money
market instruments used by commercial banks to park their surplus
funds. These IBPCs are of two types- With risk sharing IBPCs and
Without risk sharing IBPCs. In With risk sharing IBPCs certificates are

issued for 91 to 180 days and interest is determined on these PCs

between the issuing and participating bank freely. Without risk sharing
IBPCs money market instruments not exceeding 90 days. The interest
on these PCs is determined by the two contracting banks.
Players in the Indian Money Market
The following are the major players in the Indian money market.
1. Reserve Bank of India.
2. Financial institutions like IFCI, IDBI, ICICI, IRBI, LIC, UTI etc.
3. Commercial banks including scheduled as well as non- scheduled
commercial banks, private banks, foreign banks, state bank of india
and its subsidiaries, cooperative banks etc.
4. Discount and Finance House of India.
5. Brokers.
6. Provident Funds.
7. Public sector undertakings.
8. Corporate units, etc.
Defects of the Indian Money Market
• Existence of unorganized Money Market.
• Lack of integration.
• Disparity in interest rates.
• Seasonal diversity of money market.
• Lack of proper bill market.
• Lack of very well-organized banking System.

Money Market Reforms in India since 1991

The Reserve Bank of India has been making efforts to remove
the defects of the Indian money market. Vaghul Committee on money
market, Sukhmoy Chakravarty Committee on the
Review of the working of the Monetary System and
Narasimham Committee on the working of Financial System have made
important recommendations on the Indian money market.
1. Development of money market instruments: The new instruments
are 182 days treasury bills, longer maturity bills, dated Government
securities, certificates of deposits and commercial papers, 3-4 days
repos and 1-day repos from 1998-1999. The 182 days bills which
were discontinued in 1992 have been reintroduced from School of
distance education Financial Markets and services Page 30 1998-
1999. Now Indian money market has 14 days, 91 days, 182 days
and 364 days treasury bills.
2. Deregulation of interest rates: Helps banks to accustom better pricing
of assets and liabilities and to the need to manage interest rates
across their balance sheet.
3. Institutional Development: The institutional infrastructure in
government securities has been strengthened with the system of
primary Dealers announced in March 1995 and that of satellite
Dealers in December 1996.
4. Money market mutual funds: In 1992 setting up of money market
mutual funds was announced to bring it within the reach of individuals.
These funds have been introduced by financial institutions and banks.
5. Permission to foreign institutional investors (FIIs): FIIs are allowed
to operate in all dated government securities. The policy for 1998-
1999 has allowed them to buy treasury Bill’s within approved debt
ceiling.

Module III
CAPITAL MARKET
The term capital market refers to the institutional arrangements
for facilitating the borrowing and lending of long-term funds. It is
concerned with those private savings, individuals as well as corporate,
that are turned into investments through new capital issues and also
new public loans floated by government and semi-government bodies.
A capital market may be defined as an organised mechanism for effective
and efficient transfer of money capital or financial resources from
investing parties, i.e, individuals or institutional savers to the entrepreneurs
engaged in industry or commerce in the business either be in the private
or public sectors of an economy. Firms that issue capital market
securities and the investors who buy them have very different motivations
than those who operate in the money markets. Firms and individuals
use the money markets primarily to warehouse funds for short periods
of time until a more important need or a more productive use for the
funds arises. By contrast, firms and individuals use the capital markets
for long-term investments.
The following are the important features of a developed capital market
• Market for long term funds.
• Important component of financial system.
• Facilitates borrowing and lending of funds.
• Helps in raising capital.
• Involves both individual and institutional investors.

• Meets demand and supply of long-term capital.

• Involves intermediaries.
• Deals in marketable and non-marketable securities.
Functions of Capital Market
The important functions of Capital Market are:
1. Helps in capital formation.
2. Act as a link between savers and investors.
3. Helps in increasing national income.
4. Facilitates buying and selling.
5. Channelizes funds from unproductive to productive resources.
6. Minimises speculative activities.
7. Brings stability in value of stocks.
8. Promotes economic growth.
9. Play important role in underdeveloped country.
Primary Market
New Issue Market or primary market is the market for new
long-term capital. Here the securities are issued by company for the
first time directly to the investors. On receiving the money from new
issues, the company will issue the security certificates to the investors.
The amount obtained by the company after the new issues are utilized
for expansion of the present business or for setting up new ventures.
External finance for long term such as loan from financial institutions is
not included in new issue market. There is an option called “going public”
in which the borrowers in new issue market raise capital for converting

private capital into public capital. The financial assets sold can be
redeemed by the original holder of security.
Function of New Issue Market
The main function of a new issue market can be divided into
three service functions:
Origination: It refers to the work of investigation, analysis and
processing of new project proposals. This function is done by merchant
bankers who may be commercial banks, all India financial institutions
or private firms. The success of the issue depends to a large extent on
the efficiency of the market.
Underwriting: It is an agreement whereby the underwriter promises to
subscribe to a specified number of shares or debentures or a specified
amount of stock in the event of public not subscribing to the issue.
Underwriting is a guarantee for marketability of shares. There are two
types of underwriters in India- Institutional (LIC, UTI, IDBI, ICICI)
and Non- institutional are brokers.
Distribution: It is the function of sale of securities to ultimate investors.
This is performed by specialized agencies like brokers and agents who
maintain a regular and direct contact with the ultimate investors.
Role of New Issue/ Primary Market:
Capital Formation: It provides attractive issue to the potential investors
and with this company can raise capital at lower costs.
Liquidity: As the securities issued in primary market can be immediately
sold in secondary market. The rate of liquidity of securities is higher.

Diversification of Risk: Many financial intermediaries invest in primary

market, as there is less risk of failure in investment as the company
does not depend on a single investor.it reduces the overall risk.
Reduction in Cost: Prospectus containing all details about securities
are given to the investors.
Table 3.1: Differences between Money Market and Capital Market
Money market Capital market

Short term funds. Long term funds.
Operational/WC needs. FC/PC requirements.
Instruments are: bills, CPs, Shares, debentures, bonds etc.
T- bills,CDs etc.,
Huge face value for single Small face value of securities.
instrument.
Central and coml. banks are Development banks,
majorplayers. investmentinstitutions are
major players.
No formal place for transactions. Formal place, stock exchanges.
Usually no role to brokers. Brokers playing a vital role.
Primary Market Intermediaries

The major intermediaries of the primary securities market include:
1. Merchant Bankers/ Lead Managers:
Merchant bank is an institution or an organisation which
provides a number of services including management of securities issues,
portfolio management services, underwriting of capital issues, insurance,
credit syndication, financial advices and project counselling etc. They
mainly offer financial services for a fee.

2. Underwriters:
Underwriting is an act of undertaking the guarantee by an
underwriter of buying the shares or debentures placed before the public
in the event of non-subscription. According to SEBI Rules 1993,
underwriting means an agreement with or without conditions to subscribe
to the securities of a body corporate when the existing shareholders of
such body corporate or the public do not subscribe to the securities
offered to them. “underwriter” means a person who engages in the
business of underwriting of an issue of securities of a body corporate.
3. Bankers to an Issue:
Bankers to an issue is an important intermediary who accepts
applications and application monies, collects all monies, refund
application monies after allotment and participates in the payment of
dividends by companies. No person can act as a banker to an issue
without obtaining a certificate of registration from SEBI. Registration is
granted by SEBI after it is satisfied that the applicant possesses the
necessary infrastructure, communication and data processing facilities
and requisite manpower to discharge its duties effectively.
4. Registrars to an Issue & Share Transfer Agent:
The Registrar to an issue is an intermediary who performs the functions
of:
1. Collecting applications from investors.
2. Keeping a record of applications.
3. Keeping a record of money received from investors or paid to
sellers of shares.
4. Assisting the companies in the determination of basis of
allotment of shares.
5. Helping in despatch of allotment letter refund orders, share

certificates etc.
5. Debenture Trustees:
The Regulations define a debenture trustee as a trustee of a
trust deed for securing any issue of debentures of a body corporate.
Trust deed means a deed executed by the company in favour of trustees
named therein for the benefit of the debenture holders. Only the following
categories of persons are eligible to act as debenture trustees.
a. A scheduled bank carrying on commercial activity/
b. A public financial institution within the meaning of section 4A of the
companies Acts /
c. An insurance company/
d. A body corporate.
The debenture trustee performs duties of:
1. Call for periodic reports from the body corporate.
2. Carry out inspection of books of accounts/ records/documents
and registers and trust property.
3. Take possession of property as per provisions of the deed.
4. Enforce security in the interest of debenture holders.
5. Resolve grievances of debenture holders with respect to receipt of
certificates, interest and other dues.
6. Exercise due diligence to ensure that the property secured is sufficient
to pay the dues.
7. Ensures that provisions of the relevant laws are adhered to by the
body corporate.

8. Carryout such as may be necessary for the protection of interest of

debenture holders.
6. Brokers to an Issue:
The person who procures subscriptions to issue from
prospective investors spread over large area. A company can appoint
as many numbers of brokers as it wants. Members are prohibited from
acting as managers or brokers to issue by SEBI regulations.
7. Portfolio Managers.
Types of Primary Market Issues
1. Public Issue
The public issue is one of the most common methods of issuing
securities to the public. The company enters the capital market to
raise money from kinds of investors. Here, the securities are offered
for sale to new investors. The new investor becomes the shareholder
of the issuing company. This is called a public issue. The further
classification of the public issue is – Initial Public Offer (IPO)
As the name suggests, it is a fresh issue of equity shares or convertible
securities by an unlisted company. These securities are traded
previously or offered for sale to the general public. After the process
of listing, the company’s share is traded on the stock exchange. The
investor can buy and sell securities after listing in the secondary
market.
Further Public Offer or Follow-on Offer or FPO.
When a listed company on the stock exchange announces fresh
issues of shares to the general public. The listed company does this
to raise additional funds.

2. Private placement
Private placements mean that when a company offers its securities
to a small group of people. The securities may be bonds, stocks, or
other securities. The investors can be either individual or institution
or both.
Comparatively, private placements are more manageable to issue
than an IPO. The regulatory norms are significantly less. Also, it
reduces cost and time. The private placement is suitable for
companies that are at early stages (like startups). The company
may raise capital through an investment bank or a hedge fund or
ultra-high net worth individuals (HNIs)
3. Preferential Issue
The preferential issue is one of the quickest methods for a company
to raise capital for their business. Here, both listed and unlisted
companies can issue shares. Usually, these companies issue shares
to a particular group of investors.
It is important to note that the preferential issue is neither a public
issue nor a rights issue. In the preferential allotment, the preference
shareholders receive dividends before the ordinary shareholders
receive it.
4. Qualified Institutional Placement.
Qualified institutional placement is another type of private placement.
Here, the listed company issues equity shares or debentures (partly
or wholly convertible) or any other security not including warrants.
These securities are convertible in nature. Qualified institutional buyer
(QIB) purchases these securities.

5. Rights Issue
This is another type of issue in the primary market. Here, the
company issues share to its existing shareholders by offering them
to purchase more. The issue of securities is at a predetermined price.
In a rights issue, the investors have a choice of buying shares at a
discount price within a specific period. It enhances the control of
the existing shareholders of the company. It helps the company to
raise funds without any additional costs.
6. Bonus Issue
When a company issues fully paid additional shares to its existing
shareholders for free. The company issue shares from its free
reserves or securities premium account. These shares are a gift for
its current shareholders. However, the issuance of bonus shares
does not require fresh capital.
Companies come to the primary market to raise money for several
reasons. Some of them are for business expansion, business
development, and improving infrastructure, repaying its debts and
many more. This helps the company to increase its liquidity. Also, it
provides a scope for more issuance of shares in raising further capital
for business.
The company can raise capital through
• Equity: when the company raises money by issuing shares to the
public. It is termed as stock capital, also known as share capital
of the company.
• Debt: the companies raise capital by taking loans where interest is
payable on it.

When a company requires capital, the primary source of funds

is loans from banks. However, raising funds from banks requires interest
payments to them. Consequently, when a company raises funds from
the public, there is no commitment to fixed interest pay out. Also, there
is profit-sharing among the shareholders in proportion to the number of
shares held by them. There are two ways in which the company shares
the profits among its shareholders
• Dividend Pay out
• Capital appreciation
Thus, the money raised in the primary market goes directly to
the issuing company. This is where the capital formation of the company
takes place.
Secondary Market
Stock market represents the secondary market where existing
securities are traded. Stock exchanges are organised and regulated
markets for various securities issued by corporate sector and other
institutions. As per Hartely withers, “a stock exchange is something like
a vast warehouse where securities are taken away from the shelves
and sold across the countries at a fixed price in a catalogue which is
called the official list”. Husband and Dockery- “securities or stock
exchanges are privately organised markets which are used to facilitate
trading in securities”.
Salient features of stock exchange are:
It is a place where securities are purchased and sold.
A stock exchange is an association of persons whether
incorporated or not.
The trading in a stock exchange is strictly regulated.

Both genuine investors and speculators buy and sell shares.

The securities of corporations, trusts, governments, municipal
corporations etc. are both allowed to be dealt at stock
exchange.
Functions of Stock Exchange:
1. Ensure liquidity of capital.
2. Regular market for securities.
3. Evaluation of securities.
4. Mobilising surplus savings.
5. Helpful in raising new capital.
6. Safety in dealing.
7. Listing of securities.
8. Platform for public dept.
9. Clearing house of business information.
10. Smoothens the price movements.
11. Investor’s protection.
Benefits of Stock Exchanges
The stock exchanges provide a number of useful services to
investors, companies and the community at large. These are as follows.
Benefits to the Investors.
9 Ensures diversification of investment and risks by providing
liquidity of investment.
9 Imparts negotiability to securities which in turn helps investors
to raise loans by pledging their holdings as collateral security.
9 Assures safety and fair dealing.

9 Gives at all times knowledge of the true value of their investment
through stock exchange quotations.
9 Minimises risks of investment in industry by facilitating quick
disposal of securities, at all times.
9 Educates prospective investors with the advertising influence of
publicity of its transactions and enables them to make a rational
choice among competing securities.
Benefits to the company.
9 Enhances the credit standing of the company as the listing of its
securities gives an impression of being a sound concern.
9 Widens the market for the listed securities.
9 Reduces the danger of group opposition to management by
enhancing marketability to the company’s securities which in turn
diversifies ownership.
9 Minimises the risk of the new issue remaining unsold by enhancing
the response to public issue of shares.
9 Minimises price fluctuations of securities that are listed and thus
enhances the confidence of one and all dealing with it.
9 Enables the company to command better bargaining power during
amalgamation or merger.
9 Enables the company to enjoy several tax advantages.
Benefits to the Community.
9 Stimulates investment in industry, public savings and ensures a
steady flow of capital into productive enterprises.

9 Helps the government in raising necessary finance from public for

this purpose.
9 Assists in the best utilization of capital and in minimizing the waste
of scarce capital resources.
9 Smoothens the process of capital formation.
9 Reflects business conditions.
Demutualisation of Stock Exchanges
Demutualization is when a mutual company owned by its users/
members converts into a company owned by shareholders. In effect,
the users/members exchange their rights of use for shares in the
demutualized company.
Historically, Stock Exchanges were formed as ‘Mutual’
organisation –Mutual Stock Exchanges i.e, formed by trading members
themselves for their common benefits. Ownership rights &trading rights
are clubbed together in membership.
The most important disadvantage of this type of Stock Exchanges are-
a) They primarily work towards the interest of members & not to
those of investors.
b) Office bearers will have access to inside information which can
be misused by them.
c) They cannot raise large fund for modernisation or up gradation
by offering equity share to others.
Government of India has taken a decision for corporatisation
of Stock Exchanges. Corporatisation means Stock Exchange should
be organised as a company. Ownership, management and trading

memberships of Stock Exchanges are separated from each other called

demutualisation
Demutualisation of SEs means- converting mutual non-profit
body in to a corporate body where management and trading activities
are separated. It ensures stock brokers do not have access to sensitive
information & do not misuse their position. SEBI issued a direction on
10-01-2002 that, no stock broker shall be an office bearer of Stock
Exchanges.
Organisation of Stock Exchanges in India
Stock exchanges in India are organised in any of the following
forms:
a) Voluntary, non-profit making associations, e.g., Bombay,
Ahmedabad and Indore.
b) Public Limited Companies such as Calcutta, Delhi and
Bangalore stock exchanges, and
c) Company Limited by guarantee, e.g., Hyderabad and Madras
stock exchanges.
Management
A stock exchange is managed by a governing body which
consists of a President, Vice- president, Executive Director, elected
directors, public representatives and government nominees.
Regulation (SCRA)
In order to regulate the functioning of the stock exchange and
to protect the interest of investors, securities contracts (regulation) act
(SCRA) was passed in 1956. It became operation in February 1957.

The main objective of the SCRA is to prevent malpractices in

dealing of securities by regulating the purchase and sale of securities
outside the boundaries of stock exchanges through the licensing of
security dealers. The Act empowers the central Government and most
of these powers have been delegated to SEBI.
SEBI’s Power in Relation to Stock Exchange
The SEBI ordinance has given it the following powers:
I. It may call periodical return from stock exchange.
II. It has the power to prescribe maintenance of certain documents
by the stock exchange.
III. SEBI may call upon the exchange or any member to furnish
explanation or information relating to the affairs of the stock
exchange or any members.
IV. It has power to approve bye-laws of the stock exchange for
regulation and control of the contracts.
V. It can amend bye-laws of stock exchange.
VI. In certain areas it can licence the dealers in securities.
VII. It can compel a public company to list its shares.
Major Stock Exchanges in India 1.Bombay Stock Exchange
(BSE)
Bombay stock exchange was established in 1875 as a voluntary
non-profit making association at Mumbai. It is Asia’s oldest stock
exchange and is a major stock exchanges in India. Management A
Governing Board comprising of 9 elected directors (one-third to retire
every year by rotation) an Executive Director, three Government
nominees, a Reserve Bank of India nominee and 5 public nominees

regulate the working of the exchange. The executive director acts as

the Chief Executive Officer and is responsible for the day-to-day
administration of the exchange.
Working
Bombay Stock exchange allows following category of persons for
trading:
I. The commission broker.
II. The floor broker.
III. The tarawaniwala, akin to a jobber or specialist.
IV. The dealer in non-cleared securities.
V. The odd-lot dealer.
VI. The dealer in foreign securities or arbitrageur.
VII. The security dealer or dealer in government securities.
On striking a deal, traders enter appropriate details in small
books called “souda books”. SEBI has allowed BSE to extend its
trading terminals to outside centres and the Bombay Online Trading
System (BOLT) has enabled it to open trade working stations all over
the country.
2. National Stock Exchange (NSE)
National Stock Exchange was incorporated in November 1992
with an equity capital of 25 crores. NSE is professionally managed
national market for shares, PSU bonds, debentures and government
securities with all the necessary infrastructure and trading facilities. NSE
is an electronic screen-based system where members have equal access
and equal opportunity of trade irrespective of their location.

Objectives of NSE
The following are the objectives of NSE:
I. Providing a national wide trading facility for equities, debt
instruments etc.
II. Ensure equal access to investors all over the country through
an appropriate communication network.
III. Provide fair, efficient and transparent securities market to
investors using electronic trading systems.
IV. Enable shorter settlement cycles and book entry settlement
system.
V. Attain current international standards of securities market.
Working
The settlement cycle is completed within eight days from the
last day of the trading cycle. The trading period is a week (Wednesday
to Tuesday) and settlement of trade takes place in the ensuing week.
3. Over the Counter Exchange of India (OTCEI)
It was established in October 1990, with an objective to provide
an alternative market for securities of smaller companies. This exchange
has been jointly promoted by UTI, ICICI, IDIB, SBI Capital Markets
Ltd. IFCI, GIC and Can bank Financial services Ltd.
The following are the main features of OTCEI.
1. It is ringless and electronic national exchange.
2. It caters the need of the small business which have so far not met
the requirements for listing on the stock exchange.
3. This exchange has a nationwide reach.
4. Small and medium sized companies with a paid-up capital between

30 lakhs and 25 crores can be enlisted. OTCEI deals in equity
shares, preference shares, bonds, debentures, warrants.
5. The trading is by way of negotiated bidding.
6. The transactions take place through satellite communication
telephone lines.
7. A company which is listed on any other recognised stock exchange
in India will not simultaneously be eligible for listing on the OTCEI.
Advantages of OTCEI
This exchange has the following advantages:
1. There is a transparency in transactions.
2. The liquidity is ensured and a transaction is normally completed in
7 days.
3. A proper scrutiny is done of the scrips by the sponsors.
4. A company needing immediate funds can pledge its equity with the
sponsor and thereby reduce interest cost.
5. A small company at one gets national wide listing.
6. The companies listed on OTCEI are subjected to low-income tax.
Trading in Stock Markets
There are two basis ways of trading at stock exchanges
i. Trading on the exchange floor: The buying and selling at stock
exchanges is not allowed to outsiders. They have to approach
brokers who are members of the exchange and dealings can
only be through them. The following procedure is followed
for dealing at exchange:

9 Selection of a broker.
9 Placing an order.
9 Making the contract.
9 Contact note.
9 Settlement.
The settlement for ready delivery and forward contracts is
done with a different procedure.
Settlement of ready delivery contracts: The settlement in
different stock exchange is done between 3 to 7 days of the
transaction. If the settlement is done by giving actual delivery
of securities on receiving the price it is called liquidation in full.
Settlement of forward delivery contracts: The forward delivery
contracts are done for speculative purposes. Only the active
and broad market securities are traded in forward contracts.
Settlement of forward contracts can be done in any of the
three ways,
a) Liquidation in full.
b) Liquidation by payment of difference.
c) Carry over to the next settlement.
The buyer will have to pay certain amount to the seller for this
concession and the amount paid is known as “Badla” or
Contago charge”
ii. Electronic Trading: The individual investor can get instant
confirmation of his trade in the electronic trading system. It
also facilitates online investing by bringing investor closer to
the market. The advantage of electronic trading is that it brings
more transparency by displaying all buy and sell orders in the

trading system. The types of transactions that are usually
carried out on the Indian stock exchanges include spot delivery
transactions and future and forward transactions.
Buying and Selling of Securities
Stock transaction takes place in three major steps:
1. Placing order (buy or sell) online:
There are two methods for placing orders. They are online stock
trading and offline stock trading. The online trading is done by self.
For online trading you need computer, internet connection, demat
and trading account. On the other hand, in offline stock trading the
order will be placed by the broker on behalf of the buyer. The
buyer doesn’t need any computer and internet connection.
2. The order goes to the broker (like India Bulls, ICICI direct etc.)
3. From broker the order goes to stock exchange (either BSE or
NSE) and finally based on offer price the order get executed.
Online Stock Trading
Online stock trading is a facility based on trading of the stocks.
The investors can easily trade the shares by means of an online website
devoid of any labour-intensive interference from the stock brokers.
BSE and NSE are the two exchanges in which most of the companies
of online stock trading India deal in. There are two different types of
trading platforms available for online equity trading.
a) Installable software-based stock trading terminals:
These trading terminals require software to be installed on investors
computer, and are provided by stock broker. These software
require high speed internet connections.

b) Web (Internet) Based Trading Application:

They are like other internet websites which investor can access
from around the world through normal internet connection.
Advantages of Online Stock Market Trading
1. It helps in real time stock trading without calling or visiting broker’s
office.
2. It displays real time market watch, historical data, graphs etc.
3. It makes easy to invest in IPOs, mutual funds and bonds.
4. One can check demat account balance and bank account balance
at any time.
5. It offers customer service through Email or chat.
6. It secures transactions
7. It provides online tools like market watch, graphs and
recommendations to do analysis of stocks.
Disadvantages of Online Stock Trading:
1. The procedure of online stock trading in India is a bit long-learning
procedure for those who are not aware about the internet and
computer technology.
2. Sometimes the site is very slow and is not enough user friendly.
3. Brokerages are little high. If one wants to invest in share market
through online trading, he needs to have three things:
1. Money.
2. Demat account.
3. Online trading account.

Major International Stock Market

The following is the list of top 5 international stock exchanges
on the basis of market capitalization as on 31 January 2015.
a) New York Stock Exchange (NYSE)
It is an American stock exchange. It was founded on 17th may
1972. It is located at 11 wall street, lower Manhattan, New York city,
united states. Its trading floor is located at 11 wall street and is composed
of 21 rooms used for the facilitation of trading. The important features
are:
It is the world’s largest stock exchange by market
capitalization of its listed companies at US Rs. 19233 billion
as of 31th January 2015.
The average daily trading value was approximately US Rs.
19 billion in 2013.
The number of listings as on may, 2015 were 1868.
The NYSE is owned by Intercontinental Exchange, an
American holding company.
The New York stock exchange also referred to as “the BIG
BOARD”.
The NYSE is open for trading Monday through Friday with
the exception of holidaysdeclared by the Exchange in advance.
The NYSE trades in a continuous auction format where traders
can execute stock transactions on behalf of investors.
The NYSE opening bell in rung at 9.30 AM ET to mark the
start of the day’s trading session. At 4 PM ET the closing bell
id rung and trading for the day stops.
The major indices are Dow jones Industrial average, standard

& poor 500, and NYSE composite.
Its official website is NYSE.com.
b) NASDAQ
It is an American stock exchange behind only the New York
stock exchange. It stood for National Association of Securities
Dealers Automated Quotations. It was founded on February
4,1971 and it began trading on February 8, 1971. It is located
at Liberty plaza 165 Broadway, New York city, united states.
The important features are
It was the world first electronic screen-based equity securities
trading market in the united states.
It is the second largest exchange in the world by market
capitalization of 6831 US Rs. billion as on 31th January 2015.
The number of listings as on July, 2015 were 3058.
Its main index is the NASDAQ Composite.
The small order execution system (SOES) Provides an
electronic method for dealers to enter their trades.
NASDAQ has a pre-market session from 4 AM To 9.30
AM eastern, a normal trading session from 9.30 AM to 4.00
PM and a post market session from 4.00 PM to 8.00 PM.
Its official website is Nasdaq.com.
The NASDAQ has had an average annualized growth rate
of 9.24 per cent as of June 2015.
The status of NASDAQ was changed from stock market to
a licensed national securities exchange in 2006.

c) London Stock Exchange Group (LSEG)

It is a British based stock exchange and financial information
company. Its head quarter is located at 10 Paternoster square,
City of London, England, United Kingdom. It is a public limited
company rendering financial services. It was founded in 2007.
It owns the London Stock Exchange, the Borsa Italiana,
Millennium IT and Russell investments. The London Stock
Exchange is Europe’s leading stock exchange. It was founded
in London in 1801. The exchange moved to a new purpose
building and trading floor in Thread Needle Street in 1972.
The Borsa Italiana is Italy’s leading stock exchange. Millennium
IT was acquired by LSEG in 2009 as their technology service
provider. it is offering world’s fastest trading platform known
as Millennium Exchange for most of leading stock markets in
the world. Russell Investments was one of the largest providers
if Index services. Its important features are:
It is the third largest exchange in the world by market
capitalization of 6187 US Rs. billion as on January 2015.
London stock Exchange Group owns 100 per cent shares in
the index company FTSE group.
Its official website is LSEG.com
d) Japan Exchange Group, INC. (JPX)
It is an Asian financial services corporation. Its head quarters
is at Kabutocho, Chuo, Tokyo, Japan. It operates multiple
securities exchanges including Tokyo stock Exchange (TSE)
and Osaka Securities Exchange (OSE). Its important features
are:

It was formed by the merger of the two companies TSE and

OSE on January 1, 2013.
It is the Asia’s largest bourse having market capitalization of
US Rs.4485 billion as on 31th January, 2015.
On January 4, 2013 JPX Was listed at TSE’s first section
(8697). JPX also assumed OSE’s own ticker symbol (also
8697).
Its subsidiaries include Tokyo stock exchange, Osaka
Securities Exchange, Japan Exchange Regulation and Japan
Securities Clearing Corporation.
Its official website is jpx.co.jp/
e) Sanghai Stock Exchange (SSE)
It is based in the city of shanghai, china. It is a non-profit
organisation directly administered by the China Securities
Regulatory Commission (CSRC). Its important features are:
It has a market capitalization at US Rs.3968 billion as of
January 2015, and second largest in east Asia and Asia.
The Shanghai stock exchange is not entirely open to foreign
investors due to tight capital account controls exercised by
the Chinese mainland authorities.
The current exchange was re-established on November 26,
1990 after a 41-year hiatus and was in operation on December
19 of the same year.
The number of listings as on May 2015 were 1041.
Its major indices include SSE composite and SSE 50.

It provides securities for financial market participants, efficient

clearing services and development purposes.
Its official website is www.sse.com.cn and english.sse.com.cn
Demutualisation of Stock Exchanges
Demutualization is a process by which a private, member-owned
company, such as a co-op, or a mutual life insurance company, legally
changes its structure, in order to become a public- traded company
owned by shareholders. Demutualization involves the complex process
of transitioning a company’s financial structure, from a mutual company
into a shareholder-driven model. Mutual companies (not to be confused
with mutual funds) are entities seeded by private investors who are also
customers or members of these operations. Businesses such as insurance
companies, savings and loan associations, banking trusts, and credit
unions are commonly structured as mutual companies.
Mutual insurance companies typically collect policyholder
premiums from their members and spread risk and profits through various
mechanisms. In America, this practice dates back to 1716, when the
nation’s first-ever insurance company was created by the Synod of
Philadelphia, which structured the operation as a mutual company.
In 2000 and 2001, a flurry of noteworthy demutualization events
occurred in the insurance space, with the demutualization of Prudential
Insurance Company, Sun Life Assurance Company, Phoenix Home
Life Mutual Insurance Company, Principal Life Insurance Company,
and the Metropolitan Life Insurance Company (MetLife).
The Demutualization Process
In a demutualization, a mutual company elects to change its
corporate structure to a public company, where prior members may

receive a structured compensation or ownership conversion rights in

the transition, in the form of shares in the company.
Several demutualization methodologies exist. In a “full
demutualization,” a company launches an initial public offering (IPO),
where it auctions stock to shareholders, who may trade their equity
positions over a public market exchange. Under this scenario, the former
members of the mutual company do not automatically receive stock,
and must consequently invest separately.
Alternatively, with the “sponsored demutualization” method,
after the IPO, former members of the mutual company automatically
receive shares in the newly-formed company. Under this model,
members typically receive greater compensation for their previous
membership and, generally, don’t have to invest personal capital in the
newly-issued shares. However, they may buy additional shares, if they
choose.
When a demutualization occurs, former members may still utilize
the products and services as they did before, however, prices and other
terms of the transactions may change.
Liquidity Products
1. Margin Trading
Meaning of margin trading Normally investors trade in securities
on the strength of owned funds and securities. However, sometimes,
based on their outlook about the market and some specific securities in
particular, they intend to trade beyond owned resources. This trading
in the securities is supported by the borrowing facility for funds and
securities, in the system. While trading with the borrowed resources,
investors are required to put in a margin (good faith deposits) with the
intermediaries and this phenomenon is called margin trading. This margin
is usually a per cent of the value of the proposed transaction. Therefore,

broadly speaking, margin trading is a trading in the securities market
with the borrowed resources – funds or securities. As margin trading is
providing a facility to investors to trade in the market with the margin
money, it essentially is a leverage mechanism. Globally, in all the major
markets the facility of the margin trading and securities lending is
available to the investors. However, it would be
pertinent to mention here that the business models for the margin trading
and securities lending are different in different markets.
Value Drivers of The Margin Trading
Prices of the securities in the market are determined by the free
interaction of demand and supply forces. Anytime availability of the
buyer and seller in the system constitutes the essential ingredient of the
Capital Market; it ensures the liquidity in the system, which is the hall
mark of success of any market across the globe. As margin trading can
be done on both the sides i.e., buy and sell, it helps in increasing
demand for and supply of securities and funds in the market, which in
turn contributes towards better liquidity and smooth price formation of
securities. Further, with contracting settlement cycles, it becomes
important to provide for this facility of supporting buy and sell sides of
trades for smooth settlement i.e., to reduce the fail trades. Margin trading
also facilitates the price alignment across the markets through facilitating
the arbitrage. For instance, in case of the mis-pricing between cash and
derivatives market, margin trading supports the transactions in the cash
market to facilitate the arbitrage between the cash and derivatives, which
results in the better price alignment across the markets.
Margin trading also facilitates the hedging. For instance, if an
investor holds say call options (right to buy the stocks) to be exercised

only after a specific period of time, he may sell the securities in the cash
market on margin trading and hedge his risk. Similarly, the shares under
say ESOP to be available to the employees after a while may be hedged
with the help of the margin trading. Further, margin trading and trading
of derivatives generally complement rolling settlement, where the time
for round about transactions is limited to a day. This is why the markets
having the rolling settlements generally provide for the facility of margin
trading. This is important for the efficiency of the market and smooth
settlement in the rolling settlement environment. Physical settlement in
the derivatives especially American Options also requires the availability
of the funds and the securities for the smooth settlement of the trades.
Funds and securities lending and borrowing become critically important
in the environment when the derivatives are settled through the physical
delivery.
Mechanism of margin trading It is necessary to understand the
mechanism to fully appreciate the risks in margin trading. In a typical
transaction, a client interested to do margin trading is required to sign
an agreement with the lender of funds (usually the broker) to formalise
the arrangement for margin trading. The agreement provides for the
margin rate and the extent of margin. The margin rate is the prime
lending rate / bank rate plus a mark-up depending on exposure in the
margin account. The interest is normally compounded on daily basis.
The agreement provides for two types of margins, namely the initial
margin and the maintenance margin. The initial margin is the portion of
purchase value which the client deposits with lender of funds before the
actual purchase. After the agreement, the client opens a margin account
and deposits initial margin amount, based on which the lender executes
purchase order on behalf of the client. The securities so purchased are

kept as collateral with the lender. In addition to initial margin, the client
is required to maintain a certain minimum equity in the margin account.
The equity is nothing but the net value of portfolio, that is, the
value of portfolio less the margin debt. This equity should be a certain
percentage of the market value of securities. This percentage is called
maintenance margin. If the equity is less than the maintenance margin,
the client is called upon to bring in the shortfall. For example, assume
that the initial and maintenance margins are 50 per cent and 25 per cent
respectively. A client has bought securities for Rs. 100. The price
depreciates by 40 per cent. The value of portfolio reduces to Rs. 60.
The equity becomes Rs. 10 (Rs. 60 – Rs. 50 (debt)), which is less than
Rs. 15 (25 per cent of the value of securities). The client is required to
bring in Rs. 5. When the equity in the margin account falls below the
maintenance margin, the lender makes a margin call. If margin call is
not met, the lender can sell the collateral, partially or fully, to increase
the equity.
However, when price falls to an extent that the equity becomes
zero, the lender, instead of making margin call, usually sells off the
securities to recover the debt. If he waits and prices fall further, he
would not be able to recover the debt from collateral. In the above
example, the lender would make margin call, when the portfolio
depreciates by 33.33 per cent. If margin call is not met or if the equity
reduces to Rs. 0, the lender sells off the collateral. If the minimum and
maintenance margins were 50 per cent, margin call will be made with
smallest depreciation in the value of portfolio. The lender is not generally
required make a margin call or notify the client that the equity has reduced
below minimum. It is for the client to find out for himself and make

payment accordingly. The client is required to repay the debt and interest
as per agreement and till the full repayment is made, the collateral remains
with the lender. In case he wants to sell the securities earlier, the proceeds
go to the lender first to the extent of debt.
2. Short Sale
A short sale is the sale of an asset or stock the seller does not
own. It is generally a transaction in which an investor sells borrowed
securities in anticipation of a price decline; the seller is then required to
return an equal number of shares at some point in the future. In contrast,
a seller owns the security or stock in a long position.
Understanding Short Sales
A short sale is a transaction in which the seller does not actually
own the stock that is being sold but borrows it from the broker-dealer
through which they are placing the sell order. The seller then has the
obligation to buy back the stock at some point in the future. Short
sales are margin transactions, and their equity reserve requirements
are more stringent than for purchases.
Brokers borrow the shares for short sale transactions from
custody banks and fund management companies that lend them as a
revenue stream. Institutions that lend shares for short selling include
JPMorgan Chase & Co. and Merrill Lynch Wealth Management.
The main advantage of a short sale is that it allows traders to
profit from a drop in price. Short sellers aim to sell shares while the
price is high, and then buy them later after the price has dropped. Short
sales are typically executed by investors who think the price of the
stock being sold will decrease in the short term (such as a few months).

It is important to understand that short sales are considered

risky because if the stock price rises instead of declines, there is
theoretically no limit to the investor’s possible loss. As a result, most
experienced short sellers will use a stop-loss order, so that if the stock
price begins to rise, the short sale will be automatically covered with
only a small loss. Be aware, however, that the stop-loss triggers a market
order with no guaranteed price. This can be a risky strategy for volatile
or illiquid stocks.
Short sellers can buy the borrowed shares and return them to
the broker any time before they’re due. Returning the shares shields
the short seller from any further price increases or decreases the stock
may experience.
Short Sale Margin Requirements
Short sales allow for leveraged profits because these trades
are always placed on margin, which means that the full amount of the
trade does not have to be paid for. Therefore, the entire gain realized
from a short sale can be much larger than the available equity in an
investor’s account would otherwise permit.
The margin rule requirements for short sales dictate that 150
per cent of the value of the shares shorted needs to be initially held in
the account. Therefore, if the value of the shares shorted is Rs.25,000,
the initial margin requirement would be Rs.37,500. This prevents the
proceeds from the sale from being used to purchase other shares before
the borrowed shares are returned. However, since this includes the
Rs.25,000 from the short sale, the investor is only putting up 50 per
cent, or Rs.12,500.

Short Sale Risks

Short selling has many risks that make it unsuitable for a novice
investor. For starters, it limits maximum gains while potentially exposing
the investor to unlimited losses. A stock can only fall to zero, resulting in
a 100 per cent loss for a long investor, but there is no limit to how high
a stock can theoretically go. A short seller who has not covered his or
her position with a stop- loss buyback order can suffer tremendous
losses if the stock price runs higher.
For example, consider a company that becomes embroiled in
scandal when its stock is trading at Rs.70 per share. An investor sees
an opportunity to make a quick profit and sells the stock short at Rs.65.
But then the company is able to quickly exonerate itself from the
accusations by coming up with tangible proof to the contrary. The
stock price quickly rises to Rs.80 a share, leaving the investor with a
loss of Rs.15 per share for the moment. If the stock continues to rise,
so do the investor’s losses.
Short selling also involves significant expenses. There are the
costs of borrowing the security to sell, the interest payable on the
margin account that holds it, and trading commissions.
Another major obstacle that short sellers must overcome is
that markets have historically moved in an upward trend over time,
which works against profiting from broad market declines in any long-
term sense. Furthermore, the overall efficiency of the markets often
builds the effect of any kind of bad news about a company into its
current price. For instance, if a company is expected to have a bad
earnings report, in most cases, the price will have already dropped by
the time earnings are announced. Therefore, to make a profit, most

short sellers must be able to anticipate a drop in a stock’s price before

the market analyses the cause of the drop in price.
Short sellers also need to consider the risk of short squeezes
and buy-ins. A short squeeze occurs when a heavily shorted stock
moves sharply higher, which “squeezes” more short sellers out of their
positions and drives the price of the stock higher. Buy-ins occur when
a broker closes short positions in a difficult-to-borrow stock whose
lenders want it back.
Finally, regulatory risks arise with bans on short sales in a specific
sector or in the broad market to avoid panic and selling pressures.
Near-perfect timing is required to make short selling work,
unlike the buy-and-hold method that allows time for an investment to
work itself out. Only disciplined traders should sell short, as it requires
discipline to cut a losing short position rather than adding to it and
hoping it will work out.
Many successful short sellers’ profit by finding companies that
are fundamentally misunderstood by the market (e.g., Enron and
WorldCom). For example, a company that is not disclosing its current
financial condition can be an ideal target for a short seller. While short
sales can be profitable under the right circumstances, they should be
approached carefully by experienced investors who have done their
homework on the company they are shorting. Both fundamental and
technical analysis can be useful tools in determining when it is appropriate
to sell short.
Because it can damage a company’s stock price, short sales
have many critics, consisting primarily of companies that have been
shorted. A 2004 research paper by Owen Lamont, then a professor
at Yale, found that companies that engaged in a tactical war against

traders who sorted their stock suffered a 2 per cent drop in their returns
per month in the next year.
Legendary investor Warren Buffett welcomes short sellers. “The
more shorts, the better, because they have to buy the stock later on,”
he is reported to have said. According to him, short sellers are necessary
correctives who “sniff out” wrongdoing or problematic companies in
the market.
Alternative Short Sale Meaning
In real estate, a short sale is the sale of real estate in which the
net proceeds are less than the mortgage owed or the total amount of
lien debts that secure the property. In a short sale, the sale is executed
when the mortgagee or lienholder accepts an amount less than what is
owed and when the sale is an arm’s length transaction. Although not the
most favourable transaction for buyers and lenders, it is preferred over
foreclosure.
Example of a Short Sale
Suppose an investor borrows 1,000 shares at Rs.25 each, or
Rs.25,000. Let’s say the shares fall to Rs.20 and the investor closes
the position. To close the position, the investor needs to purchase 1,000
shares at Rs.20 each, or Rs.20,000. The investor captures the difference
between the amount he receives from the short sale and the amount he
paid to close the position, or Rs.5,000.
3. Securities lending and Borrowing
Selling short on margin is the other dimension of the business.
It has been argued by the market that margin trading on both the buy
and the sell sides should be in place to provide the equilibrium and
efficient price discovery. At present, securities borrowing and lending

facility is available in the market but market participants think there are
alternative ways to approach the securities lending in efficient and
effective manner. Issues covered under part 3 are present state of
securities lending and borrowing and alternative business models for
the same.
Present state of Securities Lending and Borrowing
SEBI approved the Securities Lending Scheme, which came
into existence on February 6, 1997 and is called as SLS, 1997.
According to the SLS, securities can be lent and borrowed through an
approved intermediary, which is duly registered with SEBI. As of now,
there are eight entities, which are registered with SEBI as approved
intermediaries, under the SLS (list enclosed at annexure A). Borrowers
and Lenders do transact through these intermediaries as per the
procedure laid down in the said scheme.
It is important to describe the existing business model of these
approved intermediaries. These intermediaries deal with the lenders
and borrowers on one-to-one basis. It essentially means lenders lend
the securities to the approved intermediaries and they in turn lend them
to the counterparties i.e., borrowers. Full credit risk on the securities
lent is born by the approved intermediaries. Therefore, in a broader
sense, in these transactions intermediaries provide full novation in lending
and borrowing transactions. It may also be noted that the existing market
for the securities lending and borrowing is an over-the-counter market
(OTC market).
As these approved intermediaries have limited geographical
reach, facility of borrowing and lending of securities is not available to
the widely scattered retail segment of the securities market. Limited
participation in the securities borrowing and lending market and lack of

competitive forces have resulted in the cost of borrowing of securities

being exorbitantly high, which renders the securities borrowing
transactions uneconomical.
It is felt in the market that there is an urgent need to redefine the
existing securities lending and borrowing mechanism/ or discover the
alternative business models to ensure wider participation, at the
reasonable cost and in a transparent manner. It is felt that a transparent,
online trading platform may be created for the efficient securities lending
and borrowing mechanism.
Business Models for securities lending and borrowing
Following four business models are proposed for the consideration:
1. Online trading platform with limited number of participants on the
supply side.
2. Online trading platform with investors independently on supply
side.
3. Lending through the depositories.
4. Lending through the special purpose bank.
Model 1 – Online trading platform with limited number of
participants on the supply side.
Model 1 visualises the lending and borrowing of securities to
take pace through a transparent online trading platform. This platform
may be created by any interested entity including depositories in the
market. Alternatively, exchanges may offer this facility through their
existing trading platforms. It is also possible that these intermediaries
would leverage on each other’s competencies and infrastructure and
pool down resources to provide efficient mechanism to the market.

For instance, depositories may offer the securities lending and borrowing
mechanism through using the exchanges’ infrastructure. It may be left
to the market forces, assuming that the market is prudent enough to
analyse the economic dynamics of the business.
Now, all the borrowers, who would have short position in the
market, would put in their requirements through brokers on the online
computer system with number of securities required and their borrowing
horizon. Supply side would offer the shares indicating the associated
costs. Lending and borrowing transactions would be matched through
the automated system in a transparent environment on price and time
priority basis.
Intermediary, managing the online platform for the securities
lending and borrowing purpose, would be responsible for the clearance
and settlement of all said transactions. It is also thought that this session
of the lending and borrowing could take place simultaneous to the normal
trading sessions.
However, it may be noted here that this session of Securities
Lending and Borrowing would have no linkage whatsoever with the
actual trading session at the exchanges. In other words, the exchange
trading and settlement system would be independent of the Securities
Lending and Borrowing Mechanism, which is being proposed.
Now, there are certain issues in the proposed system, which
are elaborated on here:
a) Which securities would be eligible to participate in the proposed
lending and borrowing mechanism: Though, theoretically speaking, all
the securities listed and traded on the exchanges should be eligible to
participate in the proposed mechanism, globally, wherever the securities

lending and borrowing facility is available, securities eligible for the same
are clearly defined.
Decision on eligible securities is based on the following:
1. Liquidity in the scrips.
2. Avoid the participation of scrips with low liquidity in the borrowing
and lending mechanism, which in turn would reduce the chances
of manipulation through the use of system.
Further, in India, as market is moving towards the T + 2 rolling settlement
environment, only the electronic form of shares may be lent in the
market. This would also keep the cost of transactions low. It is
assumed that this move would also encourage the investors to
convert their physical holding into electronic form to create values
from their idle holdings.
b) Who can lend the securities: Strictly speaking, anyone who has
the securities would be eligible to participate in the lending process.
But this model limits the lenders to only the DPs, Custodians and
other approved intermediaries under the Securities Lending
Scheme, 1997 of SEBI. This feature of the limited number of
professional parties on the supply side of securities is a very
important feature of this model. This is expected to professionalize
the operating environment at the securities lending and borrowing
front. This also leads to the other dimension of the business called
securities banking.
c) Who can borrow the securities: Again, anyone operating in the
market should be eligible to borrow the securities. However, any
borrower has to go through his broker to borrow securities. Broker
would borrow the securities for its client/ clients as an intermediary

on the system. If an entity is debarred under any specific regulation,

it would not be eligible to borrow the securities (for example -
FIIs).
This model also proposes the borrowing of securities strictly for the
specific purpose of delivering in the market against a sale obligation
of the borrower. This is also proposed with an objective to avoid
any price manipulation attempt. This would be with exemption to
DPs and other approved intermediaries, who can borrow to meet
their temporary short fall of securities.
d) What can be the duration of the lending: This model appreciates
the problem of duration match, for lending and borrowing, on the
system because different borrowers would have the different time
horizons in their minds. Therefore, it is proposed to standardize
the time horizon for the borrowing. It may be packed to say, 7
days, 14 days and so on with multiple of 7 days each. In any case,
the maximum limit on one time borrowing to 12 weeks. It essentially
means that if someone is interested in borrowing for say 24 weeks,
he would be required to roll over the position after say 12 weeks
of the first time borrowing.
This standardization would mean that even if someone wants to
borrow the securities for less than 7 days, he / she would incur the
cost of borrowing for at least 7 days. Though it is true that this
would cause some inconvenience to the borrowers for the broken
period but this is proposed with an objective to create a
standardized contract for online trading with liquidity consideration
in mind. However, there would not be any limitation on the borrower
returning the securities before the completion of initial borrowing
period. It may also be noted that it would generate the return for
minimum seven days to the lender.
e) What is the risk containment measures and prudential norms for

the lenders: Once the borrowers and lenders are matched by the
laid down system, securities would move from the lenders to the
borrowers. Borrowers in turn would use these securities to settle
their trades on the exchange. Sales proceeds from the short
positions would be retained by the clearing corporation/ house of
the exchange or the trading platform manager. This entity would
guarantee the return of the securities to the lenders. In addition to
the sales proceed, borrower would pay margin to provide for the
potential losses. This margin may be described by the regulator. In
global markets, this margin varies and is generally around 40 per
cent to 50 per cent of the value of the transactions. Further,
securities may be marked to market on daily basis to cover up the
losses, which have taken place during the day.
Alternatively thought is that as the securities are anyway borrowed
to meet the settlement obligation in the regular market, the securities
so borrowed may not be received by the borrowers but shall be
delivered to the settlement account with the Clearing Corporation,
direct. This would make the audit trail of securities borrowed and
returned easy.
Further, complete segregation of borrowed securities and the
regular market obligations would be maintained by the clearing
corporation/exchange.
This security borrowing and lending mechanism is assumed to offer
an efficient, transparent and effective system to the market. It will
have following distinctive advantages:
1. The wider participation: - Common trading platform for all would
ensure very wide participation from the market participants across
the country.

2. Reasonable cost of borrowing: - Equally accessible market to all

would create competitive environment and reduce the cost of
transaction. Further, prices would be the market determined prices
through the free interaction of demand and supply forces.
3. Transparency: - Online order driven price and time priority basis
system would ensure the transparency in the system.
Model 2 – Online trading platform with investors independently
on supply side
The model 1 assumes the availability of only the professional
entities like DPs, Custodians and approved intermediaries on the supply
side of the securities. It should not be construed that the individuals
would not be given the opportunity to participate in that model. Indeed,
the model proposes the participation of the individuals in the system
through the organizations/systems like DPs and other approved
intermediaries under SLS scheme of 1997. It is done to deliver the
better values to the market in terms of discipline and structure. Further,
economies of scale and scope, enjoyed by the institutions would deliver
additional values.
An alternative to the model 1 may be the model, where in
everyone is given the independent chance to participate on the supply
side. In other words, individuals would provide the supply side quote
on their own through their brokers. Some market participants think
that giving independent choice to the investors through brokers would
be better.
Here, it may be noted that other issues raised in the model 1
like the risk management, selection of securities etc. would also be the
part of this model and regulators would have to decide on the certain

parameters of this market. Further, on borrowing side, there is no limit

and even the individuals can borrow through their brokers, as described
in the model
1. Salient features of this model would be as follows:
1. The Clearing Corporation / Stock Exchange would act as an
Approved Intermediary.
2. Stock Exchange to extend their trading platform to provide a
nationwide access to the participants.
3. All investors shall be allowed to borrow and lend securities through
the trading facilities with Trading Members of the Exchange /
Clearing Members, Custodians, Depository Participants and
Banks.
4. The rate of borrowing shall be determined on screen-based trading
system in the continuous market session.
5. The lenders of the security shall deliver securities to the Clearing
Corporation towards meeting the settlement obligation of the
borrower of securities.
6. The borrowers and lenders shall be identified by making use of
unique client code which will be captured at the time of order
entry. This will also be used to ensure an audit trail of the return of
securities borrowed at the end of the prescribed tenure.
7. The tenure for borrowing shall be for a maximum of 7 days. Another
opinion is that the borrowing facility for the different time horizons
may be made available to the market participants.
8. The risk shall be managed by Clearing Corporation by

i. Implementing appropriate risk containment measure and use of

effective margining system.
ii. By position monitoring to ensure that the borrowing is within the
specified limits as also the overall exposure limits.
iii. Ensuring return of securities by use of collateral deposited with the
Clearing Corporation.
Advantages of the model
It must be clear that the broad difference between the first and
the second model is that in first model only DPs and approved
intermediaries are on the supply side and in second model all the
individual investors are required to put in their independent quotes on
the trading terminal for borrowing and lending of securities.
This model would provide the following advantages as
mentioned in the previous model:
1. Nationwide trading platform which already exists and reaches the
entire investors.
2. Screen based continuous market session will ensure transparency,
efficiency and market driven price discovery.
3. Clearing Corporation already has the track for managing risk by
having a mechanism for collecting collateral nationwide.
4. Clearing Corporation being in a position to monitor exposure
segment wise shall ensure that borrowing is within specified limits.
5. Clearing Corporation would ensure that the borrowing is done
towards settlement obligation and also ensure that the securities
so borrowed are returned to lenders

Model 3 – Lending through the depositories.

Another model may be the securities lending and borrowing
model followed by the Singapore Exchange Ltd. In this model,
depository becomes the major supplier of the securities. This model
envisages the securities to be available from the big investors, who get
themselves registered with the Depository for this specific purpose. It
may be noted that under the Singapore Exchange Ltd. Model, the
payment to the lender of securities is fixed and linked to the value of the
securities.
This model further envisages investors borrowing the securities
through their depository participants. For that purpose, depository
participants are registered with the Depository as authorized borrowers
for their clients. Again, in the Singapore model, Depository charges
fixed rate of interest from the Depository Agents (DAs) for their
borrowing for clients. But, it is interesting to note that the DAs determine
their own lending rates, while lending to the individual clients.
It may be noted that it is basically a two-tier model for the
borrowing of the securities. First, depository is lending the securities to
the DAs and then DAs are lending the securities to the investors (their
clients). It is important to mention here that in case of Singapore
exchange,
Depository called the Central Depository (CDP) is the clearing
and depository division of the Singapore Exchange. Therefore, this kind
of model may be created in India by the collaborative efforts of the
clearing corporation/ house and the depositories. Only disadvantage in
this model is that only the big investors would be eligible to be the part
of the supply side and would get themselves registered with depositories.

Other small investors may not be able to enjoy the values created
through the system.
Indeed, the model 1, suggested above is the refined version of
this model wherein even the small investors would be eligible to
participate in the lending process through their depository participants.
Accordingly, some market participants feel that the model 1 scores
over the instant model in terms of values to the investors at large.
Model 4 – Lending through the special purpose bank.
Creation of the special bank say “limited purpose bank” for
the securities lending and borrowing is another idea given by the market
participants. This assumes that a dedicated entity can undertake the
activity of supporting the securities market trades. It is felt that the
dedicate bank may do things in an organized manner with available
resources. People interested in lending the securities to the market may
deposit their securities with this limited purpose bank and borrowers
may borrow from this bank.
As described in case of the funds borrowing and lending, this bank
may lend the securities to clients in number of alternative following ways:
Bank may lend the securities to clients direct.
Bank may lend the securities to clients through the brokers of
the exchanges.
Bank may lend the securities clients through the clearing
corporation/exchange through an on-line trading platform
In the first two cases, bank would manage its risk itself. But, in
the last scenario, exchange/clearing corporation would
manage the risk for the bank.

Advantages of this model are many:

1. It would be easy to track, who is lending the securities in the
market and to what extent. This would help avoid any nexus
built up between the lender of the securities, brokers and issuer
companies.
2. Total quantum of the securities lent would be known to the
market at any point in time. Limits on the client wise
borrowing would be easy to impose and monitor.
3. This would make the risk management effective.
4. Audit trail would be easy to manage.
Only issue in this model is the creation of a fresh infrastructure.
Building a nationwide bank would require both money and time. But
that may be navigated with co-ordinated efforts of the market
participants. Another opinion on the issue is that the existing infrastructure
of the banks/financial institutions/exchanges may be leveraged on for
the purpose.
Foreign Institutional Investment
A foreign institutional investor (FII) is an investor or investment
fund investing in a country outside of the one in which it is registered or
headquartered. The term foreign institutional investor is probably most
commonly used in India, where it refers to outside entities investing in
the nation’s financial markets. The term is also used officially in China.
Foreign institutional investment can include hedge funds,
insurance companies, pension funds, investment banks, and mutual funds.
Foreign institutional investments can be important sources of capital in
developing economies, yet many developing nations, such as India,

have placed limits on the total value of assets an foreign institutional

investor can purchase and the number of equity shares it can buy,
particularly in a single company. This helps limit the influence of foreign
institutional investors on individual companies and the nation’s financial
markets, and the potential damage that might occur if foreign institutional
investments fled en masse during a crisis.
Foreign Institutional Investors (FIIs) in India
Some of the countries with the highest volume of foreign
institutional investments are those with developing economies, which
generally provide investors with higher growth potential than mature
economies. This is one reason FIIs are commonly found in India, which
has a high- growth economy and attractive individual corporations to
invest in. All foreign institutional investments in India must register with
the Securities and Exchange Board of India (SEBI) to participate in the
market.
Example of a Foreign Institutional Investor (FII)
If a mutual fund in the United States sees a high-growth
investment opportunity in an India- listed company, it can take a long
position by purchasing shares in an Indian stock market. This type of
arrangement also benefits private U.S. investors who may not be able
to buy Indian stocks directly. Instead, they can invest in the mutual fund
and take part in the high-growth potential.
Regulations on Investing in Indian Companies
Foreign institutional investors are allowed to invest in India’s
primary and secondary capital markets only through the country’s
portfolio investment scheme. This scheme allows foreign institutional
investors to purchase shares and debentures of Indian companies on
the nation’s public exchanges.
However, there are many regulations. For example, FIIs are

generally limited to a maximum investment of 24 per cent of the paid-
up capital of the Indian company receiving the investment. However,
FIIs can invest more than 24 per cent if the investment is approved by
the company’s board and a special resolution is passed. The ceiling on
foreign institutional investors’ investments in Indian public-sector banks
is only 20 per cent of the banks’ paid-up capital.
The Reserve Bank of India monitors compliance with these
limits daily by implementing cut- off points 2 per cent below the maximum
investment. This gives it a chance to caution the Indian company
receiving the investment before allowing the final 2 per cent to be
purchased.
Foreign Institutional Investors in China
China is also a popular destination for foreign institutions seeking
to invest in high-growth capital markets. In 2019, China decided to
scrap quotas on the amount of the nation’s stocks and bonds FIIs can
purchase. The decision was part of efforts to attract more foreign capital
as its economy slowed and it fought a trade war with the U.S.
Participatory Notes (P Notes)
Participatory notes also referred to as P-Notes, or PNs, are
financial instruments required by investors or hedge funds to invest in
Indian securities without having to register with the Securities and
Exchange Board of India (SEBI). P-Notes are among the group of
investments considered to be Offshore Derivative Investments (ODIs).
Citigroup (C) and Deutsche Bank (DB) are among the biggest issuers
of these instruments.

Any dividends or capital gains collected from the securities goes

back to the investors. Indian regulators are generally not in support of
participatory notes because they fear that hedge funds acting through
participatory notes will cause economic volatility in India’s exchanges.
Foreign institutional investors, issue the financial instruments to
investors in other countries who want to invest in Indian securities.
An foreign institutional investor is an investor or investment fund
registered in a country outside of the one in which it is investing.
This system lets unregistered overseas investors buy Indian
shares without the need to register with the Indian regulatory body.
These investments are also beneficial to India. They provide access to
quick money to the Indian capital market. Because of the short-term
nature of investing, regulators have fewer guidelines for foreign
institutional investors. To invest in the Indian stock markets and to avoid
the cumbersome regulatory approval process, these investors trade
participatory notes.
Working of Participatory Notes
Participatory notes are offshore derivative instruments with
Indian shares as underlying assets. Brokers and foreign institutional
investors registered with the Securities and Exchange Board of India
(SEBI) issue the participatory notes and invest on behalf of the foreign
investors. Brokers must report their participatory note issuance status
to the regulatory board each quarter. The notes allow foreign investors
with high net worth, hedge funds, and other investors, to participate in
the Indian markets without registering with the SEBI. Investors save
time, money and scrutiny associated with direct registration.

Pros and Cons of Participatory Notes

Participatory notes are easily traded overseas through
endorsement and delivery. They are popular because investors
anonymously take positions in Indian markets, and hedge funds may
anonymously carry out their operations. Some entities route their
investments through participatory notes to take advantage of tax laws
that are available in certain countries.
However, because of the anonymity, Indian regulators face
difficulty determining a participatory notes original owner and end
owner. Therefore, substantial amounts of unaccounted for money enters
the country through participatory notes. This flow of untracked funds
has raised some red flags.
Participatory Note Regulatory Issues
SEBI has no jurisdiction over participatory note trading.
Although foreign institutional investors must register with the Indian
regulatory board, the participatory notes trading among foreign
institutional investors are not recorded. Officials fear this practice may
lead to the P- Notes being used for money laundering or other illegal
activity.
This inability to track money is also why the Special
Investigation Team (SIT) would like stricter compliance measures
for the trading of participatory notes. The SIT is a specialized team of
officers in Indian law enforcement which consists of personnel who
have been trained to investigate serious crimes.
However, when the government proposed trade restrictions
on the notes in the past, the Indian market became extremely volatile.
For example, in October 2007, the government announced it was
considering curbing participatory note trading. The announcement
caused the Sensex index to plummet 1,744 points during the day’s
session, which was greater than an eight per cent drop at the time.
This market disturbance was in response to investor and
government worries that the curbing of the P-Notes would be a direct
hit on the Indian economy. That is because foreign institutional investors
help fuel the growth of the Indian economy, industries, and capital
markets, and increasing regulation would make it more difficult for foreign
money to enter the market. The government ultimately decided not to
regulate participatory notes.
Example:
P-Notes can be used to purchase any Indian security an investor
wants through a series of steps.
An investor deposits funds with the U.S. or European operations
of a registered foreign institutional investor (FII), such as HSBC or
Deutsche Bank. The investors then inform the bank of the Indian security
or securities they wish to purchase. Funds transfer from the investor to
the foreign institutional investment account, and the foreign institutional
investment issues the participatory notes to the client and buys the
underlying stock or stocks in the correct quantities from the Indian
marketplace.
The investor is eligible to receive dividends, capital gains and
any other pay-outs due to stockholders holding the shares of the Indian
company. The foreign institutional investor
reports all of its issuances each quarter to the Indian regulators, but as
per law, it does not disclose the identity of the actual investor.
Insider Trading
Insider trading is the trading of a public company’s stock or
other securities (such as bonds or stock options) by individuals with

access to non-public information about the company. In various
countries, insider trading based on inside information is illegal. This is
because it is seen as unfair to other investors who do not have access
to the information. The insider trading in a broader sense includes any
attempt to:
(i) Benefit the individual or other agency indulging in such
practice.
(ii) Benefit the company through such action, by using price
sensitive information. Insider trading may benefit some
persons at the cost of others. As a part of investors’
protection, SEBI has taken necessary steps to prohibit insider
trading by checking and curbing unhealthy and manipulative
practices by persons who have more access than others of
the information about a company. Price sensitive information
means and includes any information which relates directly or
indirectly to a company which, if published is likely to
materially affect the price of securities of the companies. Price
sensitive information includes:
(i) Periodical financial results of the company.
(ii) Intention to declare dividend.
(iii) Issue or buy-back of securities.
(iv) Expansion plans projects merger amalgamation.
(v) Disposal of whole or part of undertaking
(vi) Significant changes in policies, plans of the company

Investor Protection
Investor protection means that up to a certain limit, you receive
your money back if the broker goes into bankruptcy or commits fraud.
It is an important factor to consider when you open an account with an
online broker. When you open a trading account at a brokerage, you
usually get investor protection.
The investor protection amount defines the limit of protection
and it varies country by country. In Europe the amount of investor
protection it is usually • 20,000, while in the US is significantly higher,
Rs. 500,000. Some other countries like Australia does not provide any
investor protection. The investor protection amount is usually guaranteed
by a state fund.
The Role of SEBI in Investor Protection
SEBI has given out various methods and measures to ensure
the investor protection from time to time. It has published various
directives, driven many investor awareness programmes, set up investor
protection Fund (IPF) to compensate the investors.
Investor protection legislation is implemented under the Section
11(2) of the SEBI Act. The measures are as follows:
Stock Exchange and other securities market business regulation.
Registering and regulating the intermediaries of the business-
like brokers, transfer agents, bankers, trustees, registrars, portfolio
managers, investment consultants, merchant bankers, etc.
Recording and monitoring the work of custodians, depositors,
participants, foreign investors, credit rating agencies, etc.

Registering investment schemes like Mutual fund & venture Capital

funds, and regulating their functioning.
Promotion and controlling of self-regulatory companies.
Keeping a check on frauds and unfair trading methods related to
the securities market.
Observing and regulating major transactions and take-over of the
companies.
Carry out investor awareness and education programme.
Train the intermediaries of the business.
Inspecting and auditing the security exchanges (SEs) and
intermediaries.
Assessment of fees and other charges.
Credit Rating
Due to increase in the complexity of financial products and
globalisation in the financial markets, it is very important to bring all
securities at one level so that comparisons can be drawn among them.
This need has given rise to agencies like credit rating. Credit rating
agencies are the professional driven organisation that give their ratings
about the credit worthiness of the financial instruments. It is an opinion
on the future ability of the issuer to repay debt obligations which includes
interest as well as principal repayment. It provides an investor a fair
idea about the ability of the issuer to make timely payment of interest
and principal repayment of a debt instrument. Ratings given by these
agencies are not on subjective criteria but quantitative factors. These
agencies act as source from where individual, companies and other
relevant parties gain information. On the basis of the information from

CRAs, investor can take better decision in terms of selecting the securities
for investment purposes.
Credit rating helps in the following:
• To solve the problem of information asymmetry.
• Enhances the ability of corporate to access capital market.
• Helps pricing of securities
• Gives wake up call for institutions that have taken on too much
debt
• Provides a simple indicator of the credit quality
• Yardstick against which different instruments can be compared.
Ratings agencies don’t confine only to ratings to securities or
financial instruments but also to company and country as sovereign
credit ratings. These country ratings analyse the political economic
conditions of the country in general. It assesses the various government
policies and overall stability in the country. Various FDIs and FIIS take
decision based on these ratings.
Credit rating is not only important to public but also to the
issuer and economy as a whole.
1. Importance of credit rating to Investors
Ratings provide an independent and professionally evaluated
opinion of credit quality of financial instruments companies or
countries to investors. Investors can use this opinion in making
investments. They get information at low cost or no cost. However,
it must be noted that these ratings are not the recommendations to
buy or sell any instrument. It is not a guarantee but an opinion.

Investors can compare various instruments with the help of these

ratings. Investors can have some idea as to what is the risk
associated with the instrument and ratings can also be used to
hedge the risk and balance the return.
2. Importance of credit rating to Issuers
With the transparency of the ratings, more and more savings of
public will be channelized and more funds can be raised at low
cost. It bolsters the confidence of foreign investors to invest in the
company. Credit rating helps in getting more access to investors
which also encourages discipline among corporate borrowers.
Higher credit rating to any credit instrument tends to enhance the
corporate image and visibility and hence it induces a healthy
discipline on corporate.
3. Importance of credit rating to the economy
Credit rating encourages investors to invest their savings in
company’s shares, debentures etc. thus the idle savings can be
channelized and put to productive use. It creates the platform for
the investor protection and intervention of the government may be
reduced. Public policy guidelines on what kinds of securities are
eligible for inclusions in different kinds of institutional portfolios
can be developed with greater confidence if debt securities are
rated professionally.
Disadvantages of Credit Rating Agencies
Notwithstanding the importance of so many benefits to investors,
company and economy, Credit rating agencies are not without flaws:
1. Evaluation can be subjective
There are no standard formulas to establish an institution’s credit

rating; instead, credit rating agencies use their best judgement.

Unfortunately, they often end up making inconsistent judgments,
and the ratings between different credit rating agencies may vary
as well.
2. Conflict of Interest
After the collapse of 2008, it has been observed that credit rating
agencies usually provide ratings at the request of the institutions.
Since the company pays the rating agency to determine its rating,
that agency might be inclined to give the company a more
favourable rating so as to retain their business. This has raised
many doubts about the creditability of the ratings given by different
rating agencies.
3. Inaccurate Ratings
Although credit rating agencies offer a consistent rating scale, that
does not mean that companies are always going to be rated
accurately. However, after rating agencies provided AAA ratings
for the worthless mortgage-backed securities that contributed to
the subprime crisis, investors have lost faith in them.
Capital Market Institutions
Financial institutions are the most active constituent of the Indian
capital market. There are special financial institutions which provide
medium- and long-term loans to big business houses. Such institutions
help in promoting new companies, expansion and development of
existing companies etc. The main special financial institutions of the
Indian capital are IDBI, IFCI, ICICI, UTI, LIC, NIDC, SFCs etc.

Capital Market Instruments.

1) Traditional instruments This includes:
a. Equity shares
b. Preference shares and its various classes
c. Debentures and its types
d. bonds etc.,
2) Innovative/recent instruments
Some of the new financial instruments introduced in recent years may
be briefly explained as below:
1. Floating rate bonds:
The interest rate on these bonds is not fixed. It is a concept which
has been introduced primarily to take care of the falling market or
to provide a cushion in times of falling interest rates in the economy.
It helps the issuer to hedge the loss arising due to interest rate
fluctuations. In India, SBI was the first to introduce FRB for retail
investors.
2. Zero interest bonds: These carry no periodic interest payment.
These are sold at a huge discount. These can be converted into
equity shares or non- convertible debentures
3. Deep discount bonds: These bonds are sold at a large discount
while issuing them. These are zero coupon bonds whose maturity
is very high (say, 15 years). There is no interest payment. IDBI
was the first financial institution to offer DDBs in 1992.
4. Auction related debentures: These are a hybrid of CPs and
debentures. These are secured, redeemable, non-convertible

instrument. The interest on them is determined by the market.

These are placed privately with bids. ANZ Grind lays designed
this new instrument for Ashok Leyland Finance.
5. Secured Premium Notes: These are issued along with a detachable
warrant. This warrant gives the holder the right to apply for, or
seek allotment of one equity share, provided the SPN is fully paid.
The conversion of detachable warrant into equity shares is done
within the time limit notified by the company. There is a lock in
period during which no interest is paid for the invested amount.
TISCO was the first company to issue SPN (in 1992) to the public
along with the right issue.
6. Option bonds: Option bonds can be converted into equity or
preference shares at the option of the investor as per the condition
stated in the prospectus. These may be cumulative or non-
cumulative. In case of cumulative bonds, the interest is accumulated
and is payable at maturity. In case of non-cumulative bonds, interest
is payable at periodic intervals.
7. Warrants: A share warrant is an option to the investor to buy a
specified number of equity shares at a specified price over a
specified period of time. The warrant holder has to surrender the
warrant and pay some cash known as ‘exercise price’ of the
warrant to purchase the shares. On exercising the option, the
warrant holder becomes a shareholder. Warrant is yet to gain
popularity in India, due to the complex nature of the instrument.
8. Preference shares with warrants: These carry a certain number of
warrants. These warrants give the holder the right to apply for
equity shares at premium at any time in one or more stages between
the third and fifth year from the date of allotment.

9. Non-convertible debentures with detachable equity warrants: In

this instrument, the holder is given an option to buy a specified
number of shares from the company at a predetermined price within
a definite time frame.
10. Zero interest fully convertible debentures: On these instruments,
no interest will be paid to the holders till the lock in period. After a
notified period, these debentures will be automatically and
compulsorily converted into shares.
11. Fully convertible debentures with interest: This instrument carries
no interest for a specified period. After this period, option is given
to apply for equities at premium for which no additional amount is
payable. However, interest is payable at a predetermined rate from
the date of first conversion to second / final conversion and equity
will be issued in lieu of interest.
12. Non-voting shares: The Companies Bill,1997 proposed to allow
companies to issue nonvoting shares. These are quasi -equity
instruments with differential rights. These shares do not carry voting
right. Their divided rate is also not predetermined like preference
shares.
13. Inverse float bonds: These bonds are the latest entrants in the
Indian capital market. These are bonds carrying a floating rate of
interest that is inversely related to short term interest rates.
14. Perpetual bonds: These are debt instruments having no maturity
date. The investors receive a stream of interest payment for
perpetuity
1. Industrial Development Bank of India
IDBI Bank Limited or IDBI Bank or IDBI was established in

1964 by an Act to provide credit and other financial facilities for the
development of the fledgling Indian industry. It is a development
financial institution and now a subsidiary of Life Insurance Corporation.
Many national institutes find their roots in IDBI like SIDBI, India Exim
Bank, National Stock Exchange of India and National Securities
Depository Limited.
Initially, it operated as a subsidiary of the Reserve Bank of
India and later RBI transferred it to the Government of India. On 29
June 2018, Life Insurance Corporation of India (LIC) has got a
technical go-ahead from the Insurance Regulatory and Development
Authority of India (IRDAI) to increase stake in IDBI Bank up to 51
per cent. LIC completed the acquisition of 51 per cent controlling stake
on 21 January 2019 making it the majority shareholder of the IDBI
Bank. Reserve Bank of India has clarified vide a Press Release dated
14 March 2019, that IDBI Bank stands re-categorized as a Private
Sector Bank for regulatory purposes with effect from 21 January 2019.
The Industrial Development Bank of India (IDBI) was
established in 1964 under an Act of Parliament as a wholly-owned
subsidiary of the Reserve Bank of India. In 1976, the ownership of
IDBI was transferred to the Government of India and it was made the
principal financial institution for coordinating the activities of institutions
engaged in financing, promoting and developing industry in India. IDBI
provided financial assistance, both in rupee and foreign currencies, for
green-field projects and also for expansion, modernization, and
diversification purposes. In the wake of financial sector reforms unveiled
by the government since 1992, IDBI also provided indirect financial
assistance by way of refinancing of loans extended by State- level
financial institutions and banks and by way of rediscounting of bills of
exchange arising out of the sale of indigenous machinery on deferred
payment terms.
After the public issue of IDBI in July 1995, the government

shareholding in the bank came down from 100 per cent to 75 per cent.
IDBI played a pioneering role, particularly in the pre-reform
era (1964–91), in catalysing broad- ‘based industrial development in
India in keeping with its Government-ordained development banking’
charter. Some of the institutions built with the support of IDBI are
the Securities and Exchange Board of India (SEBI), National Stock
Exchange of India (NSE), the National Securities Depository Limited
(NSDL), the Stock Holding Corporation of India Limited (SHCIL),
the Credit Analysis & Research Ltd, the Exim Bank (India), the Small
Industries Development Bank of India (SIDBI) and the
Entrepreneurship Development Institute of India.
A committee formed by RBI recommended the development
financial institution (IDBI) to diversify its activity and harmonize the
role of development financing and banking activities by getting away
from the conventional distinction between commercial banking and
developmental banking. To keep up with reforms in financial sector,
IDBI reshaped its role from a development finance institution to a
commercial institution. With the Industrial Development Bank (Transfer
of Undertaking and Repeal) Act, 2003, IDBI attained the status of a
limited company viz., IDBI Ltd.
Subsequently, in September 2004, the Reserve Bank of India
incorporated IDBI as a ‘scheduled bank’ under the RBI Act, 1934.
Consequently, IDBI formally entered the portals of banking business
as IDBI Ltd. from 1 October 2004. The commercial banking arm,
IDBI BANK, was merged into IDBI in 2005.

2. Industrial Development Bank of India Limited

In response to the felt need and on commercial prudence, it
was decided to transform IDBI into a Bank. For the purpose, Industrial
Development Bank (Transfer of Undertaking and Repeal) Act, 2003
[Repeal Act] was passed repealing the Industrial Development Bank
of India Act, 1964. In terms of the provisions of the Repeal Act, a new
company under the name of Industrial Development Bank of India
Limited (IDBI Ltd.) was incorporated as a Banking Company under
the Companies Act, 1956 on September 27, 2004. Thereafter, the
undertaking of IDBI was transferred to and vested in IDBI Ltd. with
effect from October 01, 2004.
Merger of United Western Bank with IDBI Ltd.
The United Western Bank Ltd. (UWB), a Satara-based private
sector bank, was placed under moratorium by RBI. Upon IDBI Ltd.
showing interest to take over the said bank towards its further inorganic
growth, UWB was amalgamated with IDBI Ltd., in terms of the
provisions of Section 45 of the Banking Regulation Act, 1949. The
merger came into effect on October 03, 2006.
Change of name of IDBI Ltd. to IDBI Bank Ltd.
To truly capture its widened business functions, the name of
the Bank was changed to IDBI Bank Ltd. with effect from May 07,
2008 upon issue of the Fresh Certificate of Incorporation by Registrar
of Companies, Maharashtra.
Merger of IDBI Home Finance Ltd. and IDBI Gilts with IDBI
Bank Ltd.
Two wholly owned subsidiaries of IDBI Bank Ltd., viz. IDBI
Home Finance Ltd. and IDBI Gilts Ltd. were amalgamated with IDBI

Bank Ltd. under Section 391-394 of the Companies Act, 1956 vide
Government of India, Ministry of Corporate Affairs order dated April
08, 2011. The appointed day under the scheme of amalgamation has
been approved as January 01, 2011. In terms of Section 394(3) of the
Companies Act 1956, the Government of India’s above order has been
filed with the Registrar of Companies on April26, 2011.
Re-categorization of IDBI Bank Ltd. a as Private Sector Bank
LIC of India completed acquisition of 51 per cent controlling
stake in IDBI Bank on January 21, 2019 making it the majority
shareholder of the bank. Subsequent to enhancement of equity stake
by LIC of India on January 21, 2019, Reserve Bank of India has clarified
vide a Press Release dated March 14, 2019, that IDBI Bank stands
re-categorized as a Private Sector Bank, with retrospective effect from
January 21, 2019.
3. Industrial Finance Corporation of India
Industrial Finance Corporation of India (IFCI) is actually
the first financial institute the government established after independence.
The main aim of the incorporation of IFCI was to provide long-term finance
to the manufacturing and industrial sector of the country. Let us study more
about IFCI.
Initially established in 1948, the Industrial Finance Corporation of India
was converted into a public company on 1 July 1993 and is now known
as Industrial Finance Corporation of India Ltd.
The main aim of setting up this development bank was to provide
assistance to the industrial sector to meet their medium and long-term
financial needs.
The IDBI, scheduled banks, insurance sector, co-op banks are
some of the major stakeholders of the IFCI. The authorized capital of the
IFCI is 250 crores and the Central Government can increase this as and
when they wish to do
Functions of the IFCI
? First, the main function of the IFCI is to provide medium and long-
term loans and advances to industrial and manufacturing concerns.
It looks into a few factors before granting any loans. They study
the importance of the industry in our national economy, the overall
cost of the project, and finally the quality of the product and the
management of the company. If the above factors have satisfactory
results the IFCI will grant the loan.
? The Industrial Finance Corporation of India can also
subscribe to the debentures that these companies’ issue in the
market.
? The IFCI also provides guarantees to the loans taken by such
industrial companies.
? When a company is issuing shares or debentures the Industrial
Finance Corporation of India can choose to underwrite such
securities.
? It also guarantees deferred payments in case of loans taken from
foreign banks in foreign currency.
? There is a special department the Merchant Banking & Allied
Services Department. They look after matters such as capital
restructuring, mergers, amalgamations, loan syndication, etc.
? It the process of promoting industrialization the Industrial Finance
Corporation of India has also promoted three subsidiaries of its
own, namely the IFCI Financial Services Ltd, IFCI Insurance

Services Ltd and I-Fin. It looks after the functioning and regulation
of these three companies.
4. ICICI Bank Limited
ICICI is an Indian multinational banking and financial services
company with its registered office in Vadodara, Gujarat and corporate
office in Jharkhand. It offers a wide range of banking products and
financial services for corporate and retail customers through a variety
of delivery channels and specialised subsidiaries in the areas of
investment banking, life, non-life insurance, venture capital and asset
management. The bank has a network of 5,275 branches and 15,589
ATMs across India and has a presence in 17 countries.
ICICI was formed in 1955 at the initiative of the World Bank,
the Government of India and representatives of Indian industry. The
principal objective was to create a development financial institution for
providing medium-term and long-term project financing to Indian
businesses. Until the late 1980s, ICICI primarily focused its activities
on project finance, providing long-term funds to a variety of industrial
projects. With the liberalization of the financial sector in India in the
1990s, ICICI transformed its business from a development financial
institution offering only project finance to a diversified financial services
provider that, along with its subsidiaries and other group companies,
offered a wide variety of products and services.
As India’s economy became more market-oriented and
integrated with the world economy, ICICI capitalized on the new
opportunities to provide a wider range of financial products and services
to a broader spectrum of clients. ICICI Bank was incorporated in 1994
as a part of the ICICI group. In 1999, ICICI became the first Indian
company and the first bank or financial institution from non-Japan Asia
to be listed on the New York Stock Exchange.

The issue of universal banking, which in the Indian context meant
conversion of long-term lending institutions such as ICICI into
commercial banks, had been discussed at length in the late 1990s.
Conversion into a bank offered ICICI the ability to accept low-cost
demand deposits and offer a wider range of products and services,
and greater opportunities for earning non- fund-based income in the
form of banking fees and commissions. After consideration of various
corporate structuring alternatives in the context of the emerging
competitive scenario in the Indian banking industry, and the move
towards universal banking, the managements of ICICI and ICICI Bank
formed the view that the merger of ICICI with ICICI Bank would be
the optimal strategic alternative for both entities, and would create the
optimal legal structure for ICICI group’s universal banking strategy.
The merger would enhance value for ICICI shareholders through
the merged entity’s access to low-cost deposits, greater opportunities
for earning fee-based income and the ability to participate in the
payments system and provide transaction-banking services. The merger
would enhance value for ICICI Bank shareholders through a large capital
base and scale of operations, seamless access to ICICI’s strong
corporate relationships built up over five decades, entry into new
business segments, higher market share in various business segments,
particularly fee-based services, and access to the vast talent pool of
ICICI and its subsidiaries. In October 2001, the Boards of Directors
of ICICI and ICICI Bank approved the merger of ICICI and two of
its wholly-owned retail finance subsidiaries, ICICI Personal Financial
Services Limited and ICICI Capital Services Limited, with ICICI Bank.
The merger was approved by shareholders of ICICI and ICICI Bank

in January 2002, by the High Court of Gujarat at Ahmedabad in March

2002, and by the High Court of Judicature at Mumbai and the Reserve
Bank of India in April 2002. Consequent to the merger, the ICICI
group’s financing and banking operations, both wholesale and retail,
were integrated in a single entity.
ICICI Bank is one of the Big Four banks of India. The bank
has subsidiaries in the United Kingdom and Canada; branches in United
States, Singapore, Bahrain, Hong Kong, Qatar, Oman, Dubai
International Finance Centre, China and South Africa; as well as
representative offices in United Arab Emirates, Bangladesh, Malaysia
and Indonesia. The company’s UK subsidiary has also established
branches in Belgium and Germany.
Products
ICICI Bank offers products and services such as online money
transfers, tracking services, current accounts, savings accounts,[39]
time deposits, recurring deposits, mortgages, loans, automated lockers,
credit cards, prepaid cards, debit cards and digital wallets called ICICI
pockets.
ICICI bank launched ‘ICICI Stack’ which provides online
services such as payment options, digital accounts, instant car loans,
insurance, investments, loans etc.
5. The Unit Trust of India (UTI)
The Unit Trust of India (UTI) is a statutory body set up by an
Act of Parliament (the UTI Act). It is not bound by the mutual fund’s
regulations but by the UTI Act and UTI general regulations, although
under a voluntary arrangement SEBI oversees the investment schemes
launched by UTI since 1994. UTI operates without ownership capital,
under an independent Board of Trustees who oversee the general
management of the Trust’s operations. The Chairman of the Board is

appointed by the government.
The organizational structure of UTI is different from other mutual
funds. First, it is a statutory body rather than a trust established under
the Indian Trusts Act. Second, there is no separate AMC with a separate
Board of Directors. The Executive Committee and Board of UTI perform
the functions of the AMC and Board of Trustees. The sponsors also
cannot hold any equity in the AMC or Trustee company as neither of
these exist. Third, there has traditionally been no separation between
the asset management groups managing the schemes launched before
1994 (the mutual funds regulations only apply to schemes established
after 1994).
The first scheme launched by UTI was the Unit Scheme-1964
(US-64), and this remains UTI’s largest scheme. Under the provisions
of US-64, several institutions, including the Reserve Bank of India (RBI),
the Life Insurance Corporation (LIC), and the State Bank of India
(SBI), as well as other banks and financial institutions, contributed the
initial capital of Rs 50 million. In 1976, the RBI’s contribution was
taken up by the Industrial Development Bank of India (IDBI).
Due to its extensive distribution network (53 offices and 320
chief representatives), UTI has a much larger investor base of 45 million
accounts (as of end-1999) than any other mutual fund. At present, UTI
manages almost 100 investment schemes and is the largest institutional
investor in the equity market. During the 1990s, UTI’s portfolio shifted
markedly toward equity investments the share of equity in total investible
funds rose from 28 per cent in 1990/91 to more than 50 per cent in
1997/98. (The equity share in the US-64 scheme was even larger. This
trend reflected low interest rates, a booming stock market in the early

1990s, which made investment in equities increasingly attractive, and

UTI’s active support of the government’s divestment program.
Although their holdings have declined in recent years, partly
due to the withdrawal of some of the tax benefits previously enjoyed,
the corporate sector still holds around 40 per cent of outstanding US-
64 units. With mutual funds being given voting powers similar to those
of other shareholders in 1996, some analysts have raised concerns
regarding the effect of these large cross-shareholdings on corporate
governance.
Because its pre-1994 schemes are not regulated by SEBI, there
are areas where practices at some UTI funds (most notably US-64)
differ from those at other mutual funds. Most importantly:
? Dividend policies and accounting practices deviate from
industry standards. Unlike other mutual funds, which pass on 90 per
cent of their earnings to their unit holders,
UTI’s dividends, in particular those of US-64, are set in order to at
least maintain (and often exceed) the previous year’s dividend rate. To
do this, a scheme holds a reserve that it adds to in “good” years and
draws down in “bad” years. Also, unlike other mutual funds, which are
required to mark all investments to market, UTI’s investments have
traditionally (and until recently) been carried on its balance sheet at
historical book value.
? Policies with regard to the sale and redemption prices of the
units of its open-ended investment schemes also differ from those of
other mutual funds. For example, US-64- unit prices are not directly
linked to its net asset value (NAV), but are announced at the beginning
of UTI’s accounting year (July 1–June 30), and can be changed on a

month- to-month basis. The secondary market price of the units usually
fluctuates within the boundaries of the sale and redemption prices set
by the UTI. NAVs of most of its unit schemes are published on a regular
basis (monthly or weekly). UTI believes that in the case of US-64,
however, it is difficult to make an accurate and timely estimation of the
NAV due to the nature of its investments, which include term loans and
non- transferable debentures.
Further, UTI has evolved into an institution with a wide range
of functions from mobilizing savings through assured return savings
schemes to acting as an investment and term-lending institution. Multiple
autonomous business units have been established under the umbrella
of the UTI, such as the UTI Bank, the UTI Securities Ltd., the UTI
Investor Services Ltd., and the UTI Investment Advisory.
The October 1998 Crisis and the Restructuring of UTI
The decline in stock prices during May-June 1998 resulted in
significant valuation losses for US-64 on its investment portfolio. Despite
these losses, however, UTI decided to maintain a dividend rate of 20
per cent for the 1997/98 financial year. At the same time, the decision
was taken by the fund’s management to revise the accounting practices
followed by US-64 so as to account for the unrealized capital losses.
These developments resulted in the balance in the US- 64’s reserve
account turning negative in June 1998, and when this became public
with the release of UTI’s 1997/98 Annual Report in the fall of 1998,
investor confidence in the US-64 scheme deteriorated sharply.
If UTI had been following the standard valuation and pricing
procedures prescribed by SEBI, the sharp decline in the market value
of its assets between May and June 1998 would have resulted in a
proportionate revision of the NAV and a lower sale price. Instead,

after it was revealed that US-64’s reserves were negative, UTI raised
the sale price of its units in line with its usual annual pricing policy.
Redemption pressures continued to build, and the unit capital of US-
64 declined from Rs 156 billion in June 1998 to Rs 148 billion in
December 1998. Following the October 1998 difficulties, UTI
constituted a committee (the Deepak Parekh Committee) to undertake
a comprehensive review of the functioning of US-64 and recommend
measures for sustaining investor confidence and strengthening the
operations of the scheme.
The Committee’s report was released in March 1999 and its
view was that the problems at US- 64 were due to the excessively high
yield offered by the scheme, combined with its large equity exposure.
Consequently, it recommended that the equity exposure be gradually
reduced, the pricing of the scheme become NAV driven, and its dividend
distribution policy become more responsive to changes in market
conditions.
As part of the restructuring of UTI, the government has recently
undertaken a debt-for-equity swap with US-64 along the lines of the
Committee’s recommendations. A number of poorly performing Public
Sector Undertakings (PSU) shares, valued at Rs 3.3 billion, have been
placed in a new scheme, the Special Unit Scheme 1999 (SUS-99),
and in return the government issued five-year maturity bonds to US-
64. UTI has also implemented a number of other reforms in line with
the recommendations of the Committee. Separate Asset Management
Companies (AMCs)—equity and debt schemes, each with seven
members (five outside experts and two senior UTI officials) have been
established for US-64. The dividend on US-64 was also lowered to
13.5 per cent (implying a yield of 10 per cent on the July 1999 sale

price). Given the tax exemption, however, the after-tax yield was largely
unchanged from the previous year, while the sale and redemption prices
were reduced in July to bring them closer to the NAV. UTI also
announced that starting in July 2000, the NAV of US-64 would be
declared on a fortnightly basis, and UTI was required to submit regular
compliance reports to the Ministry of Finance on progress toward
meeting the Parekh Committee’s recommendations.
Outstanding Policy Issues
The mutual fund industry has played an important role in the
mobilization of domestic savings and the development of capital markets
in India. Substantial progress has also been made in strengthening the
regulation and improving the transparency and uniformity of the standards
in the mutual fund industry through the SEBI (Mutual Funds) Regulations
of 1996, and the subsequent amendments in 1998. However, a number
of areas remain where further improvement to the regulatory regime
would he beneficial, and, in the case of UTI, the challenges remain
considerable. Bringing UTI under SEBI’s purview, as well as the
introduction and implementation of international accounting principles
(IAP) across the whole of the mutual fund industry, will increase the
soundness and stability of the sector. Some of the other outstanding
issues are discussed below.
Mutual Fund Regulation
? Valuation standards. Existing regulations appropriately require that
the sale and redemption prices of funds should be based on their
NAVs, which should be computed according to the uniform rules
specified in the regulations. There is scope, however, for
improvements in at least two areas. First, while the regulations have

introduced broad guidelines for the valuation of thinly traded or

nontraded securities, the AMCs still have considerable room for
discretion in the valuations they adopt. Second, mutual funds are
currently only required to revise and publish NAVs on a weekly,
rather than daily, basis. A second-best option would be to require
the repricing of units in the event of a “material market move” (when
the scheme’s NAV, if revalued, would differ by more than 5 per
cent from the last valuation point).
? The legal and regulatory relationship between the sponsor, the
AMC, the unit holders, and the trustees. Several issues relating
to governance is raised by current regulations. At present, the
sponsor of a fund may hold up to 100 per cent of the AMC’s
capital, can contribute to the trustee company’s capital, and can
appoint the trustees. But while there is considerable scope for the
sponsor to indirectly influence the asset management and other
operational decisions of the trustees and/or the AMC, the regulations
do not hold the sponsor liable for such decisions. The sponsor is
financially liable only in the event of a shortfall in the net worth of
the AMC or if a mutual fund’s income is insufficient to cover the
distributions under the assured return schemes guaranteed by the
sponsor. Moreover, the regulatory constraints aimed at limiting the
potential conflicts of interest appear to be relatively lax by
international standards. For example, the 1998 amendments-
imposed constraints on mutual fund investments in the companies
affiliated with the sponsor by setting a limit of 25 per cent of the
fund’s net assets. The best practice in this area is to not allow a
mutual fund to invest in the management and/or trustee company or
in any of their affiliates. In order to address these issues, the 1996
Kaul Committee recommended the enactment of separate legislation

governing the management, responsibilities, and functioning of mutual

funds.
? The relationship between mutual funds and the corporate
sector. Current arrangements raise both prudential and governance
issues. The regulations stipulate that a fund’s ownership in any single
company should not exceed 10 per cent of its voting shares, although
there appears to be no upper limit on the total holdings of voting
and nonvoting (ordinary and preference) shares of any single
company. In addition, while corporate sector holdings of US-64
units have declined following the withdrawal of certain tax benefits,
there is an issue of whether the regulators need to impose restrictions
on corporate or financial institutions’ investments in assured return
schemes of mutual funds, in order to prevent the build-up of large
cross-shareholdings.
? The role of the government in the mutual fund industry. UTI,
which is a statutory body, accounts for more than 70 per cent of
the mutual fund industry’s investible resources. This, coupled with
the fact that the life insurance and banking sectors are also largely
publicly owned, means that the government has a major influence
on the domestic financial markets. In the past, this meant that mutual
funds and other financial sector entities were overly involved in
supporting the government’s divestment program, with adverse
implications for the financial soundness of the institutions.
? Futures and other derivative markets. In view of the authorities’
intention to promote derivatives markets, prudential regulations will
need to be developed in order to prevent the misuse of such
instruments. As a first step in the right direction, the Gupta

Committee on Derivatives recommended that mutual funds be

allowed to trade derivatives only to the extent authorized by their
Board of Trustees and to disclose their intention to engage in
derivatives trading in their offer documents. Also, existing funds
would need to obtain approval from unit holders to carry out
derivatives transactions.
? Assured return schemes. The Parekh Committee report concluded
that assured return schemes were no longer appropriate in view of
the financial market liberalization that had taken place in recent
years. While regulations now require that fund sponsors or AMCs
guarantee returns and provide sufficient funds to meet this obligation,
there does not yet seem to be a framework that would discourage
this practice among public sector mutual funds. Indeed, UTI
launched an assured return scheme in early 1999. SEBI has reported
that by March 1999, Rs 13.5 billion had been paid by mutual funds
to investors to honour the assured return commitments.
? Taxation. Tax benefits have served a useful role in developing the
mutual fund industry, but they place other financial intermediaries at
a relative disadvantage and distort investment decisions. For
example, the 1999/00 budget proposed taxing distributions by
debt schemes at a flat rate of 10 per cent, while the income from
bank deposits is taxed at standard income tax rates. In addition,
the budget provided a three-year dividend tax exemption for
distributions by equity schemes, and the Parekh Committee
suggested this be extended to US-64 regardless of future changes
in its debt/equity ratio.

Reform of UTI
The reforms proposed by the Parekh Committee provide a
useful blueprint for restructuring UTI. In particular, it is critical for US-
64 to move quickly to a NAV-based pricing system to bring it in line
with industry standards and to improve investor protection.
The reduction of US-64 equity exposure will help align the scheme’s
investments with its objective of providing unit holders with a regular
income flow. Further, the establishment of an independent board of
trustees and an AMC with an independent board would bring it more
in line with the mutual fund regulations, leading to significantly improved
accountability.
Questions regarding the scope and implementation of the
Committee’s recommendations remain. A critical issue is the systemic
importance and role of UTI in Indian financial markets. UTI operates
as a financial conglomerate, which is involved in virtually every segment
of the financial system. Also, the size of UTI’s flagship fund, US–64,
affects the flexibility of its operations as active portfolio management
becomes difficult and costly when the size of transactions has significant
impact on prices of individual stocks being traded. Moreover, the size
and complexity of UTI has made its regulations more challenging.
The size of UTI relative to overall stock market capitalization
and the number of actively traded stocks can make it difficult for the
Trust to meet prudential norms specified in mutual fund regulations.
Under the regulations, a mutual fund may not own more than 10 per
cent of a company’s voting capital. At the same time, UTI’s own
prudential guidelines stipulate that no scheme can invest more than 5
per cent of its resources in the equity of any single company.

Given the size of UTI, however, 5 per cent of its investible

resources can easily exceed 10 per cent of voting capital of large publicly
traded companies. For example, as of June 1998, UTI owned more
than 10 per cent of the outstanding shares of at least 6 of the top 25
companies listed on the BSE, although only one company’s share in
total resources of US-64 exceeded 5 per cent.
The pricing and dividend policies of US-64 also have to be
fully reconciled. Although the Deepak Parekh Committee recommended
a move toward NAV-based pricing, this is to take place over a three-
year horizon with the phased approach reflecting the fact that an
immediate shift to NAV pricing would have resulted in a sharp drop in
the value of US-64 units. This problem appears to have been mitigated
by capital injections and a widening of the spread between sale and
redemption prices of units. In addition, UTI subsequently made a
commitment to announce the NAV on a fortnightly basis starting from
July 2000, and to gradually shift to publishing the NAV on a daily basis,
although it set no time frame for this.
The Deepak Parekh Committee’s proposals represent a
substantial step toward improving the operations and transparency of
UTI. The recent improvement in the financial position of US- 64 would
seem to make a rapid move to NAV-based pricing both possible and
desirable. Further, the size and systemic importance of UTI, and US-
64 in particular, continue to raise issues both for the operation of UTI
and for capital markets in general.
6. Life Insurance Corporation of India (LIC)
The LIC of India was set up under the LIC Act, 1956 under
which the life insurance was nationalised. As a result, business of 243
insurance companies was taken over by LIC on 1-9- 1956. It is basically

an investment institution, in as much as the funds of policy holders are

invested and dispersed over different classes of securities, industries
and regions, to safeguard their maximum interest on long term basis.
LIC is required to invest not less than 75 per cent of its funds in
Central and State Government securities, the government guaranteed
marketable securities and in the socially-oriented sectors. At present, it
is the largest institutional investor. It provides long term finance to
industries. Objectives of LIC of India The LIC was established with
the following objectives:
1. Spread life insurance widely and in particular to the rural areas, to
the socially and economically backward classes with a view to
reaching all insurable persons in the country and providing them
adequate financial cover against death at a reasonable cost
2. Maximisation of mobilisation of people’s savings for nation
building activities.
3. Provide complete security and promote efficient service to the
policy-holders at economic premium rates.
4. Conduct business with utmost economy and with the full realisation
that the money belongs to the policy holders.
5. Act as trustees of the insured public in their individual and collective
capacities.
6. Meet the various life insurance needs of the community that would
arise in the changing social and economic environment
7. Involve all people working in the corporation to the best of their
capability in furthering the interest of the insured public by providing
efficient service with courtesy.

Role and Functions of LIC

The role and functions of LIC may be summarised as below:
a. It collects the savings of the people through life policies and invests
the fund in a variety of investments.
b. It invests the funds in profitable investments so as to get good return.
Hence the policy holders get benefits in the form of lower rates of
premium and increased bonus. In short, LIC is answerable to the
policy holders.
c. It subscribes to the shares of companies and corporations. It is a
major shareholder in a large number of blue-chip companies.
d. It provides direct loans to industries at a lower rate of interest. It is
giving loans to industrial enterprises to the extent of 12 per cent of
its total commitment.
e. It provides refinancing activities through SFCs in different states
and other industrial loan- giving institutions.
f. It has provided indirect support to industry through subscriptions
to shares and bonds of financial institutions such as IDBI, IFCI,
ICICI, SFCs etc. at the time when they required initial capital. It
also directly subscribed to the shares of Agricultural Refinance
Corporation and SBI.
g. It gives loans to those projects which are important for national
economic welfare. The socially oriented projects such as
electrification, sewage and water channelising are given priority by
the LIC.
h. It nominates directors on the boards of companies in which it makes
its investments.

i. It gives housing loans at reasonable rates of interest.

j. It acts as a link between the saving and the investing process. It
generates the savings of the small savers, middle income group
and the rich through several schemes. Small and medium income
groups look upon the LIC for the element of protection as well as
for certain privileges like taking loans at the time of building a house
or receiving certain tax exemptions. The higher income group
consider it as a means of receiving full tax exemption when their
income is of a large amount. Out of the total of the fund the LIC
receives, it uses to play an influential role in the Indian capital market.
k. Formerly LIC has played a major role in the Indian capital market.
To stabilise the capital market, it has underwritten capital issues.
But recently it has moved to other avenues of financing. Now it has
become very selective in its underwriting pattern.
Life insurance Policies
Life insurance policies can be grouped into the following categories:
1. Term Policy
In case of Term assurance plans, insurance company promises the
insured for a nominal premium to pay the face value mentioned in
the policy in case he is no longer alive during the term of the policy.
It provides a risk cover only for a prescribed period. Usually, these
policies are short-term plans and the term ranges from one year
onwards. If the policyholder survives till the end of this period, the
risk cover lapses and no insurance benefit payment is made to
him.

2. Whole Life Policy

This policy runs for the whole life of the assured. The sum assured
becomes payable to the legal heir only after the death of the assured.
The whole life policy can be of three types.
(1) Ordinary whole life policy – In this case premium is payable
periodically throughout the life of the assured.
(2) Limited payment whole life policy – In this case premium is
payable for a specified period (Say 20 Years or 25 Years)
Only.
(3) Single Premium whole life policy – In this type of policy the
entire premium is payable in one single payment.
3. Endowment Life Policy
In this policy the insurer agrees to pay the assured or his nominees
a specified sum of money on his death or on the maturity of the
policy whichever is earlier. The premium for endowment policy is
comparatively higher than that of the whole life policy.
4. Health insurance schemes
An individual is subject to uncertainty regarding his health. He may
suffer from ailments, diseases, disability caused by stroke or
accident, etc. For serious cases the person may have to be
hospitalized and intensive medical care has to be provided which
can be very expensive. It is here that medical insurance is helpful
in reducing the financial burden.
5. Joint Life Policy
This policy is taken on the lives of two or more persons
simultaneously. Under this policy the sum assured becomes payable
on the death of any one of those who have taken the joint life
policy. The sum assured will be paid to the survivor(s). For example,
a joint life policy may be taken on the lives of husband and wife,
sum assured will be payable to the survivor on the death of the
spouse.
6. With Profit and Without Profit Policy
Under with profit policy the assured is paid, in addition to the sum
assured, a share in the profits of the insurer in the form of bonus.
Without profit policy is a policy under which the assured does not
get any share in the profits earned by the insurer and gets only the
sum assured on the maturity of the policy. With profit and without
profit policies are also known as participating and non–participating
policies respectively.
7. Double Accident Benefit Policy
This policy provides that if the insured person dies of any accident,
his beneficiaries will get double the amount of the sum assured.
8. Annuity Policy
Under this policy, the sum assured is payable not in one lump sum
payment but in monthly, quarterly and half-yearly or yearly
instalments after the assured attains a certain age. This policy is
useful to those who want to have a regular income after the expiry
of a certain period e.g., after retirement.
9. Policies for Women
Women, now a days are free to take life assurance policies.
However, some specially designed policies suit their needs in a
unique manner; important policies for women are

A. Jeevan Sathi is also known a Life Partner plan where the

husband and wife are covered under this endowment policy
B. Jeevan Sukanya
10. Group Insurance
Group life insurance is a plan of insurance under which the lives of
many persons are covered under one life insurance policy.
However, the insurance on each life is independent of that on the
other lives. Usually, in group insurance, the employer secures a
group policy for the benefit of his employees. Insurer provides
coverage for many people under single contract.
11. Policies for Children
Policies for children are meant for the various needs of the children
such as education, marriage, security of life etc.
12. Money Back Policy
In this case policy money is paid to the insured in a number of
separate cash payments. Insurer gives periodic payments of survival
benefit at fixed intervals during the term of policy as long as the
policyholder is alive.
7. National Industrial Development Corporation (NIDC)
The NIDC was set up in October 1954 as a statutory
corporation owned by the Government of India. Its functions are:
a) To formulate and execute projects for setting up new industries.
b) To provide consultancy services
c) To finance the rehabilitation and modernisation of certain industries,
such as, cotton and jute textiles and machine tools.

It is a financial PSU, a wing of Ministry of Commerce and Industry,

Government of India.
Its spectrum of services are Industrial planning and management,
project engineering, project/construction management, procurement,
technical and quality audit, social and industrial infrastructure, human
resource management, environment engineering, energy management
and software and IT development.
8. State Financial Corporations
The State Finance Corporations (SFCs) are an integral part of
institutional finance structure of a country. Where SEC promotes
small and medium industries of the states. Besides, SFC help in
ensuring balanced regional development, higher investment, more
employment generation and broad ownership of various
industries.
At present in India, there are 18 state finance corporations (out of
which 17 SFCs were established under the SFC Act 1951). Tamil
Nadu Industrial Investment Corporation Ltd. which is established
under the Company Act, 1949, is also working as state finance
corporation.
Organization and Management
A Board of ten directors manages the State Finance Corporations.
The State Government appoints the managing director generally in
consultation with the RBI and nominates the name of three other directors.
All insurance companies, scheduled banks, investment trusts,
co-operative banks, and other financial institutions elect three directors.
Thus, the state government and quasi-government institutions
nominate the majority of the directors.
Functions of State Finance Corporations

The various important functions of State Finance Corporations are:
(i) The SFCs provides loans mainly for the acquisition of fixed assets like
land, building, plant, and machinery.
(ii) The SFCs help financial assistance to industrial units whose paid-up
capital and reserves do not exceed Rs. 3 crores (or such higher limit
up to Rs. 30 crores as may be notified by the central government).
(iii) The SFCs underwrite new stocks, shares, debentures etc., of industrial
units.
(iv) The SFCs grant guarantee loans raised in the capital market by
scheduled banks, industrial concerns, and state co-operative banks
to be repayable within 20 years.
Working of SFCs
The Indian government passed the State Financial Corporation
Act in 1951. It is applicable to all the States.
The authorized Capital of a State Financial Corporation should
be within the minimum and maximum limits of Rs. 50 lakhs and Rs. 5
crores which are fixed by the State government.
It is divided into shares of equal value which were acquired by the
respective State Governments, the Reserve Bank of India, scheduled banks,
co-operative banks, other financial institutions such as insurance companies,
investment trusts, and private parties.
The State Government guarantees the shares of SFCs. The SFCs
can augment its fund through issue and sale of bonds and debentures also,
which should not exceed five times the capital and reserves at Rs. 10
Lakh.

Problems of State Financial Corporations

1. No Independent Organization
All SFCs are dependent upon the rules and regulations made by
the state government. SFCs’ problem is that all decision of these
institutions is dependent on the political environment of the state.
Due to this, the loan is not available at the right time for the right
person.
2. Corruption
Like other government offices of our country, we can also see the
evil of corruption in state financial corporation. Hoarding of wealth
and money, SFCs’ officer object has become to earn by a good or
bad way. That is the problem that these institutions have no proper
transparency like banks.
3. Effect of the World Bank and WTO Policies
Approx. all SFCs in India is tied up with World Bank and WTO
agreement. Due to this, these institutions’ decisions are influenced by
the World Bank and WTO policies. World Bank can easily pressurize
for accepting his policies. It may also influence the Indian small-scale
industry adversely.
Capital Market Instruments
1) Traditional instruments
This includes:
a. Equity shares
b. Preference shares and its various classes
c. Debentures and its types
d. bonds etc.,
2) Innovative/recent instruments
Some of the new financial instruments introduced in recent years
may be briefly explained as below:
1. Floating rate bonds:
The interest rate on these bonds is not fixed. It is a concept which
has been introduced primarily to take care of the falling market or
to provide a cushion in times of falling interest rates in the economy.
It helps the issuer to hedge the loss arising due to interest rate
fluctuations. In India, SBI was the first to introduce FRB for retail
investors.
2. Zero interest bonds:
These carry no periodic interest payment. These are sold at a huge
discount. These can be converted into equity shares or non-
convertible debentures
3. Deep discount bonds:
These bonds are sold at a large discount while issuing them. These
are zero coupon bonds whose maturity is very high (say, 15 years).
There is no interest payment. IDBI was the first financial institution
to offer DDBs in 1992.
4. Auction related debentures:
These are a hybrid of CPs and debentures. These are secured,
redeemable, non-convertible instrument. The interest on them is
determined by the market. These are placed privately with bids.
ANZ Grind lays designed this new instrument for Ashok Leyland
Finance.

5. Secured Premium Notes:

These are issued along with a detachable warrant. This warrant
gives the holder the right to apply for, or seek allotment of one
equity share, provided the SPN is fully paid. The conversion of
detachable warrant into equity shares is done within the time limit
notified by the company. There is a lock in period during which no
interest is paid for the invested amount. TISCO was the first
company to issue SPN (in 1992) to the public along with the right
issue.
6. Option bonds:
Option bonds can be converted into equity or preference shares at
the option of the investor as per the condition stated in the
prospectus. These may be cumulative or non-cumulative. In case
of cumulative bonds, the interest is accumulated and is payable at
maturity. In case of non- cumulative bonds, interest is payable at
periodic intervals.
7. Warrants:
A share warrant is an option to the investor to buy a specified
number of equity shares at a specified price over a specified period
of time. The warrant holder has to surrender the warrant and pay
some cash known as ‘exercise price’ of the warrant to purchase
the shares. On exercising the option, the warrant holder becomes
a shareholder. Warrant is yet to gain popularity in India, due to the
complex nature of the instrument.
8. Preference shares with warrants:
These carry a certain number of warrants. These warrants give the
holder the right to apply for equity shares at premium at any time in

one or more stages between the third and fifth year from the date
of allotment.
9. Non-convertible debentures with detachable equity warrants:
In this instrument, the holder is given an option to buy a specified
number of shares from the company at a predetermined price within
a definite time frame.
10. Zero interest fully convertible debentures:
On these instruments, no interest will be paid to the holders till the
lock in period. After a notified period, these debentures will be
automatically and compulsorily converted into shares.
11. Fully convertible debentures with interest:
This instrument carries no interest for a specified period. After this
period, option is given to apply for equities at premium for which
no additional amount is payable. However, interest is payable at a
predetermined rate from the date of first conversion to second /
final conversion and equity will be issued in lieu of interest.
12. Non-voting shares:
The Companies Bill,1997 proposed to allow companies to issue
non-voting shares. These are quasi -equity instruments with
differential rights. These shares do not carry voting right. Their
divided rate is also not predetermined like preference shares.
13. Inverse float bonds:
These bonds are the latest entrants in the Indian capital market.
These are bonds carrying a floating rate of interest that is inversely
related to short term interest rates.

14. Perpetual bonds:

These are debt instruments having no maturity date. The
investors receive a stream of interest payment for perpetuity.
Depositories
The term depository refers to a facility in which something is
deposited for storage or safeguarding or an institution that accepts
currency deposits from customers such as a bank or a savings
association. A depository can be an organization, bank, or institution
that holds securities and assists in the trading of securities. A
depository provides security and liquidity in the market, uses money
deposited for safekeeping to lend to others, invests in other securities,
and offers a funds transfer system. A depository must return the deposit
in the same condition upon request.
Depositories serve multiple purposes for the general public.
First, they eliminate the risk of holding physical assets to the owner.
For instance, banks other financial institutions give consumers a place
to deposit money into time and demand deposit accounts. A time deposit
is an interest-bearing account and has a specific date of maturity such
as a certificate of deposit (CD), while a demand deposit account holds
funds until they need to be withdrawn such as a checking or savings
account. Deposits can also come in the form of securities such as
stocks or bonds. When these assets are deposited, the institution
holds the securities in electronic form also known as book-entry form,
or in dematerialized or paper format such as a physical certificate.
These organizations also help create liquidity in the market.
Customers give their money to a financial institution with the belief the
company holds it and gives it back when the customer wants it back.
These institutions accept customers’ money and pay interest on their
deposits

over time. While holding the customers’ money, the institutions lend it
to others in the form of mortgage or business loans, generating more
interest on the money than the interest paid to customers.
Transferring the ownership of shares from one investor’s
account to another account when a trade is executed is one of the
primary functions of a depository. This helps reduce the paperwork for
executing a trade and speeds up the transfer process. Another function
of a depository is the elimination of risk of holding the securities in
physical form such as theft, loss, fraud, damage, or delay in deliveries.
An investor who wants to purchase precious metals can
purchase them in physical bullion or paper form. Gold or silver bars or
coins can be purchased from a dealer and kept with a third- party
depository. Investing in gold through futures contracts is not equivalent
to the investor owning gold. Instead, gold is owed to the investor.
A trader or hedger looking to take actual delivery on a futures
contract must first establish a long (buy) futures position and wait until
a short (seller) tenders a notice to delivery. With gold futures contracts,
the seller is committing to deliver the gold to the buyer at the contract
expiry date. The seller must have the metal in this case, gold in an
approved depository. This is represented by holding COMEX approved
electronic depository warrants which are required to make or take
delivery.
Types of Depositories
The three main types of depository institutions are credit unions,
savings institutions, and commercial banks. The main source of funding
for these institutions is through deposits from customers. Customer
deposits and accounts are insured by the Federal Deposit Insurance
Corporation (FDIC) up to certain limits.
Credit unions are non-profit companies highly focused on

customer services. Customers make deposits into a credit union account,
which is similar to buying shares in that credit union. Credit union earnings
are distributed in the form of dividends to every customer.
Savings institutions are for-profit companies also known as
savings and loan institutions. These institutions focus primarily on
consumer mortgage lending but may also offer credit cards and
commercial loans. Customers deposit money into an account, which
buys shares in the company. For example, a savings institution may
approve 71,000 mortgage loans, 714 real estate loans, 340,000 credit
cards, and 252,000 auto and personal consumer loans while earning
interest on all these products during a single fiscal year.
Commercial banks are for-profit companies and are the largest
type of depository institutions. These banks offer a range of services to
consumers and businesses such as checking accounts, consumer and
commercial loans, credit cards, and investment products. These
institutions accept deposits and primarily use the deposits to offer
mortgage loans, commercial loans, and real estate loans.
A Depository can be compared with a bank, which holds the
funds for depositors. An analogy between a bank and a depository
may be drawn as follows (table 3.2):

Table3.2
BANK DEPOSITORY
Holds funds in an account Hold securities in an account
Transfers funds between accounts Transfers securities between
on the instruction of the account accounts on the instruction of
holder the account holder.
Facilitates transfers without having Facilitates transfers of
to handle money ownership without having to
handle securities.
Facilitates safekeeping of Money Facilitates safekeeping of
shares.
There are two depositories in India which provide

dematerialization of securities. The National Securities Depository
Limited (NSDL) and Central Depository Services (India) Limited
(CDSL).
The benefits of participation in a depository
The benefits of participation in a depository are:
• Immediate transfer of securities
• No stamp duty on transfer of securities
• Elimination of risks associated with physical certificates such as bad
delivery, fake securities, etc.
• Reduction in paperwork involved in transfer of securities
• Reduction in transaction cost

• Ease of nomination facility

• Change in address recorded with DP gets registered electronically
with all companies in which investor holds securities eliminating the
need to correspond with each of them separately.
• Transmission of securities is done directly by the DP eliminating
correspondence with companies
• Convenient method of consolidation of folios/accounts
• Holding investments in equity, debt instruments and Government
securities in a single account; automatic credit into demat account,
of shares, arising out of split/consolidation/merger etc.
A Depository Participant (DP)
The Depository provides its services to investors through its
agents called depository participants (DPs). These agents are appointed
by the depository with the approval of SEBI. According to SEBI
regulations, amongst others, three categories of entities, i.e. Banks,
Financial Institutions and SEBI registered trading members can become
DPs. Normally brokers and banks themselves offer DP services in order
to provide all services to the investors through a single window.
Features:
1. One need not to keep any minimum balance of securities in his
account with his DP. That is depository has not prescribed any
minimum balance. You can have zero balance in your account.
2. ISIN (International Securities Identification Number) is a unique
identification number for a security.
3. A Custodian is basically an organisation, which helps register and
safeguard the securities of its clients. Besides safeguarding securities,
a custodian also keeps track of corporate actions on behalf of its
clients. A custodian is also responsible for the following functions:

• Maintaining a client’s securities account
• Collecting the benefits or rights accruing to the client in respect
of securities
• Keeping the client informed of the actions taken or to be taken
by the issue of securities, having a bearing on the benefits or
rights accruing to the client.
4. One can convert physical holding into electronic holding i.e., he
can dematerialise securities. In order to dematerialise physical
securities, one has to fill in a Demat Request Form (DRF) which is
available with the DP and submit the same along with physical
certificates one wishes to dematerialise. Separate DRF has to be
filled for each ISIN number.
5. Odd lot share certificates can also be dematerialised.
6. Dematerialised shares do not have any distinctive numbers. These
shares are fungible, which means that all the holdings of a particular
security will be identical and interchangeable.
7. The electronic holdings be converted into Physical certificates. The
process is called Rematerialisation. If one wishes to get back your
securities in the physical form one has to fill in the Remat Request
Form (RRF) and request your DP for rematerialisation of the
balances in your securities account.
8. One can dematerialise his debt instruments, mutual fund units,
Government securities in his demat account. And also hold all
such investments in a single demat account.
Discount and Finance House of India
Pursuant to the Vaghul Working Group recommendation for

setting up an institution to provide enhanced liquidity to the money market

instruments, the RBI set up the Discount and Finance House of India
(DFHI) jointly with public sector banks and the all-India financial
institutions.
DFHI was incorporated in March 1988 and it commenced
operation in April 1988. The main objective of this money market
institution is to facilitate smoothening of the short-term liquidity
imbalances by developing an active secondary market for the money
market instruments. Its authorized capital is Rs. 250 crores.
DFHI participates in transactions in all the market segments, it
borrows and lends in the call, notice and term money market, purchases
and sells treasury bills sold at auctions, commercial bills, CDs and CPs.
DFHI quotes its daily bid (buying) and offer (selling) rates for money
market instruments to develop an active secondary market for all these.
Treasury bills are not bought back by the RBI before maturity.
Similarly, except at the fortnightly auctions these cannot be purchased
from the RBI. DFHI fills this gap by buying and selling these bills in the
secondary market. The presence of DFHI in the secondary market has
facilitated corporate entities and other bodies to invest their short-term
surpluses and to en cash them when necessary.
The RBI extends reliance limit to the DFHI against the collateral
of treasury bills and against the holdings of bills of exchange with a view
to imparting liquidity to various money market instruments.
The enhancement of such limits from time to time enabled the
DFHI to provide higher and higher levels of liquidity in the period of
stringency witnessed in the money market. In the aftermath of the
irregularities in transactions in money and securities markets which
emerged in 1992, there was a reduction in overall trading volumes in
almost all segments of the money market.
The DFHI’s business turnover in certain segments viz. treasury

bills and commercial bills continues to remain subdued even during
1993-94. The easy conditions prevailing in the call money market
discouraged secondary market transactions in the treasury bills. Both
the 91 days and 364 days treasury bills are becoming preferred
instruments in the money market.
Following the steps taken by the RBI in the last year to ensure
that recourse to bill finance takes place only in respect of genuine bills
of exchange arising from movement of goods and within the credit limits
of borrowers, the volume of bills available for discount/rediscount has
reduced.
Stock Holding Corporation of India
Stock Holding Corporation of India Limited (SHCIL) is India’s
largest custodian and depository participant, based in Mumbai,
Maharashtra.
SHCIL was established in 1986 as a Public Limited Company
and is a subsidiary of IFCI. SHCIL is known for its online trading
portal, with investors and traders. It is also responsible for e-stamping
system around India. It is also authorised by Reserve Bank of India as
Agency Bank to distribute and receive Government of India savings/
relief bond 2003 along with nationalized banks.
The Stock Holding Corporation has three subsidiaries:
• SHCIL Services Ltd (stock brokering services)
• Stock Holding Document Management Services Limited
(provides end-to-end document storage and digitization
services)

• Stock Holding Securities IFSC Limited (A SEBI registered

intermediary operating out of GIFT IFSC, Gandhinagar, Gujarat
and cetering to Eligible Foreign Investors (EFIs), FPIs and NRIs
from FATF compliant jurisdictions as of now)
Operations
1. Domestic presence
SHCIL has over 200 branches and in 100 cities around India, it
currently caters to 50+ million customers.
2. GIFT IFSC presence
SHCIL’s subsidiary, Stock Holding Securities IFSC Limited, is
operating out of India’s first International Financial Services Centre
at GIFT City, Gandhinagar, Gujarat, catering to EFIs (Eligible
Foreign Investors), FPIs & NRIs from FATF compliant jurisdictions
as of now.
3. E-Stamping
The main e-stamping facility was opened on 3 July 2008 in New
Delhi, India and was inaugurated by Chief Minister Sheila Dikshit.
The goal of the e-stamp was to “prevent paper and process-related
fraudulent practices” according to the SHICL chairman and
managing director at that time, RC Razdan. It implemented the
e-stamping facility in five cities of Gujarat - Ahmedabad,
Gandhinagar, Surat, Rajkot and Baroda – as well as Bangalore, in
March 2008.
Products and services
Stock Holding offers numerous financial services along three
main branches: personal, corporate and custodial services.

1. Personal services
Some of the personal services they offer include:
• Demat Account
• Insurance
• Mutual Funds
• NPS (Retirement)
• GOI Bonds (Government of India)
• IPOs
• Stock Holding
2. GoldRush
A platform that allows users to buy gold online and is one of the
only two ways to do so in India.
3. Corporate services
• Demat services for business
• CSGL services (government bonds)
• Trading accounts
• NPS accounts
• Bullion (gold and silver) 4.Custodial services
Custodial services include any safekeeping, administration,
transaction and further activities done on behalf of a company by
its custodian, and include:
• Fund accounting
• FDI (Foreign Direct Investment)
• Company Valuation

• Vaults
• Customized Reporting
• Electronic and Physical Safekeeping Services
• Clearing and Settlement Services
Securities Trading Corporation of India
STCI Finance Ltd (formerly Securities Trading Corporation of
India Limited), is a Systemically Important Non-Deposit taking NBFC
registered with Reserve Bank of India (RBI). Presently STCI Finance
Ltd is classified as a loan NBFC.
In May 1994, STCI Finance Limited was promoted by RBI
with the main objective of fostering an active secondary market in
Government of India Securities and Public Sector bonds. RBI owned
a majority stake of 50.18 per cent in the paid-up share capital of the
company. In 1996, the Company was accredited as the first Primary
Dealer in the India. As one of the leading Primary Dealers in the country,
the Company was a market maker in government securities, corporate
bonds and money market instruments. Its other lines of activities included
trading in interest rate swaps and trading in equity - cash & derivatives
segment. The Company enjoyed a successful track record of achieving
profits during consecutive years spanning nearly a decade. RBI divested
its entire shareholding in STCI in two stages- first in 1997 to bring it
down from 50.18 per cent to 14.41per cent and the balance in 2002 to
the existing shareholders. Bank of India became the largest shareholder
in the company with 29.96 per cent stake.
In order to diversify into new activities, the Company hived off
its Primary Dealership business to its separate 100 per cent subsidiary,
STCI Primary Dealer Limited (STCI-PD) in June 2007. Since year
2007, the Company has been undertaking lending and investment
activities with its main focus on lending/ financing activities. With growth
in the size of the Look Book, the lending activity became the core
business of the Company and STCI Finance Limited was classified as
a Loan NBFC. With a view to reflecting the lending/ financing business
of the Company, the name of the Company was changed from Securities
Trading Corporation of India to ‘STCI Finance Limited’ with effect
from October 24, 2011.
STCI Finance Limited is a diversified mid-market B2B NBFC
offering its product and services across multiple locations in the areas
of Capital Markets, Real Estate, Corporate Finance and Structured
Finance.
Subsidiaries:
STCI Primary Dealer Limited (STCI PD)
This company is a wholly owned subsidiary of STCI Finance
Limited established consequent to the hiving off of the Company’s
primary dealership business in line with the Reserve Bank of India
guidelines on diversification of business activities by primary dealers.
The Company undertakes trading in government securities, corporate
bonds, money market instruments, interest rate swaps and trading in
equity.
STCI Commodities Limited
This company is a wholly owned subsidiary of STCI Finance
Limited. The Company has discontinued its commodity broking
operations with effect from September 20, 2011 and has also
surrendered its membership with Multi Commodity Exchange (MCX)
and National Commodity and Derivative Exchange (NCDEX).

Securities and Exchange Board of India (SEBI)

The SEBI of India was established in April 1988. It has been
functioning the full administrative control of the Government of India. It
works under the guidance of Ministry of Finance. It is the agent of the
Central Government in capital market. It is established for the regulation
and orderly functioning of the stock exchanges. It also works for
protecting the investor’s rights, prevents malpractices in security trading
and promotes healthy growth of the capital markets. It was granted
statutory status in 1992 under SEBI Act. It has the full authority to
control, regulate, monitor and direct the capital markets. It is the
watchdog of the securities market. It is the most powerful organ of the
Central Government in the capital market. After the repeal of the
Capital Issue Control Act and abolition of the CCI the SEBI was given
full powers on the new issue market and stock market. It has been
issuing guidelines since April 1992 for all financial intermediaries in the
capital market. The guidelines have been issued with the objective of
investor protection. The guidelines also include the obligations of
merchant bankers in respect of free pricing, disclosure of all correct
and true information and to Incorporate the highlights and risk factors
in investment in each issue through the prospectus. It has been
established for the healthy development and regulation of the capital
market.
Objectives of the SEBI
The main objectives of the SEBI are
9 To save the rights and interests of investors particularly individual
investors and to guide and educate them.
9 To prevent trading malpractices like rigging the price, insider trading,
misleading statements in prospectus, etc.

9 To regulate stock exchanges and the securities market to promote

their orderly functioning.
9 To registering and regulating the working of stock brokers,
sub-brokers etc
9 To promote the development of Securities Market;
9 To Promoting and regulating self-regulatory organizations.
The SEBI is a very powerful and important organ in the capital
market. It represents the Central Government. It is a statutory body in
the capital market. It leads, monitors, regulates and controls the activities
of the capital market. The organization has divided its activities into the
five operational departments. Each department will be headed by an
executive director. The Legal department and investigation department
also are headed by the executive directors.
The following are the main departments which are functioning in the
organization:
1. Primary Market Department:
The Primary market department is the most important division in
the organization of the SEBI. It deals with the new issue market
activities. It is headed by a division chief with specific
responsibilities. It relates to the policy matters of the public issues.
It looks after all the regulatory issues for the primary market in
India. It also involves in regulatory matters with regard to the
financial intermediaries. It also looks after the investor grievances.
It deals with the investor complaints for refund of application money
for non-allotted refund of excess money, non-receipt of dividends,
non-receipt of share certificates etc. Therefore, it has the full
authority with reference to the public issues.

2. Issue Management and Intermediaries Department:

This particular department will take care about the critical
examination of offer document. The offer document is the most
important paper in public issue. It is the tool for attracting the
investors. It is the basic document which is promised by the
company to the newly becoming shareholders. The offer document
should contain only facts and a right projection about the future.
Some companies can misguide the investors by creating a gloomy
picture about their product and company. Therefore, this
department shall closely monitor the contents of the offer
documents. This department also involve in the registration of the
financial intermediary. It also monitors the activities of various
financial intermediaries.
3. Secondary Market Department:
It occupies a vital role in the regulation of the capital market
operations. It takes into account framing the policy matters
regarding stock exchange activities. It controls the secondary
market activities. It also guides and monitors the stock exchange
administration. It continuously monitors the price movements in
the stock market. It involves in the development of new investment
products. It closely observes the market movements and gathers
information through market surveillance. It also looks about the
insider trading practices. It makes the policy and also develops
the regulatory matters. It is basically done for the secondary markets
in India. Also, it gives directions to the administration of stock
exchange authorities on various matters. It also takes into the affairs
of stock exchanges administration inspection by making inquiry
towards financial intermediaries. It also regulates the sub-brokers
activities.

4. The Institutional Investment Department:

This department makes various the policy matters in regard to the
institutional investors. These are more important in the capital
market. They will keep the higher amount of investment in the stock
markets. They are involved in the buying and selling of shares with
crores of investment. The following members will be treated as
institutional investors:
(a) Mutual funds.
(b) FII (Foreign Institutional Investors).
(c) Corporate investors.
(d) Institutional investors.
It takes care of mergers and acquisitions in the corporate sector. It
also concentrates on research and publications. It also maintains
international relations in the process of globalization. It makes the
policy matters for investors who are institutional. The education of
the investor has also emerged as a important part of SEBI’s efforts
to protect the interest of the investors in securities market.
5. Legal Department:
The legal department undertakes the job of providing legal advisory
services to the organization. It also handles all litigations and other
legal issues.
6. Depositories Department:
This department regulates and promotes the market for derivative
instruments. 7.Takeover department:
This department takes care of the substantial acquisition of shares
and takeovers of companies.
Functions of SEBI
SEBI has the responsibility to safeguard the interests of the investors in
securities and to enhance the development of, and regulation of the
securities market by such measures as it thinks fit. The measures referred
to therein may provide for: -
1. Protective Functions:
• It stops and bans unfair trade practices in the securities
market, e.g., price rigging, market misleading statements in
prospectus manipulations etc.
• It controls insider trading and imposes penalties for such
practices.
• It undertakes steps for investors protection
• It promotes fair practices and code of conduct in securities
market.
2. Regulatory Functions:
• It involves regulation of the business in security markets and
other stock exchanges;
• It involves registration and regulation of the working of a variety
of agents such as stock brokers share transfer agent, bankers
and sub brokers to a given issue, trustees belonging to trust
deeds, registrars for a particular issue, underwriters, merchant
bankers, portfolio managers, investment advisers and many
other intermediaries who may be associated with securities
markets in any manner;
• Registration and regulation of participants working,
depositories, custodians of securities, FNIS, credit rating

agencies and many other intermediaries for example SEBI may,

by notification, specify in this behalf;
• Registration and regulation in the working of venture capital
funds and collective investment schemes which includes mutual
funds; regulating substantial acquisition of shares and takeover
of companies;
• promoting and regulating self-regulatory organizations;
3. Development Functions:
• Promotion of the education of investors and their training of
intermediaries of securities markets;
• Banning any company to issue prospectus, any offer
document, or advertisement soliciting money from the public
for the issue of securities,
• For conducting research and publication of information that
is useful to all market participants.
Powers of SEBI
The powers have been given to the SEBI with the enactment of
SEBI Act, 1992. They are:
1. Regulating the business activities in the capital market.
2. Power to grant registration to financial intermediaries.
3. Register and regulate how the depositories work. Working of
custodians, FIIs, credit rating agencies is also seen
4. Registering and regulating the working of venture capital funds
and mutual funds.

5. Power to grant approval to bye-laws of recognized exchanges.

6. Power to prohibit insider trading.
7. Power to compel listing of securities by public companies.
8. Power to control and regulate stock exchanges.
9. Power to call for any information or explanation from recognized
stock exchanges or its members.
10. Power to levy fee.
11. Power to regulate substantial acquisition of shares and takeover
of companies.
12. Power to promote and regulate self-regulatory bodies.
13. Stopping fraud and unfair trade practices which relate to the
securities markets.
14. Promotion of investors, education and training.
15. Performing any other functions as may be assigned by the
government from time-to-time.
Capital market reforms in India since 1991
Capital market reforms to the institutional arrangements for long
term lending and borrowings with a view to increase number of services
to introduce improved practices, the Government had various reforms
of capital market in the post reforms era (1992) few of those are
discussed below: -
1. General Reforms:
i. Statutory Status to SEBI:With an act of parliament, statutory
status was given to SEBI from March 31, 1992. It was

provided with the necessary power to control regulate and

supervise stock market.
ii. Permission to foreign institutional investors:
Investment norms for NRIs have been liberalized so as to
attract more funds into the capital market. The foreign
institutional investors can invest into the Indian Capital Market
on registration with SEBI.
iii. Permission to Indian Companies:
Indian companies have been permitted to raise capital for
modernization and raise capital from the international capital
market.
2. Reforms of Primary Market:
The important reforms of Indian primary market areas under:
1. Merchant banking has been brought under the regulation act of
SEBI.
2. Companies are required to disclose all material facts and specific
risk factors, which are associated with their project while making
public issues.
3. Stock exchanges are required to ensure that the companies should
have a valid acknowledgement card issued by SEBI. In other
words, the companies should fulfil all the requirements to be listed
in the stock market as per SEBI guidelines.
4. SEBI has also introduced a code of advertisement for public issue
to ensure fair and truthful disclosures.

3. Reforms of Secondary Market:

i. Unit Trust of India has been brought under the regulatory
jurisdiction of SEBI.
ii. Private Mutual Funds have been permitted and all Mutual Funds
are allowed to apply for firm allotment in public issues.
iii. Fresh guidelines were issued for advertising mutual funds.
iv. SEBI has also introduced capital adequacy norms for brokers
and main rules for marking client broker relationship more
transparent.
v. SEBI also issued guidelines to make the governing body of
stock exchange broader based. It should have 5 elected
members not more than 4 members are nominated by SEBI
and 3 or 4 members are nominated as public representatives
further an Executive Director will also be there.

Module IV
DERIVATIVES MARKET
Derivative securities are financial instruments that are based on
other assets. In this one sense, they are similar securitized assets.
However, derivative securities, unlike securitized assets, are not
obligations backed by the original issuer of the underlying security.
Instead, derivative securities are contracts between two parties other
than the original issuer of the underlying security derivative securities
have evolved to help protect investors from certain risks:
A manufacturer of cereal products is dependent on the grain
market for inputs for its finished products. If the crops during a
particular year are damaged by drought or other unfavourable
conditions, the price of grain (and the manufacturer’s cost of
doing business) will increase.
The owner of a large block of stock may fear that the stock’s
price will decline. such a decline occurs, the investor will sustain
large losses.
A commercial bank may need to offer relatively long term, fixed-
rate loans in order to be competitive with other financial
institutions. If interest rates increase significantly, the bank
will incur a significant opportunity cost in the form of lost interest
income.
All of these are financial risks that derivative securities can help reduce.
The food manufacturer can lock in the price of grain by buying a futures
contract. The owner of the common stock can guard against losses by
buying an option to sell the stock at a predetermined price. The
commercial bank can enter into a swap contract to receive interest

payments that vary with market condition.
The derivatives market refers to the financial market for financial
instruments such as underlying assets and financial derivatives
Participants in the derivative markets
The participants in the derivatives market can be broadly categorized
into the following four groups:
1. Hedgers
Hedging is when a person invests in financial markets to reduce the
risk of price volatility in exchange markets, i.e., eliminate the risk
of future price movements. Derivatives are the most popular
instruments in the sphere of hedging. It is because derivatives are
effective hedges in correspondence with their respective underlying
assets.
2. Speculators
Speculation is the most common market activity that participants
of a financial market take part in. It is a risky activity that investors
engage in. It involves the purchase of any financial instrument or an
asset that an investor speculates to become significantly valuable in
the future. Speculation is driven by the motive of potentially earning
lucrative profits in the future
3. Arbitrageurs
Arbitrage is a very common profit-making activity in financial
markets that comes into effect by taking advantage of or profiting
from the price volatility of the market. Arbitrageurs make a profit

from the price difference arising in an investment of a financial

instrument such as bonds, stocks, derivatives, etc.
4. Margin traders
In the finance industry, the margin is the collateral deposited by an
investor investing in a financial instrument to the counterparty to
cover the credit risk associated with the investment
Types of Derivative Contracts
Derivative contracts can be classified into the following four types:
1. Options
Options are financial derivative contracts that give the buyer the
right, but not the obligation, to buy or sell an underlying asset at a
specific price (referred to as the strike price) during a specific period
of time. American options can be exercised at any time before the
expiry of its option period. On the other hand, European options
can only be exercised on its expiration date.
2. Futures
Futures contracts are standardized contracts that allow the holder
of the contract to buy or sell the respective underlying asset at an
agreed price on a specific date. The parties involved in a futures
contract not only possess the right but also are under the obligation,
to carry out the contract as agreed. The contracts are standardized,
meaning they are traded on the exchange market.
3. Forwards
Forwards contracts are similar to futures contracts in the sense
that the holder of the contract possess not only the right but is also
under the obligation to carry out the contract as agreed. However,

forwards contracts are over the counter products, which means

they are not regulated and are not bound by specific trading rules
and regulations.
Since such contracts are unstandardized, they are traded over the
counter and not on the exchange market. As the contracts are not
bound by a regulatory body’s rules and regulations, they are
customizable to suit the requirements of both parties involved
4. Swaps
Swaps are derivative contracts that involve two holders, or parties
to the contract, to exchange financial obligations. Interest rate swaps
are the most common swaps contracts entered into by investors.
Swaps are not traded on the exchange market. They are traded
over the counter, because of the need for swaps contracts to be
customizable to suit the needs and requirements of both parties
involved.
Uses of Derivatives
Derivatives can be used to hedge a position, speculate on the
directional movement of an underlying asset, or give leverage to holdings.
Their value comes from the fluctuations of the values of the underlying
asset.
Originally, derivatives were used to ensure balanced exchange
rates for goods traded internationally. With the differing values of national
currencies, international traders needed a system to account for
differences. Today, derivatives are based upon a wide variety of
transactions and have many more uses. There are even derivatives based
on weather data, such as the amount of rain or the number of sunny
days in a region.

For example, imagine a European investor, whose investment

accounts are all denominated in euros (EUR). This investor purchases
shares of a U.S. company through a U.S. exchange using
U.S. dollars (USD). Now the investor is exposed to exchange
rate risk while holding that stock. Exchange-rate risk the threat that the
value of the euro will increase in relation to the USD. If the value of the
euro rises, any profits the investor realizes upon selling the stock become
less valuable when they are converted into euros.
To hedge this risk, the investor could purchase a currency
derivative to lock in a specific exchange rate. Derivatives that could be
used to hedge this kind of risk include currency futures and currency
swaps. A speculator who expects the euro to appreciate compared to
the dollar could profit by using a derivative that rises in value with the
euro. When using derivatives to speculate on the price movement of an
underlying asset, the investor does not need to have a holding or
portfolio presence in the underlying asset.
OPTIONS
This is an agreement that confers the right to buy or sell an
asset at a set price through some future date. The right is exercisable at
the discretion of the option buyer. Like futures, options are traded on
organized exchanges and guaranteed by the exchange on which they
trade. Unlike futures purchasers, options purchasers are not obligated
to take any action on or before the maturity date. If the option confers
the right to purchase it is a call option. A put option confers the right to
sell. The option buyer will either exercise the option (if is profitable to
do so) or elect to not exercise. The relationship between the price at
which the option can be exercised (the strike price), and the market
price of the asset determine the profitability of exercising. The owner

of a call option will exercise if the market price is sufficiently above the
strike price. Exercising the call option enables the investor to purchase
the asset below its current market value and resell at the higher market
price.
Conversely, the owner of a put option will exercise if the market
price is sufficiently below the strike price, because the asset can be
bought at the lower market price and immediately sold for the higher
strike price. Thus, the owner of a large block of common stock can
purchase a put option on the stock with a strike price at or near the
current market price; should the market price decline in the future, the
owner can exercise the option to sell at the higher strike price. When it
is profitable to exercise an option, the option is in the money. When it is
out of the money, exercising is unprofitable. An option buyer obtains
the right to buy or sell by paying a fee, or premium, to an option writer,
or seller. This premium depends on the current market price, the strike
price, and volatility of the price of the asset. Volatility is an important
factor because the market value of a relatively volatile asset is more
likely to reach a given strike price than a less volatile asset, all other
things being equal. An option can be written so that the buyer can
exercise either any time up to the expiration date or only on the expiration
date. The first is an American option, the second a European option.
The four different roles market participants may play in the
options market are to: Buy a call and obtain the right to buy the asset.
Write (sell) a call and make a commitment to sell the asset, if the option
is exercised. Write (sell) a put and make a commitment to buy the
asset, if the option is exercised Buy a put and obtain the right to sell the
asset. The buyer of an option will lose no more than the premium paid
at the time of purchase. But the writer can lose much more.

Types of Options
1.Call Options
A call option gives the purchaser (or buyer) the right to buy an
underlying security (e.g., a stock) at a prespecified price called the
exercise or strike price (X). In return, the buyer of the call option must
pay the writer (or seller) an up-front fee known as a call premium (C).
This premium is an immediate negative cash flow for the buyer of the
call option. However, he or she potentially stands to make a profit
should the underlying stock’s price be greater than the exercise price
(by an amount exceeding the premium). If the price of the underlying
stock is greater than X (the option is referred to as “in the money”), the
buyer can exercise the option, buying the stock at X and selling it
immediately in the stock market at the current market price, greater
than X. If the price of the underlying stock is less than X (the option is
referred to as “out of the money”), the buyer of the call would not
exercise the option (i.e., buy the stock at X when its market value is
less than X). If this is the case when the option matures, the option
expires unexercised. The same is true when the underlying stock price
is exactly equal to X when the option expires (the option is referred to
as “at the money”). The call buyer incurs a cost C (the call premium)
for the option, and no other cash flows result.
2. A Put Option
A put option gives the option buyer the right to sell an underlying
security (e.g., a stock) at a prespecified price to the writer of the put
option. In return, the buyer of the put option must pay the writer (or
seller) the put premium (P). If the underlying stock’s price is less than
the exercise price (X) (the put option is “in the money”), the buyer will
buy the underlying stock in the stock market at less than X and

immediately sell it at X by exercising the put option. If the price of the

underlying stock is greater than X (the put option is “out of the money”),
the buyer of the put option would not exercise the option (i.e., selling
the stock at X when its market value is more than X). If this is the case
when the option matures, the option expires unexercised. This is also
true if the price of the underlying stock is exactly equal to X when the
option expires (the put option is trading “at the money”). The put option
buyer incurs a cost P for the option, and no other cash flows result.
3. An American option gives the option holder the right to buy or sell
the underlying asset at any time before and on the expiration date of the
option. A European option (e.g., options on the S&P 500 Index) gives
the option holder the right to buy or sell the underlying option only on
the expiration date. Most options traded on exchanges in the United
States and abroad are American options.
4. Stock Options.
The underlying asset on a stock option contract is the stock of a
publicly traded company. One option generally involves 100 shares of
the underlying company’s stock. Thesame stock can have many different
call and put options differentiated by expiration and strike price. Further,
the quote gives an indication of whether the call and put options are
trading in, out of, or at the money. For example, the American Airlines
call option with an exercise price of Rs.6.00 is trading in the money
(Rs.6.00 is less than the current stock price, Rs.6.27), while the call
options with an exercise price of Rs.7.00 are trading out of the money
(Rs.7.00 is greater than the current stock price, Rs.6.27). The exact
opposite holds for the put options. That is, the put option with an exercise
price of Rs.6.00 is trading out of the money (Rs.6.00 is less than the
current stock price, Rs.6.27), while the put options with an exercise

price of Rs.7.00 are trading in the money (Rs.7.00 is greater than the
current stock price, Rs.6.27).
5. Credit Options
Options also have a potential use in hedging the credit risk of a
financial institution. Compared to their use in hedging interest rate risk,
options used to hedge credit risk are a relatively new phenomenon.
Two alternative credit option derivatives exist to hedge credit risk on a
balance sheet: credit spread call options and digital default options. A
credit spread call option is a call option whose payoff increases as the
(default) risk premium or yield spread on a specified benchmark bond
of the borrower increases above some exercise spread. A financial
institution concerned that the risk on a loan to that borrower will increase
can purchase a credit spread call option to hedge its increased credit
risk. A digital default option is an option that pays a stated amount in
the event of a loan default (the extreme case of increased credit risk).
In the event of a loan default, the option writer pays the financial
institution the par value of the defaulted loans. If the loans are paid off
in accordance with the loan agreement, however, the default option
expires unexercised. As a result, the institution will suffer a maximum
loss on the option equal to the premium (cost) of buying the default
option from the writer (seller).
Different Uses of Options:
There are a number of reasons for being either a writer or a
buyer of options. The writer assures an uncertain amount of risk for a
certain amount of money, whereas the buyer assures an uncertain
potential gain for a fixed cost. Such a situation can lead to a number of
reasons for using options.

However, fundamental to either writing or buying an option is

the promise that option is fairly valued in terms of the possible outcomes.
If the option is not fairly priced then, of course, an additional source of
profit or loss is introduced, and the writer or buyer of such a contract
may be subject to an additional handicap that will reduce his or her
return.
The reasons for writing option contracts are varied, but three
of the most common are to cash additional income on a securities
portfolio, the fact that option buyers are not as sophisticated as writers,
and to hedge a long position.
It is sometimes argued that option writing is a source of
additional income for the portfolio of an investor with a large portfolio
of securities. Such an approach assumes that the portfolio manager can
guess the direction of specific stock prices closely rough to make this
strategy worth-while.
What cannot be overlooked is that the writer gives up certain
rights when the option is written. For example, suppose a call option is
written. In this case, the writer would presumably cover the call by
giving up securities from his or her portfolio. Hence, the writer is giving
up any appreciation beyond the striking price plus the option premium.
Second, it is believed by some that the buyer of options is not
as sophisticated as the writers. The proponents of this view argue that
option writers are the most sophisticated participants in the securities
market and view argue that option premiums simply as additional income.
However, it should be held that this view pre-supposes that the
buyers are “lambs ready to be shorn” whether this view is correct or
not is unclear, but it follows that over the long-term they may find option
writing an unprofitable undertaking.
There are a number of reasons for buying options; two of the

most common are leverage and changing the risk complexion of a
portfolio. The term leverage in connection with options indicates buyer
being able to control more securities than could be done with realistic
margin requirements.
In other words, with the use of margins, the buyer of securities
can but more securities and hopefully make a greater profit than could
be done by taking a basic long position. Puts and calls can be used in
much the same fashion and perhaps provide a higher return.
For example, suppose an investor has Rs. 50,000 to invest in
securities and that call options can be purchased for Rs. 5,000. The
remaining Rs. 45,000 can be invested in short-term securities, the interest
earned on the short-term securities would reduce the cost of the call
options, and if the stock did appreciate, the portfolio would participate
in the appreciation.
Another reason of buying options is to change the risk
complexion of a portfolio of securities. It should be noted that this
benefit of options is available not only to buyers but also to writers.
Therefore, they permit the portfolio manager to undertake as
much or as little risk as he or she feels is appropriate at a point of time.
They also give additional flexibility in setting the amount or risk the
portfolio manager is willing to accept with respect to a specific portfolio.
Platforms for Options Trade
1. Markets Used to Trade Options
The Chicago Board Options Exchange (CBOE), which was
created in 1973, is the most important exchange for trading options. It
serves as a market for options on more than 2,000 different stocks.

The options listed on the CBOE have a standardized format, as will be

explained shortly. The standardization of the contracts on the CBOE
proved to be a major advantage because it allowed for easy trading of
existing contracts (a secondary market). With standardization, the
popularity of options increased and the options became more liquid.
Since there were numerous buyers and sellers of the standardized
contracts, buyers and sellers of a particular option contract could be
matched.
Options are also traded at the CME Group, which was formed
in July 2007 by the merger of the Chicago Board of Trade (CBOT)
and the Chicago Mercantile Exchange (CME). To increase efficiency
and reduce operating and maintenance expenses after the merger, the
CME Group consolidated the CME and CBOT trading floors into a
single trading floor at the CBOT and consolidated the products of the
CME and CBOT on a single electronic platform. Transactions of new
derivative products typically are executed by the CME Group’s
electronic platform.
As the popularity of stock options increased, various stock
exchanges began to list options. In particular, the American Stock
Exchange (acquired by NYSE Euronext in 2008), the Nasdaq, and
the Philadelphia Stock Exchange (acquired by Nasdaq in 2008) list
options on many different stocks. So does the International Securities
Exchange, which was the first fully electronic U.S. options exchange.
Today, any particular options contract may be traded on various
exchanges, and competition among the exchanges may result in more
favourable prices for customers.
Some specialized option contracts are sold “over the counter,”
rather than on an exchange, whereby a financial intermediary (such as a

commercial bank or an investment bank) finds a counterparty or serves

as the counterparty. These over-the-counter arrangements are more
personalized and can be tailored to the specific preferences of the parties
involved. Such tailoring is not possible for the more standardized option
contracts sold on the exchanges.
2. Listing Requirements
Each exchange has its own requirements concerning the stocks
for which it creates options. One key requirement is a minimum trading
volume of the underlying stock, since the volume of options traded on
a particular stock will normally be higher if the stock trading volume is
high. The decision to list an option is made by each exchange, not by
the firms represented by the options contracts.
3. Role of the Options Clearing Corporation
Like a stock transaction, the trading of an option involves a
buyer and a seller. The sale of an option imposes specific obligations
on the seller under specific conditions. The exchange itself does not
take positions in option contracts, but provides a market where the
options can be bought or sold. The Options Clearing Corporation
(OCC) serves as a guarantor on option contracts traded in the United
States, which means that the buyer of an option contract does not have
to be concerned that the seller will back out of the obligation.
4. Regulation of Options
Trading Options trading is regulated by the Securities and
Exchange Commission and by the various option exchanges. The
regulation is intended to ensure fair and orderly trading. For example, it
attempts to prevent insider trading (trading based on information that
insiders have about their firms and that is not yet disclosed to the public).

It also attempts to prevent price fixing among floor brokers that could
cause wider bid–ask spreads that would impose higher costs on
customers.
5. How Option Trades Are Executed
When options exchanges were created, floor brokers of
exchanges were available to execute orders for brokerage firms. They
went to a specific location on the trading floor where the option was
traded to execute the order. Today, computer technology allows
investors to have trades executed electronically. Most small,
standardized transactions are executed electronically, whereas complex
transactions are executed by competitive open outcry among exchange
members. Many electronic communication networks (ECNs) are
programmed to consider all possible trades and execute the order at
the best possible price. Market-makers can also execute stock option
transactions for customers. They earn the difference between the bid
price and the ask price for this trade, although the spread has declined
significantly in recent years. Market-makers also generate profits or
losses when they invest their own funds in options.
6. Types of Orders
As with stocks, an investor can use either a market order or a
limit order for an option transaction. A market order will result in the
immediate purchase or sale of an option at its prevailing market price.
With a limit order, the transaction will occur only if the market price is
no higher or lower than a specified price limit. For example, an investor
may request the purchase of a specific option only if it can be purchased
at or below some specified price. Conversely, an investor may request
to sell an option only if it can be sold for some specified limit or more.

7. Online Trading
Option contracts can also be purchased or sold online. Many
online brokerage firms, including E*Trade and TD Ameritrade, facilitate
options orders. Online option contract orders are commonly routed to
computerized networks on options exchanges, where they are executed.
For these orders, computers handle the order from the time it is placed
until it is executed.
8. Institutional Use of Options
Although options positions are sometimes taken by financial
institutions for speculative purposes, they are more commonly used for
hedging. Savings institutions and bond mutual funds use options to hedge
interest rate risk. Stock mutual funds, insurance companies, and pension
funds use stock index options and options on stock index futures to
hedge their stock portfolios. Some of the large commercial banks often
serve as an intermediary between two parties that take derivative
positions in an over-the-counter market.
Trading Mechanics
Options were originally traded in the over-the-counter (OTC)
market, where the terms of the contract were negotiated. The advantage
of the OTC market over the exchanges is that the option contracts can
be tailored: strike prices, expiration dates, and the number of shares
can be specified to meet the needs of the option buyer. However,
transaction costs are greater and liquidity is less.
Option trading really took off when the first listed option
exchange the Chicago Board Options Exchange (CBOE) was organized
in 1973 to trade standardized contracts, greatly increasing the market
and liquidity of options. The CBOE was the original exchange for options,

but, by 2003, it has been superseded in size by the electronic

International Securities Exchange (ISE), based in New York. Most
options sold in Europe are traded through electronic exchanges. Other
exchanges for options in the United States include: NYSE Euronext
(NYX), and the NASDAQtrader.com.
Option exchanges are central to the trading of options:
• they establish the terms of the standardized contracts
• they provide the infrastructure both hardware and software
to facilitate trading, which is increasingly computerized
• they link together investors, brokers, and dealers on a
centralized system, so that traders can from the best bid and
ask prices
• they guarantee trades by taking the opposite side of each
transaction
• they establish the trading rules and procedures
Options are traded just like stocks the buyer buys at the ask
price and the seller sells at the bid price. The settlement time for option
trades is 1 business day (T+1). However, to trade options, an investor
must have a brokerage account and be approved for trading options
and must also receive a copy of the booklet Characteristics and Risks
of Standardized Options.
The option holder, unlike the holder of the underlying stock,
has no voting rights in the corporation, and is not entitled to any dividends.
Brokerage commissions, which are a little higher for options than for
stocks, must also be paid to buy or sell options, and for the exercise
and assignment of option contracts. Prices are usually quoted with a
base price plus cost per contract, usually ranging from Rs.5 to Rs.15

minimum charge for up to 10 contracts, with a lower per contract charge,

typically Rs.0.50 to Rs.1.50 per contract, for more than 10 contracts.
Most brokerages offer lower prices to active traders. Here are some
examples of how option prices are quoted:
• Rs.9.99 + Rs.0.75 per contract for online option trades
• Rs.9.99 + Rs.0.75 per contract for online option trades;
phone trades are Rs.5 more, and broker-assisted trades are
Rs.25 more
• Rs.1.50 per contract with a minimum standard rate of
Rs.14.95, with several discounts for active traders
• Sliding commission scale ranging from Rs.6.99 + Rs.0.75
per contract for traders making at least 1500 trades per
quarter to Rs.12.99 + Rs.1.25 per contract for investors
with less than Rs.50,000 in assets and making fewer than
30 trades per quarter. Rs.19.99 for exercise and assignments.
The Options Clearing Corporation

The Options Clearing Corporation (OCC) is the counterparty
to all option trades. The OCC issues, guarantees, and clears all option
trades involving its member firms, which includes all U.S. option
exchanges, and ensures that sales are transacted according to the current
rules. The OCC is jointly owned by its member firms the exchanges
that trade options and issues all listed options, and controls and effects
all exercises and assignments. To provide a liquid market, the OCC
guarantees all trades by acting as the other party to all purchases and
sales of options.

The OCC publishes, at optionsclearing.com, statistics, news

on options, and any notifications about changes in the trading rules, or
the adjustment of certain option contracts because of a stock split or
that were subjected to unusual circumstances, such as a merger of
companies whose stock was the underlying security to the option
contracts.
The OCC operates under the jurisdiction of both the Securities
and Exchange Commission (SEC) and the Commodities Futures
Trading Commission (CFTC). Under its SEC jurisdiction, OCC clears
transactions for put and call options on common stocks and other equity
issues, stock indexes, foreign currencies, interest rate composites and
single- stock futures. As a registered Derivatives Clearing Organization
(DCO) under CFTC jurisdiction, the OCC clears and settles transactions
in futures and options on futures.
Option Premium
1. Determinants of Stock Option Premiums
Stock option premiums are determined by market forces. Any
characteristic of an option that results in many willing buyers but few
willing sellers will place upward pressure on the option premium. Thus,
the option premium must be sufficiently high to equalize the demand by
buyers and the supply that sellers are willing to sell. This generalization
applies to both call options and put options. The specific characteristics
that affect the demand and supply conditions, and therefore affect the
stock option premiums, are described in the table 4.1.

Commercial banks
Table 4.1
TYPE PF FINANCIAL
INSTITUTION PARTICIPATION IN OPTIONS MARKETS
Commercial banks Sometimes offer options to businesss.
Savings Institutions Sometimes take positions in options on futures contracts to hedge interest risk.
Mutual funds Stock mutual funds take positions in stock index options to hedge against a
possible decline in prices of stocks in their porfolios.
Stock mutual funds spmetimes take speculative positions in stock index
options in an attempt to increase their returns.
Bond mutual funds sometimes take positions in options on futures to hedge
interest rate risk.
Securities firms Serve as brokers by executing stock option transactions for individuals and business.
Pension funds Take positions in stock index options to hedge against a possible decline in
prices of stocks in their porfolio.
Take posiotions in options on futures contracts to hedge their bond porfolios
against interest rate movements.
Insurance Take positions in stock index options to hedge against a possible decline in
Companies prices of stocks in their porfolio.
Take posiotions in options on futures contracts to hedge their bond porfolios
against interest rate movements.
1. Determinants of Call Option Premiums

Call option premiums are affected primarily by the following factors:
Market price of the underlying instrument (relative to the option’s
exercise price)
Volatility of the underlying instrument
Time to maturity of the call option
Influence of the Market Price
The higher the existing market price of the underlying financial
instrument relative to the exercise price, the higher the call option
premium, other things being equal. A stock’s value has a higher
probability of increasing well above the exercise price if it is already
close to or above the exercise price. Thus, a purchaser would be willing

to pay a higher premium for a call option on such a stock. The influence
of the market price of a stock (relative to the exercise price) on the call
option premium can also be understood by comparing stock options
with different exercise prices on the same instrument at a given time.
Influence of the Stock’s Volatility
The greater the volatility of the underlying stock, the higher the
call option premium, other things being equal. If a stock is volatile,
there is a higher probability that its price will increase well above the
exercise price. Thus, a purchaser would be willing to pay a higher
premium for a call option on that stock. For instance, call options on
small stocks normally have higher premiums than call options on large
stocks because small stocks are typically more volatile.
Influence of the Call Option’s Time to Maturity
The longer the call option’s time to maturity, the higher the call
option premium, other things being equal. A longer time period until
expiration allows the owner of the option more time to exercise the
option. Thus, there is a higher probability that the stock’s price will
move well above the exercise price before the option expires.
Determinants of Put Option Premiums
The premium paid on a put option depends on the same factors
that affect the premium paid on a call option. However, the direction of
influence varies for one of the factors, as explained next. Influence of
the Market Price The higher the existing market price of the underlying
stock relative to the exercise price, the lower the put option premium,
all other things being equal. A stock’s value has a higher probability of
decreasing well below the exercise price if it is already close to or
below the exercise price. Thus, a purchaser would be willing to pay a

higher premium for a put option on that stock. This influence on the put
option premium differs from the influence on the call option premium
because, from the perspective of put option purchasers, a lower market
price is preferable. The influence of the market price of a stock (relative
to the exercise price) on the put option premium can also be understood
by comparing options with different exercise prices on the same
instrument at a given moment in time.
Influence of the Stock’s Volatility
The greater the volatility of the underlying stock, the higher the
put option premium, all other things being equal. This relationship also
held for call option premiums. If a stock is volatile, there is a higher
probability of its price deviating far from the exercise price. Thus, a
purchaser would be willing to pay a higher premium for a put option on
that stock because its market price is more likely to decline well below
the option’s exercise price.
Influence of the Put Option’s Time to Maturity
The longer the time to maturity, the higher the put option
premium, all other things being equal. This relationship also held for call
option premiums. A longer time period until expiration allows the owner
of the option more time to exercise the option. Thus, there is a higher
probability that the stock’s price will move well below the exercise
price before the option expires.
Profits and Losses with Options
Options traders can profit by being an option buyer or an option
writer. Options allow for potential profit during both volatile times, and
when the market is quiet or less volatile. This is possible because the
prices of assets like stocks, currencies, and commodities are always

moving, and no matter what the market conditions are there is an options
strategy that can take advantage of it.
Basics of Option Profitability
A call option buyer stands to make a profit if the underlying
asset, let’s say a stock, rises above the strike price before expiry. A
put option buyer makes a profit if the price falls below the strike
price before the expiration. The exact amount of profit depends on the
difference between the stock price and the option strike price at
expiration or when the option position is closed.
A call option writer stands to make a profit if the underlying
stock stays below the strike price. After writing a put option, the
trader profits if the price stays above the strike price. An option writer’s
profitability is limited to the premium they receive for writing the option
(which is the option buyer’s cost). Option writers are also called option
sellers.
Option Buying vs. Writing
An option buyer can make a substantial return on investment if
the option trade works out. This is because a stock price can move
significantly beyond the strike price.
An option writer makes a comparatively smaller return if the
option trade is profitable. This is because the writer’s return is limited
to the premium, no matter how much the stock moves. So, write
options because the odds are typically overwhelmingly on the side of
the option writer. A study in the late 1990s, by the Chicago Mercantile
Exchange (CME), found that a little over 75 per cent of all options held
to expiration expired worthless.

This study excludes option positions that were closed out or

exercised prior to expiration. Even so, for every option contract that
was in the money (ITM) at expiration, there were three that were out
of the money (OTM) and therefore worthless is a pretty telling statistic.
Evaluating Risk Tolerance
Here’s a simple test to evaluate your risk tolerance in order to
determine whether you are better off being an option buyer or an option
writer. Let’s say you can buy or write 10 call option contracts, with the
price of each call at Rs.0.50. Each contract typically has 100 shares as
the underlying asset, so 10 contracts would cost Rs.500 (Rs.0.50 x
100 x 10 contracts).
If you buy 10 call option contracts, you pay Rs.500 and that is
the maximum loss that you can incur. However, your potential profit is
theoretically limitless. So, the probability of the trade being profitable is
not very high. While this probability depends on the implied volatility of
the call option and the period of time remaining to expiration, let’s say
it 25 per cent.
On the other hand, if you write 10 call option contracts, your
maximum profit is the amount of the premium income, or Rs.500, while
your loss is theoretically unlimited. However, the odds of the options
trade being profitable are very much in your favour, at 75 per cent. It is
important to keep in mind that these are the general statistics that apply
to all options, but at certain times it may be more beneficial to be an
option writer or a buyer in a specific asset. Applying the right strategy
at the right time could alter these odds significantly.
Option Strategies Risk/Reward
While calls and puts can be combined in various permutations
to form sophisticated options strategies, let’s evaluate the risk/reward
of the four most basic strategies.
Buying a Call
This is the most basic option strategy. It is a relatively low-risk
strategy since the maximum loss is restricted to the premium paid to
buy the call, while the maximum reward is potentially limitless. Although,
as stated earlier, the odds of the trade being very profitable are typically
fairly low. “Low risk” assumes that the total cost of the option represents
a very small percentage of the trader’s capital. Risking all capital on a
single call option would make it a very risky trade because all the money
could be lost if the option expires worthless.
Buying a Put
This is another strategy with relatively low risk but the potentially
high reward if the trade works out. Buying puts is a viable alternative to
the riskier strategy of short selling the underlying asset. Puts can also be
bought to hedge downside risk in a portfolio. But because equity indices
typically trend higher over time, which means that stocks on average
tend to advance more often than they decline, the risk/reward profile of
the put buyer is slightly less favourable than that of a call buyer.
Writing a Put
Put writing is a favoured strategy of advanced options traders
since, in the worst-case scenario, the stock is assigned to the put writer
(they have to buy the stock), while the best-case scenario is that the
writer retains the full amount of the option premium. The biggest risk of
put writing is that the writer may end up paying too much for a stock if
it subsequently tanks. The risk/reward profile of put writing is more
unfavourable than that of put or call buying since the maximum reward
equals the premium received, but the maximum loss is much higher.
That said, the probability of being able to make a profit is higher.

Writing a Call
Call writing comes in two forms, covered and naked. Covered
call writing is another favourite strategy of intermediate to advanced
option traders, and is generally used to generate extra income from a
portfolio. It involves writing calls on stocks held within the portfolio.
Uncovered or naked call writing is the exclusive province of risk-tolerant,
sophisticated options traders, as it has a risk profile similar to that of a
short sale in stock. The maximum reward in call writing is equal to the
premium received. The biggest risk with a covered call strategy is that
the underlying stock will be “called away.” With naked call writing, the
maximum loss is theoretically unlimited, just as it is with a short sale.
Options Spreads
Often times, traders or investors will combine options using a
spread strategy, buying one or more options to sell one or more different
options. Spreading will offset the premium paid because the sold option
premium will net against the options premium purchased. Moreover,
the risk and return profiles of a spread will cap out the potential profit
or loss. Spreads can be created to take advantage of nearly any
anticipated price action, and can range from the simple to the complex.
As with individual options, any spread strategy can be either bought or
sold.
Reasons to Trade Options
Investors and traders undertake option trading either to hedge
open positions (for example, buying puts to hedge a long position, or
buying calls to hedge a short position) or to speculate on likely price
movements of an underlying asset.
The biggest benefit of using options is that of leverage. For
example, say an investor has Rs.900 to use on a particular trade and
desires the most bang-for-the-buck. The investor is bullish in the short

term on XYZ Inc. So, assume XYZ is trading at Rs.90. Our investor
can buy a maximum of 10 shares of XYZ. However, XYZ also has
three-month calls available with a strike price of Rs.95 for a cost Rs.3.
Now, instead of buying the shares, the investor buys three call option
contracts. Buying three call options will cost Rs.900 (3 contracts x 100
shares x Rs.3).
Shortly before the call options expire, suppose XYZ is trading
at Rs.103 and the calls are trading at Rs.8, at which point the investor
sells the calls. Here’s how the return on investment stacks up in each
case.
• Outright purchase of XYZ shares at Rs.90: Profit = Rs.13 per
share x 10 shares = Rs.130 = 14.4 per cent return (Rs.130 /
Rs.900).
• Purchase of three Rs.95 call option contracts: Profit = Rs.8 x
100 x 3 contracts = Rs.2,400 minus premium paid of Rs.900
= Rs.1500 = 166.7 per cent return (Rs.1,500 / Rs.900).
Of course, the risk with buying the calls rather than the shares
is that if XYZ had not traded above Rs.95 by option expiration, the
calls would have expired worthless and all Rs.900 would be lost. In
fact, XYZ had to trade at Rs.98 (Rs.95 strike price + Rs.3 premium
paid), or about 9 per cent higher from its price when the calls were
purchased, for the trade just to breakeven. When the broker’s cost to
place, the trade is also added to the equation, to be profitable, the
stock would need to trade even higher.
These scenarios assume that the trader held till expiration. That
is not required with American options. At any time before expiry, the
trader could have sold the option to lock in a profit. Or, if it looked the

stock was not going to move above the strike price, they could sell the
option for its remaining time value in order to reduce the loss. For
example, the trader paid Rs.3 for the options, but as time passes, if the
stock price remains below the strike price, those options may drop to
Rs.1. The trader could sell the three contracts for Rs.1, receiving
Rs.300 of the original Rs.900 back and avoiding a total loss.
The investor could also choose to exercise the call options rather
than selling them to book profits/losses, but exercising the calls would
require the investor to come up with a substantial sum of money to buy
the number of shares their contracts represent. In the case above, that
would require buying 300 shares at Rs.95.
Selecting the Right Option
Here are some broad guidelines that should help you decide
which types of options to trade.
Bullish or Bearish
Making the determination regarding you are rampantly,
moderately, or just a tad bullish/bearish will help you decide which
option strategy to use, what strike price to use and what expiration to
go for. Let’s say you are rampantly bullish on hypothetical stock ZYX,
a technology stock that is trading at Rs.46.
Volatility
If the implied volatility for ZYX is not very high (say 20 per
cent), then it may be a good idea to buy calls on the stock, since such
calls could be relatively cheap.
Strike Price and Expiration
As you are rampantly bullish on ZYX, you should be
comfortable with buying out of the money calls. Assume you do not

want to spend more than Rs.0.50 per call option, and have a choice
of going for two-month calls with a strike price of Rs.49 available for
Rs.0.50, or three-month calls with a strike price of Rs.50 available for
Rs.0.47. You decide to go with the latter since you believe the slightly
higher strike price is more than offset by the extra month to expiration.
Option Trading Tips
As an option buyer, your objective should be to purchase
options with the longest possible expiration, in order to give your trade
time to work out. Conversely, when you are writing options, go for the
shortest possible expiration in order to limit your liability.
Trying to balance the point above, when buying options,
purchasing the cheapest possible ones may improve your chances of a
profitable trade. Implied volatility of such cheap options is likely to be
quite low, and while this suggests that the odds of a successful trade are
minimal, it is possible that implied volatility and hence the option are
under-priced. So, if the trade does work out, the potential profit can
be huge. Buying options with a lower level of implied volatility may be
preferable to buying those with a very high level of implied volatility,
because of the risk of a higher loss (higher premium paid) if the trade
does not work out.
There is a trade-off between strike prices and options
expirations, as the earlier example demonstrated. An analysis of support
and resistance levels, as well as key upcoming events (such as an earnings
release), is useful in determining which strike price and expiration to
use.
Understand the sector to which the stock belongs. For example,
biotech stocks often trade with binary outcomes when clinical trial results
of a major drug are announced. Deeply out of the money calls or puts

can be purchased to trade on these outcomes, depending on whether

one is bullish or bearish on the stock. Obviously, it would be extremely
risky to write calls or puts on biotech stocks around such events, unless
the level of implied volatility is so high that the premium income earned
compensates for this risk. By the same token, it makes little sense to
buy deeply out of the money calls or puts on low-volatility sectors like
utilities and telecoms.
Use options to trade one-off events such as corporate
restructurings and spin-offs, and recurring events like earnings releases.
Stocks can exhibit very volatile behaviour around such events, giving
the savvy options trader an opportunity to cash in. For instance, buying
cheap out of the money calls prior to the earnings report on a stock that
has been in a pronounced slump, can be a profitable strategy if it manages
to beat lowered expectations and subsequently surges.
The Bottom Line
Investors with a lower risk appetite should stick to basic
strategies like call or put buying, while more advanced strategies like
put writing and call writing should only be used by sophisticated investors
with adequate risk tolerance. As option strategies can be tailored to
match one’s unique risk tolerance and return requirement, they provide
many paths to profitability.
Stock Options and Stock Index Options in India
Options are also traded on exchange-traded funds (ETFs) and
stock indexes. Exchange traded funds are funds that are designed to
mimic particular indexes and are traded on an exchange. Thus, an ETF
option provides the right to trade a specified ETF at a specified price
by a specified expiration date. Since ETFs are traded like stocks, options
on ETFs are traded like options on stocks. Investors who exercise a

call option on an ETF will receive delivery of the ETF in their account.
Investors who exercise a put option on an ETF will have the ETF
transferred from their account to the counterparty on the put option.
A stock index option provides the right to trade a specified
stock index at a specified price by a specified expiration date. Call
options on stock indexes allow the right to purchase the index, and put
options on stock indexes allow the right to sell the index. If and when
the index option is exercised, the cash payment is equal to a specified
dollar amount multiplied by the difference between the index level and
the exercise price.
Options on stock indexes are similar to options on ETFs.
However, the values of stock indexes change only at the end of each
trading day, whereas ETF values can change throughout the day.
Therefore, an investor who wants to capitalize on the expected
movement of an index within a particular day will trade options on
ETFs. An investor who wants to capitalize on the expected movement
of an index over a longer period of time (such as a week or several
months) can trade options on either ETFs or indexes.
Options on indexes have become popular for speculating on
general movements in the stock market. Speculators who anticipate a
sharp increase in stock market prices overall may consider purchasing
call options on one of the market indexes. Likewise, speculators who
anticipate a stock market decline may consider purchasing put options
on these indexes.
Options on sector indexes also exist, allowing investors the
option to buy or sell an index that reflects a particular sector. These
contracts are distinguished from stock index options because they
represent a component of a stock index. Investors who are optimistic

about the stock market in general might be more interested in stock

index options, while investors who are especially optimistic about one
particular sector may be more interested in options on a sector index.
There are options available for many different sectors, including banking,
energy, housing, oil exploration, semiconductors, and utilities.
Hedging with Stock Index Options
Financial institutions and other firms commonly take positions
in options on ETFs or indexes to hedge against market or sector
conditions that would adversely affect their asset portfolio or cash flows.
The following discussion is based on the use of options on stock indexes,
but options on ETFs could be used in the same manner. Financial
institutions such as insurance companies and pension funds maintain
large stock portfolios whose values are driven by general market
movements. If the stock portfolio is broad enough, any changes in its
value will likely be highly correlated with market movements. For this
reason, portfolio managers consider purchasing put options on a stock
index to protect against stock market declines. The put options should
be purchased on the stock index that most closely mirrors the portfolio
to be hedged. If the stock market experiences a severe downturn, the
market value of the portfolio declines.
However, the put options on the stock index will generate a
gain because the value of the index will be less than the exercise price.
The greater the market downturn, the greater the decline in the market
value of the portfolio but also the greater the gain from holding put
options on a stock index. Thus, this offsetting effect minimizes the overall
impact on the firm. If the stock market rises, the put options on the
stock index will not be exercised. In this case, the firm will not recover
the cost of purchasing the options. This situation is similar to purchasing
other forms of insurance and then not using them. Some portfolio
managers may still believe the options were worthwhile for temporary
protection against downside risk.
Dynamic Asset Allocation with Stock Index Options
Dynamic asset allocation involves switching between risky and
low-risk investment positions over time in response to changing
expectations. Some portfolio managers use stock index options as a
tool for dynamic asset allocation. For example, when portfolio managers
anticipate favourable market conditions, they purchase call options on
a stock index, which intensify the effects of the market conditions.
Essentially, the managers are using stock index options to increase their
exposure to stock market conditions. Conversely, when they anticipate
unfavourable market movements, they can purchase put options on a
stock index in order to reduce the effects that market conditions will
have on their stock portfolios. Because stock options are available
with various exercise prices, portfolio managers can select an exercise
price that provides the degree of protection desired.
Using Index Options to Measure the Market’s Risk
Just as a stock’s implied volatility can be derived from
information about options on that stock, a stock index’s implied volatility
can be derived from information about options on that stock index.
The same factors that affect the option premium on a stock affect the
option premium on an index. Thus, the premium on an index option is
positively related to the expected volatility of the underlying stock index.
If investors want to estimate the expected volatility of the stock index,
they can use software packages to insert values for the prevailing option
premium and all the other factors (except volatility) that affect an option
premium.

The CBOE volatility index (VIX) represents the implied volatility

derived from options on the S&P 500 index (an index of 500 large
stocks). This index is closely monitored by many investors because it
indicates the market’s anticipated volatility for the market (with the S&P
500 serving as proxy for the market). The VIX is sometimes referred
to as the “fear index” because high values are perceived to reflect a
high degree of fear that stock prices could decline.
Options on Futures Contracts
In recent years, the concept of options has been applied to
futures contracts to create options on futures contracts (sometimes
referred to as “futures options”). An option on a particular futures
contract gives its owner the right (but not an obligation) to purchase or
sell that futures contract for a specified price within a specified period
of time. Thus, options on futures grant the power to take the futures
position if favourable conditions occur but the flexibility to avoid the
futures position (by letting the option expire) if unfavourable conditions
occur.
As with other options, the purchaser of options on futures pays
a premium. Similarly, options are available on stock index futures. They
are used for speculating on expected stock market movements or
hedging against adverse market conditions. Individuals and financial
institutions use them in a manner similar to the way stock index options
are used. Options are also available on interest rate futures, such as
Treasury note futures or Treasury bond futures. The settlement dates of
the underlying futures contracts are usually a few weeks after the
expiration date of the corresponding options contracts. A call option
on interest rate futures grants the right to purchase a futures contract at
a specified price within a specified period of time. A put option on
financial futures grants the right (again, not an obligation) to sell a
particular financial futures contract at a specified price within a specified
period of time. Because interest rate futures contracts can hedge interest
rate risk, options on interest rate futures might be considered by any
financial institution that is exposed to that risk, including savings
institutions, commercial banks, life insurance companies, and pension
funds.
FUTURES
Futures are widely used in various markets to hedge against
price volatility, and by speculators who want to take advantage of price
movements. A futures contract gives a buyer or seller the right to buy or
sell a particular asset at a specific future price.
Types of Futures
There are many types of futures, in both the financial and
commodity segments. Some of the types of financial futures include
stock, index, currency and interest futures. There are also futures for
various commodities, like agricultural products, gold, oil, cotton, oilseed,
and so on.
Different types of futures are:
1. Currency Futures:
We shall look at both hedging and speculation in currency
futures. Corporations, banks and others use currency futures for hedging
purposes.
The underlying principle is as follows:
Assume that a corporation has an asset, e.g., a receivable in a
currency A that it would like to hedge, it should take a futures position
such that futures generate a positive cash whenever the asset declines
in value. In this case, since the firm in long, in the underlying asset, it
should go short in futures, i.e., it should sell futures contracts in A.
Obviously, the firm cannot gain from an appreciation of A since the gain
on the receivable will be eaten away by the loss on the futures. The
hedger is willing to sacrifice this potential profit to reduce or eliminate
the uncertainty. Conversely, a firm with a liability in currency A, e.g., a
payable, should go long in futures.
In hedging too, the corporation has the option of a direct hedge
and a cross hedge. A British firm with a dollar payable can hedge by
selling sterling futures (same effect as buy dollar futures) on the IMM
or LIFFE. This is an example of a direct hedge. If the dollar appreciates,
it will lose on the payable but gain on the futures, as the dollar price of
futures will decline.
An example of a cross hedge is as follows:
A Belgian firm with a dollar payable cannot hedge by selling
Belgian franc futures because they are not traded. However, since the
Belgian franc is closely tied to the Deutschemark in the European
Monetary System (EMS). It can sell DM futures.
An important point to note is that, in a cross hedge, a firm must
choose a futures contract on an underlying currency that is highly
positively correlated with the currency exposure being hedged.
Also, even when a direct hedge is available, it is extremely
difficult to achieve a perfect hedge. This is due to two reasons. One is
that futures contracts are for standardized amounts as this is designed
by the exchange. Evidently, this will only rarely match the exposure
involved. The second reason involves the concept of basis risk.
The difference between the spot price at initiation of the contract
and the futures price agreed upon is called the basis. Over the term of
the contract, the spot price changes, as does the futures price. But the
change is not always perfectly correlated in other words, the basis is
not constant. This gives rise to the basis risk. Basis risk is dealt with
through the hedge ratio and a strategy called delta hedging.
A speculator trades in futures to profit from price movements.
They hold views about the future price movements – if these differ from
those of the general market, they will trade to profit from this discrepancy.
The flip side is that they are willing to take the risk of a loss if the prices
move against their views of opinions.
Speculation using futures can be in the either open position
trading or spread trading. In the former, the speculator is betting on
movements in the price of a particular futures contract. In the latter, he
is betting on the price differential between two futures contracts.
An example of open position trading is as follows: Rs. /DM Prices:
Spot – 0.5785
March Futures – 0.5895
June Futures – 0.5915
September Futures – 0.6015
These prices evidently indicate that the market expects the DM
to appreciate over the next 6-7 months. If there is a speculator who
holds the opposite view i.e., he believes that the DM is actually going
to depreciate. There is another speculator who believes that the DM
will appreciate but not to the extent that the market estimates in other
words, the appreciation of the DM will fall short of market expectations.
Both these speculators sell a September futures contract (standard size
– DM 125,000) at Rs.0.6015.
On September 10, the following rates prevail:
Spot Rs. /DM – 0.5940, September Futures – 0.5950

Both speculators reverse their deal with the purchase of a

September futures contract.
The profit they make is as follows:
Rs 0.6015 – 0.5950), i.e., Rs.0.0065 per DM or Rs. (125000 x
0.0065), i.e., Rs.812.5 per contract.
A point to be noted in the above example is that the first
speculator made a profit in spite the fact that his forecast was faulty.
What mattered therefore was the movement in September futures price
relative to the price that prevailed on the day the contract was initiated.
In contrast to the open position trading, spread trading is
considered a more conservative form of speculation. Spread trading
involves the purchase of one futures contract and the sale of another.
An intra-commodity spread involves difference in prices of two futures
contract with the same underlying commodity and different maturity
dates.
These are also termed as time spreads. An inter-commodity
spread involves the difference in prices of two futures contracts with
different but related commodities. These are usually with the same
maturity dates.
2. Interest Rate Futures:
Interest rate futures are one of the most successful financial
innovations in recent years. The underlying asset is a debt instrument
such as a treasury bill, a bond or time deposit in a bank.
The International Monetary Market (IMM) a part of the
Chicago Mercantile Exchange, has futures contracts on US Government
treasury bonds, three-month Eurodollar time deposits and medium-

term US treasury notes among others. The LIFFE has contracts on

Eurodollar deposits, sterling time deposits and UK Government bonds.
The Chicago Board of Trade offers contracts on long-term US treasury
bonds.
Interest rate futures are used by corporations, banks and
financial institutions to hedge interest rate risk. A corporation planning
to issue commercial paper can use T-bill futures to protect itself against
an increase in interest rate.
A treasurer who is expecting some surplus cash in the near
future to be invested in some short- term investments may use the same
as insurance against a fall in interest rates. Speculators bet on interest
rate movements or changes in the term structure in the hope of generating
profits.
A complete analysis of interest rate futures would be a complex
exercise as it involves thorough understanding and familiarity with
concepts such as discount yield, yield-to- maturity and elementary
mathematics of bond valuation and pricing.
3. Stock Index Futures:
A stock index futures contract is an obligation to deliver on the
settlement date an amount of cash equivalent to the value of 500 times
the difference between the stock index value at the close of the last
trading day of the contract and the price at which the futures contract
was originally struck.
For example, if the S&P 500 Stock Index is at 500 and each
point in the index equals Rs.500, a contract struck at this level is worth
Rs.250,000 (Rs.500 * Rs.500). If, at the expiration of the contract,
the S&P 500 Stock Index is at 520, a cash settlement of Rs.10,000 is
to be made [(520– 510) * Rs.500].
It must be noted that no physical delivery of stock is made.

Therefore, in order to ensure that sufficient funds are available for
settlement, both parties have to maintain the requisite deposit and meet
the variation margin calls as and when required.
4. Commodity Futures
Commodity futures allow hedging against price changes in the
future of various commodities, including agricultural products, gold, silver,
petroleum etc. Speculators also use them to bet on price movements.
Currency markets are highly volatile and are generally the domain of
large institutional players, including private companies and governments.
Since initial margins are low in commodities, players in commodity futures
can take significant positions. Of course, the profit potential is enormous,
but the risks tend to be high. In India, these futures are traded on
commodity exchanges like the Multi Commodity Exchange (MCX)
and the National Commodity and Derivatives Exchange.
Uses of Futures
Hedgers use futures contracts as protection from price changes.
Hedgers are producers or users of the underlying commodity. Farmers,
ranchers, feedlots, ethanol plants, meat packers, and grain processers
are a few examples of hedgers. Those who are hedgers will, at some
point, own the physical commodity being traded. Hedgers use the futures
market to reduce price risk.
Speculators use the futures market with the hope of making a profit.
Speculators generally do not produce or use the underlying commodity
being traded. Rather, they buy or sell futures contracts in hopes of
profiting from price movements in the market by buying a contract at a
lower price and selling at a higher price. Speculators accept risk in the
futures market

Market Mechanics
With a futures contract, the underlying merchandise is known.
For example, an investor can buy a futures contract on gold, lumber,
pork bellies, swiss francs, and many other items. The underlying item
or commodity is described specifically in the contract specifications
which are determined by the futures exchange on which it trades. The
price of a futures transaction is agreed upon initially between the buyer
and seller, and remains fixed over the holding period, or length of the
contract. Each participant in a futures contract is required to open a
futures account for depositing margin. Margin is money deposited by
both the buyer and the seller to assure the integrity of the contract.
Finally, the full price of the commodity must be paid only upon contract
expiration at which point the trader takes delivery, if the trader bought
futures, or make delivery, if he sold futures, of the underlying commodity.
Transactions in futures can only be done on futures exchanges. These
exchanges are located primarily in Chicago and New York.
Mechanics of Futures Markets include:
• Specification of a futures contract
• Convergence of futures price to spot price
• Operation of margins
• Quotes and prices
• Delivery
• Types of orders
• Regulation
• Accounting and taxes

Market Participants
While there are thousands of traders who are trading in and
out of various precious metals, industrial metals and agricultural
commodities, these traders and participants can be broadly classified
into four broad categories. This classification is very important as each
of these categories of participants has a unique imprint on the market
and contributes to the robustness of the market in their own way.
1. Commodity Market Speculators
Speculators are there in the market for a very short period of
time. They may look to exit their long / short position within the same
day or may look to exit in a few day time. They operate on thin margins,
leveraged trades and rapid churning of funds. Speculators are also
popularly referred to as intraday traders in the equity derivatives market.
Speculators are largely agnostic to direction of the market and are willing
to trade both ways i.e., on the long side and on the short side. Speculators
typically try to ensure that they are on the side of the momentum of the
market overall and the specific commodity they are trading. Since
speculators rely heavily on minor trading opportunities in the commodity
markets, they extensively base their speculative trades on technical charts,
supports, resistances, break-outs, patterns etc. Speculators have a very
important role to play in the commodity markets in the sense that they
provide liquidity in the markets and also ensure that the bid-ask spreads
are kept at the bare minimum.
2. Directional Margin Traders
These traders have a slightly longer-term view on specific
commodities compared to speculators who typically operate at the short
end of the market. Margin traders use futures as a proxy for buying
the commodity in the sport market as the benefit of margin trading is

available in the futures market. Instead of locking up their entire capital

in holding to a spot position, the margin traders use futures as a proxy
for spot positions by paying a margin. Margin traders are not only willing
to wait till expiry but are also willing to take a longer period contract
and even to bear the rollover cost for carrying forward the position.
Margin traders normally do not rely too much on technical but have a
very strong fundamental premise due to which they are willing to bear
the roll cost to carry the position longer. The trades of these margin
traders typically give hints to traders and analysts regarding which
commodities are attracting long term interest and acting as a lead
indicator of underlying shifts.
3. Spot / Futures Arbitrageurs
Arbitrageurs play a very unique role in the commodity markets.
They actually even out the pricing inefficiencies in the market but trying
to lock in spreads. Before understanding how arbitrageurs operate in
the commodity markets, let us first understand how they operate in the
equity markets. If Tata Motors is quoting at Rs.440 in the spot market
and at Rs.449 in the stock futures market, then the arbitrageur will buy
Tata Motors at Rs.440 in the spot market and sell Tata Motors Futures
at Rs.449. That way he can lock in an assured profit of Rs.9 (2 per
cent ROI) for one month. On the expiry day, the spot and futures position
will expire at the same price enabling the arbitrageur to realize the 2 per
cent spread. Commodity markets can be slightly more complicated.
Firstly, the spot and futures market in commodities are regulating by
different regulators which makes it more complicated. Secondly, unlike
equities, commodities have additional costs in the form of transportation
charges, insurance costs, storage charges, stamp duty etc and all this
will have to be factored in when calculating the spread. However, the
bottom-line is that if the arbitrage spread on any commodity is positive

after considering all these costs, then the arbitrageur will buy in the spot
and sell in the futures. By ironing out any pricing anomalies, the arbitrageur
will not only make an assured profit but will also ensure that the market
becomes more efficient in the process. Arbitrage requires much more
resources compared to speculating or margin trading.
4. Commodity Price Hedgers
Hedgers are those participants who have an underlying
exposure to a particularly commodity. Let us assume that you have a
large order of silver that you need to deliver to a jeweller after 3
months. The only problem is that the deal will be done at the prevailing
price on that date. That exposes you to the price risk over the next 3
months. You are quite satisfied with the price of silver today but you are
apprehensive that 3 months down the line the price of silver may be
lower. You can hedge by selling 3-month silver futures short. By doing
so you are locking in your position at a price that is prima facie attractive
to you. You are therefore indifferent to the price movement of silver
over the next 3 months. Of course, you will incur a notional loss if the
price of silver goes up but that is the job of a speculator. As a hedger,
your job is to protect your downside risk and that is something you
have managed effectively. Hedgers are traders with genuine exposure
to the underlying market and hence lend stability and credibility to the
commodity markets.
These four participants actually form the four pillars of the
commodity markets. It is the joint actions of these four participants that
determines the direction and robustness of the commodity markets.
The Clearing Processes
Futures exchanges provide access to clearing houses that stands
in the middle of every trade. Suppose trader A purchases Rs.145,000

of gold futures contracts from trader B, trader A really bought a futures

contract to buy Rs.145,000 of gold from the clearing house at a future
time, and trader B really has a contract to sell Rs.145,000 to the clearing
house at that same time. Since the clearing house took on the obligation
of both sides of that trade, trader A do not have worry about trader B
becoming unable or unwilling to settle the contract - they do not have
to worry about trader B’s credit risk. Trader A only has to worry about
the ability of the clearing house to fulfil their contracts.
Even though clearing houses are exposed to every trade on the
exchange, they have more tools to manage credit risk. Clearing houses
can issue Margin Calls to demand traders to deposit Initial Margin
moneys when they open a position, and deposit Variation Margin (or
Mark-to- Market Margin) moneys when existing positions experience
daily losses. A margin in general is collateral that the holder of a financial
instrument has to deposit to cover some or all of the credit risk of
their counterparty, in this case the central counterparty clearing houses.
Traders on both sides of a trade has to deposit Initial Margin, and this
amount is kept by the clearing house and not remitted to other traders.
Clearing houses calculate day-to-day profit and loss amounts by
‘marking-to-market‘ all positions by setting their new cost to the previous
day’s settlement value, and computing the difference between their
current day settlement value and new cost. When traders accumulate
losses on their position such that the balance of their existing posted
margin and their new debits from losses is below a thresh-hold called
a maintenance margin (usually a fraction of the initial margin) at the end
of a day, they have to send Variation Margin to the exchange who
passes that money to traders making profits on the opposite side of
that position. When traders accumulate profits on their positions such
that their margin balance is above the maintenance margin, they are
entitled to withdraw the excess balance.
The margin system ensures that on any given day, if all parties in a trade
closed their positions after variation margin payments after settlement,
nobody would need to make any further payments as the losing side of
the position would have already sent the whole amount, they owe to
the profiting side of the position. The clearinghouse does not keep any
variation margin. When traders cannot pay the variation margin they
owe or are otherwise in default the clearing house closes their positions
and tries to cover their remaining obligations to other traders using
their posted initial margin and any reserves available to the
clearing house. Several popular methods are used to compute initial
margins. They include the CME- owned SPAN (a grid simulation
method used by the CME and about 70 other exchanges),
STANS (a Monte Carlo simulation based methodology used by the
Options Clearing Corporation (OCC)), TIMS (earlier used by the
OCC, and still being used by a few other exchanges).
Traders do not interact directly with the exchange, they interact
with clearing house members, usually futures brokers, that pass contracts
and margin payments on to the exchange. Clearing house members are
directly responsible for initial margin and variation margin requirements
at the exchange even if their client’s default on their obligations, so they
may require more initial margin (but not variation margin) from their
clients than is required by the exchange to protect themselves. Since
clearing house members usually have many clients, they can net out
margin payments from their client’s offsetting positions. For example, if
a clearing house member have half of their clients holding a total of
1000 long position in a contract, and half of their clients holding a total
of 500 short position in a contract, the clearing house member is only
responsible for the initial and variation margin of a net 500 contracts

Stock Futures and Stock Index Futures in India

Stock Futures
A single stock futures contract is an agreement to buy or sell a
specified number of shares of a specified stock on a specified future
date. Such contracts have been traded on futures exchanges in Australia
and Europe since the 1990s. The Chicago Board Options Exchange
and the CME Group recently engaged in a joint venture called One
Chicago, where single stock futures contracts of U.S. stocks are traded.
The size of a contract is 100 shares. Investors can buy or sell singles
stock futures contracts through their broker, and they can be purchased
on margin. The orders to buy and sell a specific single stock futures
contract are matched electronically. Single stock futures have become
increasingly popular, and today are available on more than 2,200 stocks.
They are regulated by the Commodity Futures Trading Commission
and the Securities and Exchange Commission.
Settlement dates are on the third Friday of the delivery month
on a quarterly basis (March, June, September, and December) for the
next five quarters as well as for the nearest two months. For example,
on January 3, an investor could purchase a stock futures contract for
the third Friday in the next two months (January or February) or over
the next five quarters (March, June, September, December, and March
of the following year).
Investors who expect a particular stock’s price to rise over
time may consider buying futures on that stock. To obtain a contract
to buy March futures on 100 shares of Zyco stock for Rs.5,000 (Rs.50
per share), an investor must submit the Rs.5,000 payment to the
clearinghouse on the third Friday in March and will receive shares of
Zyco stock on the settlement date. If Zyco stock is valued at Rs.53 at

the time of settlement, the investor can sell the stock in the stock market
for a gain of Rs.3 per share or Rs.300 for the contract (ignoring
commissions). This gain would likely reflect a substantial return on the
investment, since the investor had to invest only a small margin (perhaps
20 per cent of the contract price) to take a position in futures. If Zyco
stock is valued at Rs.46 at the time of settlement, the investor would
incur a loss of Rs.4 share, which would reflect a substantial percentage
loss on the investment. Thus, single stock futures offer potential high
returns but also high risk.
Investors who expect a particular stock’s price to decline over
time can sell futures contracts on that stock. This activity is similar to
selling a stock short, except that single stock futures can be sold without
borrowing the underlying stock from a broker (as short-sellers must
do). To obtain a contract to sell March futures of Zyco stock, an
investor must deliver Zyco stock to the clearinghouse on the third Friday
in March and will receive the payment specified in the futures contract.
Investors can close out their position at any time by taking the
opposite position. Suppose that, shortly after the investor purchased
futures on Zyco stock with a March delivery at Rs.50 per share, the
stock price declines. Rather than incur the risk that the price could
continue to decline, the investor could sell a Zyco futures contract with
a March delivery. If this contract specifies a price of Rs.48 per share,
the investor’s gain will be the difference between the selling price and
the buying price, which is Rs.2 per share or Rs.200 for the contract.
Risk of Trading Futures Contracts
Users of futures contracts must recognize the various types of
risk exhibited by such contracts and other derivative instruments.

a. Market Risk
Market risk refers to fluctuations in the value of the instrument as a
result of market conditions. Firms that use futures contracts to
speculate should be concerned about market risk. If their
expectations about future market conditions are wrong, they may
suffer losses on their futures contracts. Firms that use futures
contracts to hedge are less concerned about market risk because
if market conditions cause a loss on their derivative instruments,
they should have a partial offsetting gain on the positions that they
were hedging.
b. Basis Risk
A second type of risk is basis risk, or the risk that the position
being hedged by the futures contracts is not affected in the same
manner as the instrument underlying the futures contract. This type
of risk applies only to those firms or individuals who are using
futures contracts to hedge. The change in the value of the futures
contract position may not move in perfect tandem with the change
in value of the portfolio that is being hedged, so the hedge might
not perfectly hedge the risk of the portfolio.
c. Liquidity Risk
A third type of risk is liquidity risk, which refers to potential price
distortions due to a lack of liquidity. For example, a firm may
purchase a particular bond futures contract to speculate on
expectations of rising bond prices. However, when it attempts to
close out its position by selling an identical futures contract, it may
find that there are no willing buyers for this type of futures contract
at that time. In this case, the firm will have to sell the futures contract
at a lower price.

Users of futures contracts may reduce liquidity risk by using only

those futures contracts that are widely traded.
d. Credit Risk
A fourth type of risk is credit risk, which is the risk that a loss will
occur because a counterparty defaults on the contract. This type
of risk exists for over-the-counter transactions, in which a firm or
individual relies on the creditworthiness of a counterparty. The credit
risk of counterparties is not a concern when trading futures and
other derivatives on exchanges, because the exchanges normally
guarantee that the provisions of the contract will be honoured. The
financial intermediaries that make the arrangements in the over-
the-counter market can also take some steps to reduce this type
of risk. First, the financial intermediary can require that each party
provide some form of collateral to back up its position. Second,
the financial intermediary can serve (for a fee) as a guarantor in the
event that the counterparty does not fulfil its obligation.
e. Prepayment Risk
Prepayment risk refers to the possibility that the assets to be hedged
may be prepaid earlier than their designated maturity. Suppose
that a commercial bank sells Treasury bond futures in order to
hedge its holdings of corporate bonds and that, just after the futures
position is created, the bonds are called by the corporation that
initially issued them. If interest rates subsequently decline, the bank
will incur a loss from its futures position without a corresponding
gain from its bond position (because the bonds were called earlier).
As a second example, consider a savings and loan association
with large holdings of long-term, fixed-rate mortgages that are
mostly financed by short-term funds. It sells Treasury bond futures

to hedge against the possibility of rising interest rates; then, after

the futures position is established, interest rates decline and many
of the existing mortgages are prepaid by homeowners. The savings
and loan association will incur a loss from its futures position without
a corresponding gain from its fixed-rate mortgage position (because
the mortgages were prepaid).
f. Operational Risk
A sixth type of risk is operational risk, which is the risk of losses as
a result of inadequate management or controls. For example, firms
that use futures contracts to hedge are exposed to the possibility
that the employees responsible for their futures positions do not
fully understand how values of specific futures contracts will
respond to market conditions. Furthermore, those employees may
take more speculative positions than the firms desire if the firms do
not have adequate controls to monitor them. E.g.: The case of MF
Global Holdings serves as a good example of operational risk.
During 2011, it experienced major losses from its speculative
positions, and it pulled funds from its customer accounts to cover
its losses. It ultimately experienced liquidity problems and went
bankrupt in October 2011. The funds that it pulled from customer
accounts were not repaid. A few months later, another brokerage
firm for futures traders (Peregine Financial Group) also experienced
liquidity problems, as its actual bank cash balance was more than
Rs.100 million less than what it had reported. It ultimately filed for
bankruptcy in July 2012. These events triggered concerns about
the exposure of traders to financial fraud in the futures markets.
Stock Index Futures in India
A stock index is a composition of select securities traded on an
exchange, e.g., Sensex is a composition of 30 blue- chip securities
being traded on BSE. Therefore, a stock index futures contract is simply

a futures contract where the underlying variable is a stock index such
as BSE Sensex, S&P CNX, NIFTY etc.
The value of stock index futures derives its value from a stock
index value. Theoretically, an investor who buys a stock index futures
contract agrees to buy the entire stock index and the seller agrees to
sell the entire stock index. The SEBI has taken a landmark decision
permitting the use of derivatives based on L.C. Gupta Committee Report.
The SEBI has suggested phased introduction of derivatives starting
with Stock Index Futures to be followed by Stock Index Options.
Distinguishing features of Stock Index Futures contract are as
follows:
1. Multiple or Market Lot Size:
The Stock Index Futures can be bought or sold only in a specified
lot size. The market lot size for Nifty futures is 200. It means that if
on a day Nifty future is quoting at a price of Rs. 1,400 then the
value of one Nifty futures contract shall be Rs.2,80,000 i.e. (200 x
Rs.1,400).
2. Margin Requirement and Mark to the Market:
Like any other futures contract a Stock Index Futures contract is
also characterized by margin requirement. The traders in a Stock
Index Futures market are required to keep good faith deposits
which are adjusted on a daily basis to account for the gains or
losses.
There are three types of margins in a futures market:
(a) Initial Margin:
It is the margin amount initially required to open a margin account
for trading.
(b) Maintenance Margin:

It is the minimum amount of margin money that must be maintained
in a margin account. If balance in margin account falls below this
level, a margin call is made and the trader is required to deposit
additional amount so as to restore the balance in margin account
back to the level of initial margin.
(c) Variation Margin:
Variation margin is the amount of ‘margin call’ required to be
deposited by the trader in case balance in margin account falls
below maintenance margin level.
(d) Cash Settlement:
A Stock Index Futures contract does not entitle physical delivery
of stocks and the contract is settled in cash on the settlement date.
This is because it is virtually impossible to deliver all the stocks
comprising the Stock Index and that too in the same proportion in
which they appear in the index at the time of settlement.
(e) Specifications:
On a Stock Index Futures contract indicate the underlying index,
contract size, price steps or tick size, price bands or price range,
trading cycle, expiry day, settlement basis and settlement price.
These specifications make a Stock Index as a tradable security
that can be bought or sold.
(f) Contract Lifetime:
The lifetime of each series is generally three months worldwide. At
any point of time there are three series open for trading.

Trading in Stock Index Futures:

Trading in Sensex or Nifty futures is just like trading in any
other security. An investor is able to buy or sell futures on the BSE –
Bolt terminal or the NSE – NEAT screen with his broker. The order
will have to be punched in the system and the confirmation will be
immediate like the existing system.
Since the tick size and market lot size in futures is similar to
individual stock, the feel of trading in Stock Index Futures is the same
as trading on stocks. Separate bid and ask quotations are available like
shares.
You simply have to punch in your order of the required quantity
at a price you wish to buy, sell or execute the same at the market price.
On execution of the order you would receive a confirmation of the
same. A trader can carry the Stock Index Futures contract till maturity
or square it off at any time before expiry.
Pricing of Stock Index Futures Contract:
Theoretical or fair price of a Stock Index Futures contract is
derived from the well celebrated cost of carry model.
Accordingly, Stock Index Futures price depends upon:
1. Spot index value
2. Cost of carry or interest rate
3. Carry return i.e., dividends expected on securities comprising
the index.
Mathematically:
F = Se (r – y) t

Where,
F = Future Price
S = Spot value of index
e = Exponential constant with value r = Cost of carry or interest cost
y = Carry return e.g., dividend income t = Time to maturity in years
Stock index futures are the most popular equity derivatives
where the contract value is based on the stock index value. For instance,
if BSE-200 is currently trading at 350 points then the contract value
will be Rs.35,000 which is derived by multiplying index value of 350
by 100 which is fixed.
The investor has to deposit a margin of say 10 per cent of the
contract value which is Rs.3,500. As the margin is mark to market, the
margin requirements shall be calculated daily linked to the value of the
stock index. Thus, if the BSE-200 moves in the following manner over
the next 6 days the margin requirement will be calculated accordingly.
Particulars Day0 Day1 Day2 Day3 Day4 Day5 Day6
BSE - 200 350 370 340 355 340 335 360
Value of the contract ( `) 35,000 37,000 34,000 35,500 34,000 33,500 36,000
Margin 3,500 3,400 3,400 3,550 3,400 3,350 3,600
In the above case the profit to the investor over a period of 6

days shall be Rs.1,000 (i.e., 36,000 – 35,000).
As the settlement is done on cash basis the risk of fake
certificates, forgery and bad deliveries can be avoided. Secondly, the
investment to be made is low which is restricted to the margin amount.
Thirdly, the stock index is difficult to be manipulated and the
possibility of cornering is reduced. Fourthly, as the Stock index is an
average, it is much less volatile than individual stock prices. Lastly, as

the stock index futures enjoy great popularity, they are likely to be
more liquid than all other types of equity derivatives.
NSE’s Volatility Index: India VIX:
The Chicago Board Options Exchange was the first to develop
volatility index in 1993. The CBOE Volatility Index is a key measure of
market expectations of near-term implied volatility conveyed by S&P
500 Stock Index Options prices. Implied volatility increases when the
market is bearish and decreases when the market is bullish. This is due
to the common belief that bearish markets are more risky than bullish
markets.
NSE introduced volatility index called ‘India VIX’ into Indian
stock market. A volatility index reflects the market’s expectation of
volatility in the near term. Volatility index is a measure of the amount by
which an underlying index is expected to fluctuate in the near term,
based on the order book of the underlying index options.
It is a volatility index based on the Nifty 50 index option prices.
From the best bid/ask prices of Nifty 50 options contracts (which are
traded on the F&O segment of the NSE), a volatility figure percentage
is calculated, which indicates the expected market volatility over the
next 30 calendar days. Higher the implied volatility, higher the India
VIX value and vice versa. Options prices themselves change with changes
in spot prices and volatility.
There are some differences between a price index, such as the
Nifty 50 and India VIX. Nifty 50 is calculated based on the price
movement of the underlying 50 stocks, which comprises the index.\
India VIX is calculated based on the bid-offer prices of the
near-and mid-month Nifty 50 Index Options. While Nifty 50 signifies

how the markets have moved directionally, India VIX indicates expected
near-term volatility and how the volatility is changing from time to time.
Speculation in Stock Index Futures Trading:
An investor can speculate by trading in Stock Index Futures
based on his expectations of market rise or market fall. Suppose an
investor expects market to rise then he can buy Stock Index Futures.
For instance, if the BSE-200 rises from 350 to 400 over a contract
period of 3 months then the investor makes a profit of Rs.5,000 [(400
– 350) x 100] on a contract value of Rs.35,000.
Supposing if the investor buys 10 BSE-200 at 350 points cash,
then he makes a profit of Rs.50,000 [(400 – 350) × 100 × 10]. On the
other hand, if the investor expects market to fall then he can sell Stock
Index Futures. Thus, without the backing of a commercial position an
investor can make profits by speculation. However, if the investor makes
a wrong judgment regarding the movement of the market, then he loses
in the case of speculation.
Hedging with Stock Index Futures:
Hedging technique is very useful in the case of high-net-worth
entities such as mutual funds having a portfolio of securities. For instance,
if the investor wants to reduce the loss on his holding of securities due
to uncertain price movements in the market, then he can sell futures
contracts.
In such a case if the market comes down then the losses incurred
on individual securities shall be compensated by profits made in the
futures contract. On the contrary if the market rises, then the loss
incurred in the futures contract shall be compensated by profit made on
the individual securities.

Supposing if the value of a portfolio of a mutual fund is Rs.10

crores and the BSE-200 is currently trading at 350 then the number of
futures contracts to be sold shall be Rs.10 crores/350 × 100 = 2857.14
contracts. However, it is not possible to have a perfect hedge as the
contracts cannot be traded in fractions. Hence, the mutual fund can sell
2857 or 2858 futures contracts.
Reasons for Popularity of Stock Index Futures:
The Stock Index Futures is the most preferred derivatives in
India owing to the undernoted reasons:
1. The portfolio hedging is given priority by the institutional and other
enormous equity- holders.
2. The most cost-efficient hedging is the Stock Index Futures.
3. Stock index is almost beyond the scope of manipulation whereas
it is very easy to manipulate the individual stock price.
4. The most liquidity featured Stock Index Futures are the most
popular in India and abroad.
5. The remote possibility of bankruptcy in Stock Index Futures has
been guaranteed by the clearing house effects.
6. The Stock Index Futures are cash settled all over the world and
its value is derived independently from the cash market and safely
accepted as the settlement price, where as in the case of individual
stock the outstanding positions remaining on expiration date have
to be settled by physical delivery. But these settlements by means
of physical delivery in case of Stock Index Futures are not
practically accepted globally as it is cash settled.
7. The volatility of Stock Index Futures is much lower than the
individual stock price.

8. The Individual Stock Futures are always used for manipulating

their prices in cash market.
9. The less volatility featured Stock Index Futures has lowered the
requirement of capital adequacy and margin in comparison to
Individual Stock Futures.
10. The well regulatory framework for Stock Index Futures ensures
less complexity and thereby growing popularity for equity
derivatives.
Stock Index Futures offer implementation advantages and
incremental returns to portfolios only because of the fact that
some useful strategies are available for institutions using Stock
Index Futures.
They are:
1. The benefits of the lowest possible transaction costs are attractive.
2. The actual disposing of equity holdings may be made gradually
subject to the market conditions.
3. The low commission rate on stock index futures trading and the
high level of liquidity in Stock Index Futures market offers the
potential for significant savings.
4. The portfolio construction via Stock Index Futures contract offers
the specific advantage of actually buying the index i.e., the
purchase of Stock Index Futures lead to exposure to all stocks
being bought.
5. In Stock Index Future approach of index-fund construction gives
an advantage of not reinvestment of dividends as dividends are
already priced within the future contract.

6. The Stock Index Futures can considerably take care for investing
the funds raised by floating a new scheme with suitable securities
at reasonable price without losing time.
7. Stock Index Futures allow the unit holders to liquidate a part of
portfolio in case of open- end fund.
8. Stock Index Futures offer an attractive strategy for maintaining
the desired stock market exposure of the portfolio at all points of
time.
9. Stock Index Futures are strategically used for insuring against
market risks.
10. Stock Index Futures offer an effective ‘beta’ control to the portfolio
manager for having advantages of:
(a) The optimal stock mix;
(b) Considerably lower transaction costs; and
(c) Achieving the portfolio target ‘beta’ through buying targeted
futures.
11. Stock Index Futures offer the most productive as well as effective
asset allocation strategy to the portfolio manager in order to
maximize the investors’ wealth by minimizing the market risks.
12. The market volatility can be effectively managed by Stock Index
Futures by making transactions with greater speed with lower
implementation cost.
13. The market disruptions caused by the external investment
managers can effectively be reduced with the strategic use of Stock
Index Futures.

14. The most important advantage of Stock Index Futures is that less
money needs to be involved to alter the asset- mix due to the
leveraged impact of contracts.
Criteria for Stock Market Derivatives Trading:
In the derivatives market there shall be a two-level system of
members viz., clearing members and non-clearing members. The
clearing member takes the responsibility for settlement of trades on
behalf of the non-clearing member. Thus, the clearing member acts as a
guarantor for the non-clearing member.
The clearing member shall have a minimum net worth of Rs.300
lakhs as per the SEBI’s definition and shall made a deposit of Rs.50
lakhs with the exchange/clearing corporation in the form of liquid assets
such as cash. Fixed deposits pledged in the name of the exchange, or
other securities. Bank guarantees in lieu of such deposit may also be
accepted.
The broker members/dealers in the derivatives market should
have passed a certification program considered adequate by SEBI.
Moreover, they should be registered with SEBI as brokers/dealers of
derivative exchange apart from their registration as brokers/dealers of
any stock exchange. The stock exchange should have minimum of 50
members to start derivatives trading.
Stock Index Derivatives Market in India:
The most notable development concerning the secondary
segment of the Indian capital market is the introduction of derivatives
trading in June 2000. SEBI approved derivatives trading based on
futures contracts at both BSE and NSE in accordance with the rules/
by laws and regulations of the stock exchanges.

A beginning with equity derivatives has been made with the introduction
of stock index futures by BSE and NSE. Stock Index Futures contract
allows for the buying and selling of the particular stock index for a
specified price at a specified future date. Stock Index Futures, inter
alia, help in overcoming the problem of asymmetries in information.
Information asymmetry is mainly a problem in individual stocks
as it is unlikely that a trader has market-wide private information. As
such, the asymmetric information component is not likely to be present
in a basket of stocks.
This provides another rationale for trading in stock index futures.
Trading in index derivatives involves low transaction cost in comparison
with trading in underlying individual stocks comprising the index.
While the BSE introduced Stock Index Futures for S&P CNX
Nifty comprising 50 scrips. Stock Index Futures in India are available
with one month, two month and three-month maturities. While derivatives
trading based on the Sensitive Index (Sensex) commenced at the BSE
on June 9, 2000, derivatives trading based on S&P CNX Nifty
commenced at the NSE on June 12, 2000.
SIF is the first attempt in the development of derivatives trading.
This was followed by approval for trading in options based on these
two indices and options on individual securities. The trading in index
options commenced in June 2001 and trading in options on individual
securities is scheduled to commence in July 2001.

Table 4.2
Index based and Individual Securities based Futures and Options: Comparison
Products Index Futures Index Options Futures on Options on

Individual Securities Individual Securities
Underlying S&P CNX Nifty S&P CNX Nifty Securities as Securities as
stipulated stipulated by SEBI. stipulated by SEBI.
Type European American

Trading cycle Maximum of Same as Index Same as Index Same as Index
3-months trading futures futures futures
cycle. At any point
of time, there will
be 3 contracts
available:
1) near month
2) mid month &
3) far month
duration.
Expiry Day Last Thursday Same as Index Same as Index Same as Index
of the expiry month futures futures futures
Contract size Permited lot size Same as Index As stipulated by As stipulated by
is 200 & multiples futures NSE (not less than NSE (not less than
thereof 2 lakhs) 2 lakhs)
Price steps 0.05 0.05
` Base price Previous day Theorctical value Previous day closing Same as Index
First day of closing of the options value of underlying options
trading Nifty value. contract arrived security.
at based on Black-
Scholes model
Base price Daily settlement Daily close price Daily settlement price Same as Index
subsequent price options
Price bands Operating ranges Operating ranges Operating ranges Operating ranges
are kept at + 10% are kept at 99% of are kept at + 20 % are kept at 99% of
the base price the base price
Quantity freeze 20,000 units or 20,000 units or Lower of 1% of market Same as Individual
greater greater wide position limit futires
stipulated for open
positions or 5 crores
Difference between Options and Futures

A market much bigger than equities is the equity derivatives
market in India. Derivatives basically consist of 2 key products in India
viz Options and Futures. The difference between future and options is
that while futures are linear, options are not linear. Derivatives mean

that they do not have any value of their own but their value is derived
from an underlying asset. For example, options and futures on Reliance
Industries will be linked to the stock price of Reliance Industries and
will derive their value from the same. Options and Futures trading
constitutes an important part of the Indian equity markets. Let us
understand the differences between Options and Futures and how equity
futures and the options market form an integral part of the overall equity
market.
A Future is a right and an obligation to buy or sell an underlying
stock (or other assets) at a predetermined price and deliverable at a
predetermined time. Options are a right without an obligation to buy or
sell equity or index. A Call Option is a right to buy while a Put Option is
a right to sell.
Benefit from Options and Futures
Let us look at futures first. Assume that you want to buy 1500
shares of Tata Motors at a price of Rs.400. That will entail an investment
of Rs.6 lakhs. Alternatively, you can also buy 1 lot (consisting of 1500
shares) of Tata Motors. The advantage is that when you buy futures,
you only pay the margin which (let us say) is around 20 per cent of the
full value. That means your profits will be five-fold that of when you are
invested in equities. But the losses could also be five-fold and that is the
risk of leveraged trades.
An Option is a right without an obligation. So, you can buy a
Tata Motors 400 Call Option at a price of Rs. 10. Since the lot size
is 1,500 shares, your maximum loss will be Rs. 15,000 only. On the
downside, even if Tata Motors goes up to Rs .300, your loss will only
be Rs. 15,000. On the upside, above Rs. 410 your profits will be
unlimited.

Trade in Options and Futures

Options and Futures are traded in contracts of 1 month, 2
months and 3 months. All F&O contracts will expire on the last Thursday
of the month. Futures will trade at a Futures price which is normally at
a premium to the spot price due to the time value. There will only be
one Futures price for a stock for one contract. For example, in January
2018, one can trade in January Futures, February Futures and March
Futures of Tata Motors. Trading in Options is slightly more complicated
as you actually trade the premiums. So, there will be different strikes
traded for the same stock for Call Options and for Put Options. So, in
the case of Tata Motors, the Call Options premium of 400 call will be
Rs. 10 while these Option prices will be progressively lower as your
strikes go higher.
Understanding some Options and Futures basics
Futures offer the advantage of trading equities with a margin.
But the risks are unlimited on the opposite side irrespective of whether
you are long or short on the futures. When it comes to options, the
buyer can limit losses to the extent of the premium paid only. Since
options are non-linear, they are more amenable to complex Options
and Futures strategies. When you buy are sell futures you are required
to pay upfront margin and mark-to-market (MTM) margins. When
you sell an option also you are required to pay initial margins and MTM
margins. However, when you buy options you are only required to pay
the premium margins.
Understanding the quadrants of Options and Futures
When it comes to Futures the periphery is quite simple. If you
expect the stock price to go up then you buy Futures on the stock and

if you expect the stock price to go down then you sell Futures on the
stock or the index. Options will have 4 possibilities. Let us understand
each one of them with an Options and Futures trading example. Let us
assume that Infosys is currently quoting at Rs. 1,000. Let us understand
how different traders will use different kinds of options based on their
outlook.
1. Investor A expects Infosys to go up to Rs. 1,150 over the next 2
months. The best strategy for him will be buying a Call Option on
Infosys of 1,050 strike. He will get to participate in the upside by
paying a much lower premium.
2. Investor B expects Infosys to go down to Rs. 900 over the next 1
month. The best approach for him will be to buy Put Options on
Infosys of 980 strikes. He can easily participate in the downside
movement and make profits after his premium cost is covered.
3. Investor C is not sure of the downside in Infosys. However, he is
certain that with the pressure on the stock from global markets,
Infosys will not cross 1,080. He can sell Infosys 1,100 Call Option
and take home the entire premium.
4. Investor D is not sure of the upside potential of Infosys. However,
he is certain that considering its recent management changes, the
stock should not dip below Rs. 920. A good strategy for him will
be to sell the 900 Put Option and take the entire premium.
Options and Futures are conceptually different but intrinsically they
are the same as they try to profit from stock or an index without
investing the full sum.

SWAPS
A swap is an agreement between two parties (called
counterparties) to exchange specified periodic cash flows in the future
based on some underlying instrument or price (e.g., a fixed or floating
rate on a bond or note). Like forward, futures, and option contracts,
swaps allow firms to better manage their interest rate, foreign exchange,
and credit risks. However, swaps also can result in large losses. At the
heart of the financial crisis in 2008–2009 were derivative securities,
mainly credit swaps, held by financial institutions. Specifically, in the
late 2000s, FIs such as Lehman Brothers and AIG had written and
also (in the case of AIG) insured billions of dollars of credit default
swap (CDS) contracts. When the mortgages underlying these contracts
fell drastically in value, credit swap writers found themselves unable to
make good on their promised payments to the swap holders. The
result was a significant increase in risk and a decrease in profits for the
FIs that had purchased these swap contracts. To prevent a massive
collapse of the financial system, the federal government had to step in
and bail out several of these FIs.
Swaps were introduced in the early 1980s, and the market for
swaps has grown enormously in recent years. The five generic types of
swaps are interest rate swaps, currency swaps, credit risk swaps,
commodity swaps, and equity swaps. The asset or instrument underlying
the swap may change, but the basic principle of a swap agreement is
the same in that it involves the transacting parties restructuring their
asset or liability cash flows in a preferred direction. In this section, we
consider the role of the two major generic types of swaps—interest
rate and currency.

Interest Rate Swaps

An interest rate swap is an arrangement whereby one-party
exchanges one set of interest payments for another. In the most common
arrangement, fixed-rate interest payments are exchanged for floating-
rate interest payments over time.
The provisions of an interest rate swap include the following:
The notional principal value to which the interest rates are applied
to determine the interest payments involved
The fixed interest rate
The formula and type of index used to determine the floating rate
The frequency of payments, such as every six months or every
year
The lifetime of the swap
For example, a swap arrangement may involve an exchange of
11 per cent fixed-rate payments for floating payments at the prevailing
one-year Treasury bill rate plus 1 per cent, based on Rs.30 million of
notional principal, at the end of each of the next seven years. Other
money market rates are sometimes used instead of the T-bill rate to
index the interest rate. Although each participant in the swap agreement
owes the other participant at each payment date, the amounts owed
are typically netted out so that only the net payment is made. If a firm
owes 11 per cent of Rs.30 million (the notional principal) but is supposed
to receive 10 per cent of Rs.30 million on a given payment date, it will
send a net payment of 1 per cent of the Rs.30 million, or Rs.300,000.
The market for swaps is facilitated by over-the-counter trading
rather than trading on an organized exchange. Given the uniqueness of

the provisions in each swap arrangement, swaps are less standardized

than other derivative instruments such as futures or options. Thus, a
telecommunications network is more appropriate than an exchange to
work out specific provisions of swaps. Interest rate swaps became
more popular in the early 1980s when corporations were experiencing
the effects of large fluctuations in interest rates. Although some
manufacturing companies were exposed to interest rate movements,
financial institutions were exposed to a greater degree and became the
primary users of interest rate swaps. Initially, only those institutions
wishing to swap payments on amounts of Rs.10 million or more engaged
in interest rate swaps. In recent years, however, swaps have been
conducted on smaller amounts as well.
Use of Swaps for Hedging
Financial institutions such as savings institutions and commercial
banks in the United States traditionally had more interest rate sensitive
liabilities than assets and therefore were adversely affected by increasing
interest rates. Conversely, some financial institutions in other countries
(such as some commercial banks in Europe) had access to long-term
fixed-rate funding but used funds primarily for floating-rate loans. These
institutions were adversely affected by declining interest rates.
By engaging in an interest rate swap, both types of financial
institutions could reduce their exposure to interest rate risk. Specifically,
a U.S. financial institution could send fixed-rate interest payments to a
European financial institution in exchange for floating-rate payments.
This type of arrangement is illustrated in the diagram 4.1

Diagram 4.1
Short - term Fixed-Rate

Deposits Long-Term Loans
U.S. U.S. Financial U.S.
Depositors Institution Depositors
Interest on Fixed Interest
Deposits Payments on Loans
Fixed Floating
Interest Interest
Payments Payments
Fixed - Rate
Long Terms Floating - Rate
Deposits Long
European
European European
Financial
Depositors Borrowers
Institution
Interest on Floating Interest
Deposits Payments on Loans
In the event of rising interest rates, the U.S. financial institution

receives higher interest payments from the floating-rate portion of the
swap agreement, which helps to offset the rising cost of obtaining
deposits. In the event of declining interest rates, the European financial
institution provides lower interest payments in the swap arrangement,
which helps to offset the lower interest payments received on its floating-
rate loans. In our example, the U.S. financial institution forgoes the
potential benefits from a decline in interest rates while the European
financial institution forgoes the potential benefits from an increase in
interest rates.
The interest rate swap enables each institution to offset any
gains or losses that result specifically from interest rate movements.
Consequently, as interest rate swaps reduce interest rate risk, they can
also reduce potential returns. Most financial institutions that anticipate
that interest rates will move in a favourable direction do not hedge their
positions. Interest rate swaps are primarily used by financial institutions

that would be adversely affected by the expected movement in interest

rates. A primary reason for the popularity of interest rate swaps is the
existence of market imperfections. If the parties involved in a swap
could easily access funds from various markets without having to pay a
premium, they would not need to engage in swaps.
A U.S. financial institution could access long-term funds directly
from the European market while the European institution could access
short term funds directly from the U.S. depositors. However, a lack of
information about foreign institutions and convenience encourages
individual depositors to place deposits locally. Consequently, swaps
are necessary for some financial institutions to obtain the maturities or
rate sensitivities on funds that they desire.
Use of Swaps for Speculating
Interest rate swaps are sometimes used by financial institutions
and other firms for speculative purposes. For example, a firm may engage
in a swap to benefit from its expectations that interest rates will rise
even if not all of its operations are exposed to interest rate movements.
When the swap is used for speculating rather than for hedging, any loss
on the swap positions will not be offset by gains from other operations.
It was positioned to generate large gains if interest rates declined. But
instead, interest rates increased, and the treasurer of the county took
more positions to make up for the resulting losses. He continued to
take positions in anticipation that interest rates would decline, but the
rates kept on rising throughout 1994. In December 1994, the treasurer
resigned and Orange County announced that it would be filing for
bankruptcy. The substantial losses incurred in these cases encouraged
firms to more closely monitor the actions of their managers who take
derivative positions in order to ensure that those positions are aligned
with the firm’s goals.
Participation by Financial Institutions

Financial institutions participate in the swap markets in various
ways, as summarized in table 4.3.
Table 4.3
TYPE PF FINANCIAL INSTITUTION PARTICIPATION IN OPTIONS MARKETS
Commercial banks * Engage in swaps to reduce interest rate risk.
* Serve as an intermediary by matching up two parties in
a swap.
* Serve as a dealer by taking the counterparty to
accommodate a party that desires to engage in a swap.
Savings & Loan Associations & savings * Engage in swaps to reduce interest rate risk.
banks
Finance Companies * Engage in swaps to reduce interest rate risk.
Securities firms * Serve as an intermediary by matching up two parties
in a swap.
* Serve as a dealer by taking the counterparty position
to accommodate a party that desires to engage in a
swap.
Insurance Companies * Engage in swaps to reduce interest rate risk.
Pension funds * Engage in swaps to reduce interest rate risk.
Financial institutions such as commercial banks, savings
institutions, insurance companies, and pension funds that are exposed
to interest rate movements commonly engage in swaps to reduce interest
rate risk. A second way to participate in the swap market is by acting
as an intermediary. Some commercial banks and securities firms serve
in this capacity by matching up firms and facilitating the swap
arrangement. Financial institutions that serve as intermediaries for swaps
charge fees for their services. They may even provide credit guarantees
(for a fee) to each party in the event that the counterparty does not fulfil
its obligation. Under these circumstances, the parties engaged in swap
agreements assess the creditworthiness of the intermediary that is backing
the swap obligations. For this reason, participants in the swap market
prefer intermediaries that have a high credit rating.

A third way to participate is by acting as a dealer in swaps. The

financial institution takes the counterparty position in order to serve a
client. In such a case, the financial institution may be exposing itself to
interest rate risk unless it has recently taken the opposite position as a
counterparty to another swap agreement.
Types of Interest Rate Swaps
In response to firms’ diverse needs, a variety of interest rate swaps
have been created. The following are some of the more commonly
used swaps:
Plain vanilla swaps
Forward swaps
Callable swaps
Putable swaps
Extendable swaps
Zero-coupon-for-floating swaps
Rate-capped swaps
Equity swaps
Some types of interest rate swaps are more effective than others
at offsetting any unfavourable effects of interest rate movements on the
U.S. institution. However, those swaps also offset any favourable effects
to a greater degree. Other types of interest rate swaps do not provide
as effective a hedge but do allow the institution more flexibility to benefit
from favourable interest rate movements.

a. Plain Vanilla Swaps

In a plain vanilla swap, sometimes referred to as a fixed-for-
floating swap, fixed-rate payments are periodically exchanged for
floating-rate payments. The earlier example of the U.S. and European
institutions involved this type of swap. Consider the exchange of
payments under different interest rate scenarios in diagram 4.2 when
using a plain vanilla swap. Although infinite possible interest rate scenarios
exist, only two scenarios are considered:
Diagram 4.2:Illustration of a Plain Vanilla
(Fixed-for-Floating) Swap
Level of Interest Payments
Scenario of Declining
Scenario of Rising Floating Inflow Payments Interest Rates
Interest Rates
Fixed Outflow Payments Fixed Outflow Payments
Floating Inflow Payments
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
End of Year End of Year
(1) a consistent rise in market interest rates and

(2) a consistent decline in market interest rates.
The Bank of Orlando has negotiated a plain vanilla swap in
which it will exchange fixed payments of 9 per cent for floating payments
equal to LIBOR plus 1 per cent at the end of each of the next five
years. LIBOR is the London Interbank Offer Rate, or the interest rate
charged on loans between European banks. The LIBOR varies among
currencies; for swap examples involving U.S. firms, the LIBOR on
U.S. dollars would normally be used. Assume the notional principal is
Rs.100 million. The swap differential derived for each scenario

represents the floating interest rate received minus the fixed interest
rate paid. The net dollar amount to be transferred as a result of the
swap is determined by multiplying the swap differential by the notional
principal.
a. Forward Swaps
A forward swap involves an exchange of interest payments
that does not begin until a specified future time. It is useful for financial
institutions or other firms that expect to be exposed to interest rate risk
at some time in the future.
Eg: Detroit Bank is currently insulated against interest rate risk. Three
years from now, it plans to increase its proportion of fixed-rate loans
(in response to consumer demand for these loans) and reduce its
proportion of floating-rate loans. In order to prevent the adverse effects
of rising interest rates after these changes go into effect, Detroit Bank
may want to engage in interest rate swaps. It can immediately arrange
for a forward swap that will begin three years from now. The forward
swap allows Detroit Bank to lock in the terms of the arrangement today
even though the swap period is delayed (diagram 4.3). Although Detroit
Bank could have waited before arranging for a swap, it may prefer a
forward swap to lock in the terms of the swap arrangement at the
prevailing interest rates. If it expects interest rates to be higher three
years from now than they are today, and waits until then to negotiate a
swap arrangement, the fixed interest rate specified in the arrangement
will likely be higher. A forward interest rate swap may allow Detroit
Bank to negotiate a fixed rate today that is less than the expected fixed
rate on a swap negotiated in the future. Because Detroit Bank will be
exchanging fixed payments for floating-rate payments, it wants to
minimize the fixed rate used for the swap agreement.

Diagram 4.3: Illustration of a Forward Swap
Scenario of Rising Floating Inflow Scenario of Declining


Interest Rates Payments Interest Rates
Floating Inflow
Payments
Fixed Outflow
Payments Fixed Outflow
Forward Forward Payments
Swap Is Swap Is
Arranged Arranged Swapping of Payments
at this Time at this Time Begins at This Time
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
The fixed rate negotiated on a forward swap will not necessarily

be the same as the fixed rate negotiated on a swap that begins
immediately. The pricing conditions on any swap are based on expected
interest rates over the swap’s lifetime. Like any interest rate swap,
forward swaps involve two parties. Our example of a forward swap
involves a U.S. institution that expects interest rates to rise and wants
to immediately lock in the fixed rate that it will pay when the swap
period begins. The party that takes the opposite position in the forward
swap will likely be a firm that will be adversely affected by declining
interest rates and expects interest rates to decline. This firm would prefer
to lock in the prevailing fixed rate because that rate is expected to be
higher than the applicable fixed rate when the swap period begins.
This institution will be receiving the fixed interest payments, so it wishes
to maximize the fixed rate specified in the swap arrangement.
a. Callable Swaps
Another use of interest rate swap is through swap options (or
swaptions). A callable swap gives the party making the fixed payments
the right to terminate the swap prior to its maturity. It allows the fixed-
rate payer to avoid exchanging future interest payments if it desires.
Eg: Reconsider the U.S. institution that wanted to swap fixed interest
payments for floating interest payments to reduce any adverse effects
of rising interest rates. If interest rates decline, the interest rate swap
arrangement offsets the potential favourable effects on this institution. A
callable swap allows the institution to terminate the swap in the event
that interest rates decline (diagram 4.4).
Diagram 4.4: Illustration of a Callable Swap
Scenario of Rising Floating Inflow Scenario of Declining


Interest Rates Payments Interest Rates
Fixed Outflow Payments*
Fixed Outflow
Payments* Floating Inflow Payments
Option is exercised to
terminate the swap at
this time because interest
rate trend is downward.
{
1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
The disadvantage of a callable swap is that the party given the

right to terminate the swap pays a premium that is reflected in a higher
fixed interest rate than that party would pay without the call feature.
The party may also incur a termination fee in the event that it exercises
its right to terminate the swap arrangement.
a. Putable Swaps
A putable swap gives the party making the floating-rate
payments the right to terminate the swap. To illustrate, reconsider the
European institution that wanted to exchange floating-rate payments
for fixed-rate payments to reduce the adverse effects of declining interest
rates. If interest rates rise, the interest rate swap arrangement offsets

the potential favourable effects on the financial institution. A putable

swap allows the institution to terminate the swap in the event that interest
rates rise (diagram 4.5). As with callable swaps, the party given the
right to terminate the swap pays a premium. For putable swaps, the
premium is reflected in a higher floating rate than would be paid without
the put feature. The party may also incur a termination fee in the event
that it exercises its right to terminate the swap arrangement.
Diagram 4.5: Illustration of a Putable Swap
Scenario of Rising Scenario of Declining

Interest Rates
Interest Rates
Floating Inflow Payments* Fixed Outflow
Fixed Outflow Payments Payments*
Option is exercised by receipient Floating Inflow

of fixed outflow payments to terminate Payments
the swap at this time because interest
rate trend is upward.
{
0 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
a. Extendable Swaps
An extendable swap contains a feature that allows the fixed-
for-floating party to extend the swap period.
Eg: Cleveland Bank negotiates a fixed-for-floating swap for eight years.
Assume that interest rates increase over this time period as expected.
If Cleveland Bank believes interest rates will continue to rise, it may
prefer to extend the swap period (diagram 4.6). Although it could create
a new swap, the terms would reflect the current economic conditions.
A new swap would typically involve an exchange of fixed payments at
the prevailing higher interest rate for floating payments. Cleveland Bank
would prefer to extend the previous swap agreement that calls for fixed
payments at the lower interest rate that existed at the time the swap
was created. It has additional flexibility because of the extendable
feature.
Diagram 4.6: Illustration of an Extendable Swap
Scenario of Rising Scenario of Declining

Interest Rates Floating Inflow
Payments* Interest Rates

Fixed Outflow
Fixed Outflow Payments*
Payments
Floating Inflow
At this time the institution At this time the institution Payments
would likely extend the would likely extend the
swap period swap period
0 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
The terms of an extendable swap reflect a price paid for the

extendibility feature. That is, the interest rates specified in a swap
agreement allowing an extension are not as favourable for Cleveland
Bank as they would have been without the feature. In addition, if
Cleveland Bank does extend the swap period, it may have to pay an
extra fee.
a. Zero-Coupon-for-Floating Swaps
Another special type of interest rate swap is the zero-coupon-
for-floating swap. The fixed-rate payer makes a single payment at the
maturity date of the swap agreement, and the floating-rate payer makes
periodic payments throughout the swap period. For example, consider
a financial institution that primarily attracts short-term deposits and
currently has large holdings of zero- coupon bonds that it purchased

several years ago. At the time it purchased the bonds, it expected interest
rates to decline. Now it has become concerned that interest rates will
rise over time, which will not only increase its cost of funds but also
reduce the market value of the bonds. This financial institution can
request a swap period that matches the maturity of its bond holdings. If
interest rates rise over the period of concern, the institution will benefit
from the swap arrangement, thereby offsetting any adverse effects on
the institution’s cost of funds. The other party in this type of transaction
might be a firm that expects interest rates to decline (diagram 4.7).
Such a firm would be willing to provide floating-rate payments based
on this expectation because the payments will decline over time even
though the single payment to be received at the end of the swap period
is fixed.
Diagram 4.7: Illustration of a Zero-Coupon-for-Floating Swap
Scenario of Rising A Single Lump-Sum Scenario of Declining A Single Lump-Sum

Interest Rates Fixed Outflow Payments Interest Rates Fixed Outflow Payments
Floating Inflow
Payments
Floating Inflow
Payments
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8
a. Rate-Capped Swaps
A rate-capped swap involves the exchange of fixed-rate
payments for floating-rate payments that are capped. Reconsider the
example in which the Bank of Orlando arranges to swap fixed payments

for floating payments. The counterparty may want to limit its possible
payments by setting a cap or ceiling on the interest rate it must pay. The
floating-rate payer pays an up-front fee to the fixed-rate payer for this
feature.
In this case, the size of the potential floating payments to be
received by the Bank of Orlando would now be limited by the cap,
which may reduce the effectiveness of the swap in hedging its interest
rate risk. If interest rates rise above the cap, the floating payments
received will not move in tandem with the interest the Bank of Orlando
will pay depositors for funds (diagram 4.8). Yet the Bank of Orlando
might believe that interest rates will not exceed a specified level and
would therefore be willing to allow a cap. Moreover, the Bank of
Orlando would receive an upfront fee from the counterparty for allowing
this cap.
An equity swap involves the exchange of interest payments for
payments linked to the degree of change in a stock index. For example,
using an equity swap arrangement, a company could swap a fixed interest
rate of 7 per cent in exchange for the rate of appreciation on the S&P
500 index each year over a four-year period. If the stock index
appreciates by 9 per cent over the year, the differential is 2 per cent (9
per cent received minus 7 per cent paid), which will be
Diagram 4.8: Illustration of a Rate-Capped Swap Equity Swaps
Scenario of Rising Floating Inflow Payments Scenario of Declining

Interest Rates if a Cap did not Exist Interest Rates

Cap Floating Inflow Payments Cap
Level Based on Cap Level Fixed Outflow
Fixed Outflow Payments Payments
Floating Inflow
Payer of Fixed Outflow Payments Payer of Fixed Outflow Payments
Receives Premium at This Time Payments Receives Premium
for Agreeing to Cap at This Time for Agreeing to Cap
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8

multiplied by the notional principal to determine the dollar amount

received. If the stock index appreciates by less than 7 per cent, the
company will have to make a net payment. This type of swap
arrangement may be appropriate for portfolio managers of insurance
companies or pension funds that are managing stocks and bonds. The
swap would enhance their investment performance in bullish stock
market periods without requiring the managers to change their existing
allocation of stocks and bonds.
Risks of Interest Rate Swaps
Several types of risk must be considered when engaging in
interest rate swaps. Three of the more common types of risks are basis
risk, credit risk, and sovereign risk.
1 . Basis Risk
The interest rate of the index used for an interest rate swap will not
necessarily move perfectly in tandem with the floating-rate
instruments of the parties involved in the swap. For example, the
index used on a swap may rise by 0.7 per cent over a particular
period while the cost of deposits to a U.S. financial institution rises
by 1.0 per cent over the same period. The net effect is that the
higher interest rate payments received from the swap agreement
do not fully offset the increase in the cost of funds. This so-called
basis risk prevents the interest rate swap from completely
eliminating the financial institution’s exposure to interest rate risk.
2 . Credit Risk
There is risk that a firm involved in an interest rate swap will not
meet its payment obligations. This credit risk is not a deal breaker,
however, for the following reasons. As soon as the firm recognizes

that it has not received the interest payments it is owed, it will

discontinue its payments to the other party. The potential loss is a
set of net payments that would have been received (based on the
differential in swap rates) over time. In some cases, the financial
intermediary that matched up the two parties incurs the credit risk
by providing a guarantee (for a fee). If so, the parties engaged in
the swap do not need to be concerned with the credit risk, assuming
that the financial intermediary will be able to cover any guarantees
promised.
3. Sovereign Risk
Sovereign risk reflects potential adverse effects resulting from a
country’s political conditions. Various political conditions could
prevent the counterparty from meeting its obligation in the swap
agreement. For example, the local government might take over
the counterparty and then decide not to meet its payment
obligations. Alternatively, the government might impose foreign
exchange controls that prohibit the counterparty from making its
payments. Sovereign risk differs from credit risk because it depends
on the financial status of the government rather than on the
counterparty itself. A counterparty could have very low credit risk
but conceivably be perceived as having high sovereign risk because
of its government. The counterparty does not have control over
some restrictions that may be imposed by its government.
Pricing Interest Rate Swaps
The setting of specific interest rates for an interest rate swap is
referred to as pricing the swap. This pricing is influenced by several
factors, including prevailing market interest rates, availability of
counterparties, and credit and sovereign risk.

a. Prevailing Market Interest Rates

The fixed interest rate specified in a swap is influenced by supply
and demand conditions for funds having the appropriate maturity.
For example, a plain vanilla (fixed for-floating) interest rate swap
structured when interest rates are very high would have a much
higher fixed interest rate than one structured when interest rates
were low. In general, the interest rates specified in a swap
agreement reflect the prevailing interest rates at the time of the
agreement.
b. Availability of Counterparties
Swap pricing is also determined by the availability of counterparties.
When numerous counterparties are available for a particular desired
swap, a party may be able to negotiate a more attractive deal. For
example, consider a U.S. financial institution that wants a fixed-
for- floating swap. If several European institutions are willing to
serve as the counter party, the U.S. institution may be able to
negotiate a slightly lower fixed rate. The availability of counterparties
can change in response to economic conditions. For example, in a
period when interest rates are expected to rise, many institutions
will want a fixed-for-floating swap but few institutions will be willing
to serve as the counterparty. The fixed rate specified on interest
rate swaps will be higher under these conditions than in a period
when many financial institutions expect interest rates to decline.
c. Credit and Sovereign Risk
A party involved in an interest rate swap must assess the probability
of default by the counterparty. For example, a firm that desires a
fixed-for-floating swap will likely require a lower fixed rate applied
to its outflow payments if the credit risk or sovereign risk of the
counterparty is high. If a well-respected financial intermediary
guarantees payment by the counterparty, however, the fixed rate
will be higher.
Performance of Interest Rate Swaps

Diagram 4.9 shows how the performance of an interest rate
swap is influenced by several underlying forces that affect interest rate
movements. The impact of the underlying forces on the performance of
an interest rate swap depends on the party’s swap position. For example,
to the extent that strong economic growth can increase interest rates, it
will be beneficial for a party that is swapping fixed-rate payments for
floating-rate payments but detrimental to a party that is swapping floating-
rate payments for fixed-rate payments.
The diagram 4.9 can be adjusted to fit any currency. For an
interest rate swap involving an interest rate benchmark denominated in
a foreign currency, the economic conditions of that country are the
primary forces that determine interest rate movements in that currency
and
Diagram 4.9: Framework for Explaining Net Payments Resulting
from an Interest Rate Swap
International U.S. U.S. U.S.

Economic Fiscal Monetary Economic
Conditions Policy Policy Conditions
U.S.
Risk- Free
Interest Rate
London Interbant
Offer Rate
(LIBOR)
Fixed-Rate Floating-Rate
Swap Payment Swap Payment
Per Period Per Period
Net Payment
Due to
Interest Rate
Swap

thereby the performance of the interest rate swap. Because the

performance of a particular interest rate swap position is normally
influenced by future interest rate movements, participants in the interest
rate swap market closely monitor indicators that may affect these
movements. Among the more closely watched indicators are indicators
of economic growth (employment, gross domestic product), indicators
of inflation (consumer price index, producer price index), and indicators
of government borrowing (budget deficit, expected volume of funds
borrowed at upcoming Treasury bond auctions).
Foreign Currency Swaps.
A foreign currency swap, also known as an FX swap, is an
agreement to exchange currency between two foreign parties. The
agreement consists of swapping principal and interest payments on a
loan made in one currency for principal and interest payments of a loan
of equal value in another currency. One party borrows currency from a
second party as it simultaneously lends another currency to that party.
The purpose of engaging in a currency swap is usually to procure
loans in foreign currency at more favourable interest rates than if
borrowing directly in a foreign market. The World Bank first introduced
currency swaps in 1981 in an effort to obtain German marks and Swiss
francs. This type of swap can be done on loans with maturities as long
as 10 years. Currency swaps differ from interest rate swaps in that
they also involve principal exchanges.
In a currency swap, each party continues to pay interest on the
swapped principal amounts throughout the length of the loan. When
the swap is over, principal amounts are exchanged once more at a
pre-agreed rate (which would avoid transaction risk) or the spot rate.

There are two main types of currency swaps. The fixed-for-fixed

currency swap involves exchanging fixed interest payments in one
currency for fixed interest payments in another. In the fixed-for-floating
swap, fixed interest payments in one currency are exchanged for floating
interest payments in another. In the latter type of swap, the principal
amount of the underlying loan is not exchanged.
Examples of Foreign Currency Swaps
A common reason to employ a currency swap is to secure
cheaper debt. For example, European Company A borrows Rs.120
million from U.S. Company B; concurrently, European Company A
lends 100 million euros to U.S. Company B. The exchange is based on
a Rs.1.2 spot rate, indexed to the London Inter Bank Offered Rate
(LIBOR). The deal allows for borrowing at the most favourable rate.
In addition, some institutions use currency swaps to reduce
exposure to anticipated fluctuations in exchange rates. If U.S. Company
A and Swiss Company B are looking to obtain each other’s currencies
(Swiss francs and USD, respectively), the two companies can reduce
their respective exposures via a currency swap.
During the financial crisis in 2008 the Federal Reserve allowed
several developing countries, facing liquidity problems, the option of a
currency swap for borrowing purposes.
FX Swaps and Exchange Rates
Swaps can last for years, depending on the individual agreement,
so the spot market’s exchange rate between the two currencies in
question can change dramatically during the life of the trade. This is one
of the reasons institutions use currency swaps. They know exactly how
much money they will receive and have to pay back in the future.

If they need to borrow money in a particular currency, and they expect

that currency to strengthen significantly in coming years, a swap will
help limit their cost in repaying that borrowed currency.
FX Swaps and Cross Currency Swaps
A currency swap is often referred to as a cross currency swap,
and for all practical purposes the two are basically the same. But there
can be slight differences. Technically, a cross currency swap is the same
as an FX swap, except the two parties also exchange interest payments
on the loans during the life of the swap, as well as the principal amounts
at the beginning and end. FX swaps can also involve interest payments,
but not all do.
There are number of ways interest can be paid. It can be paid
at a fixed rate, floating rate, or one party may pay a floating while the
other pays a fixed, or they could both pay floating or fixed rates.
In addition to hedging exchange-rate risk, this type of swap
often helps borrowers obtain lower interest rates than they could get if
they needed to borrow directly in a foreign market.

Module V
GLOBAL FINANCIAL MARKETS
Instruments
The flow of external funds into a country depends on various
factors like the policy guidelines of the country on commercial
borrowings by individual entities, the exchange control regulations of
the country, the interest rate ceilings in the financial sector and the structure
of taxation. The integration of financial markets across countries has
opened up the international markets and large varieties of financial
instruments have merged to suit the changing needs of the international
investor. The global financial markets include the market for foreign
exchange, the Eurocurrency and related money markets, the international
capital markets, notably the Eurobond and global equity markets, the
commodity market and last but not least, the markets for forward
contracts, options, swaps and other derivatives.
As in any domestic capital structuring we can segregate
international financing into two broad categories.
These are:
i. Equity financing and
ii.Debt financing.
The various instruments used to raise funds abroad include; Equity,
straight debt or hybrid instruments. The figure 5.1shows the classification
of international capital markets based on instruments used and market(s)
accessed.

Figure 5.1
International Capital Markets
International Bond Market International Equity Market
Foreign bonds Euro Bond Foreign Equity Euro Equity
Yankee Bonds Euro/Dollar ADR GDR

Samurai Bonds Euro / Yen IDR/EDR
Buildog Bonds Euro / Pounds
American Depository Receipts (ADR)

An alternative means of investing in foreign stocks is by
purchasing American depository receipts (ADRs), which are certificates
representing shares of non-U.S. stock. An American depositary receipt
(ADR) is a negotiable certificate issued by a U.S. depositary bank
representing a specified number of shares—often one share—of a
foreign company’s stock. The ADR trades on U.S. stock markets as
any domestic shares would. Many non-U.S. companies establish ADRs
in order to develop name recognition in the United States. In addition,
some companies wish to raise funds in the United States.
ADRs offer U.S. investors a way to purchase stock in overseas
companies that would not be available otherwise. Foreign firms also
benefit, as ADRs enable them to attract American investors and capital
without the hassle and expense of listing on U.S. stock exchanges.

ADRs are denominated in U.S. dollars, with the underlying

security held by a U.S. financial institution, often by an overseas branch.
ADR holders do not have to transact the trade in the foreign currency
or worry about exchanging currency on the forex market. These
securities are priced and traded in dollars and cleared through U.S.
settlement systems.
To offer ADRs, a U.S. bank will purchase shares on a foreign
exchange. The bank will hold the stock as inventory and issue an
ADR for domestic trading. ADRs list on either the New York Stock
Exchange (NYSE) or the Nasdaq, but they are also sold over-the-
counter (OTC).
U.S. banks require that foreign companies provide them with
detailed financial information. This requirement makes it easier for
American investors to assess a company’s financial health.
Types of ADRs
American depositary receipts come in two basic categories:
• A bank issues a sponsored ADR on behalf of the foreign company.
The bank and the business enter into a legal arrangement. Usually,
the foreign company will pay the costs of issuing an ADR and
retaining control over it, while the bank will handle the transactions
with investors. Sponsored ADRs are categorized by what degree
the foreign company complies with U.S. Securities and Exchange
Commission (SEC) regulations and American accounting
procedures.
• A bank also issues an unsponsored ADR. However, this certificate
has no direct involvement, participation, or even permission from
the foreign company. Theoretically, there could be several

unsponsored ADRs for the same foreign company, issued by

different U.S. banks. These different offerings may also offer
varying dividends. With sponsored programs, there is only one
ADR, issued by the bank working with the foreign company.
One primary difference between the two types of ADRs is where
investors can buy them. All except the lowest level of sponsored
ADRs register with the SEC and trade on major U.S. stock
exchanges. Unsponsored ADRs will trade only over-the-counter.
Also, unsponsored ADRs never include voting rights.
ADRs are additionally categorized into three levels, depending on
the extent to which the foreign company has accessed the U.S.
markets:
• Level I - This is the most basic type of ADR where foreign
companies either don’t qualify or don’t want to have their ADR
listed on an exchange. This type of ADR can be used to establish
a trading presence but not to raise capital. Level I ADRs found
only on the over-the-counter market have the loosest requirements
from the Securities and Exchange Commission (SEC) – and they
are typically highly speculative. While they are riskier for investors
than other types of ADRs, they are an easy and inexpensive way
for a foreign company to gauge the level of U.S. investor interest
in its securities.
• Level II – As with Level I ADRs, Level II ADRs can be used to
establish a trading presence on a stock exchange, and they can’t
be used to raise capital. Level II ADRs have slightly more
requirements from the SEC than do Level I ADRs, but they get
higher visibility and trading volume.

• Level III – Level III ADRs are the most prestigious. With these,
an issuer floats a public offering of ADRs on a U.S. exchange.
They can be used to establish a substantial trading presence in the
U.S. financial markets and raise capital for the foreign issuer. Issuers
are subject to full reporting with the SEC.
American Depositary Receipt Pricing and Costs
An ADR may represent the underlying shares on a one-for-one
basis, a fraction of a share, or multiple shares of the underlying
company. The depositary bank will set the ratio of U.S. ADRs per
home-country share at a value that they feel will appeal to investors.
If an ADR’s value is too high, it could deter some investors.
Conversely, if it is too low, investors may think the underlying
securities resemble riskier penny stocks. Because of arbitrage, an
ADR’s price closely tracks that of the company’s stock on its
home exchange.
Holders of ADRs realize any dividends and capital gains in U.S.
dollars. However, dividend payments are net of currency conversion
expenses and foreign taxes. Usually, the bank automatically
withholds the necessary amount to cover expenses and foreign
taxes. Since this is the practice, American investors would need to
seek a credit from the IRS or a refund from the foreign government’s
taxing authority to avoid double taxation on any capital gains
realized.
Pros
• Easy to track and trade
• Denominated in dollars
• Available through U.S. brokers

• Offer portfolio diversification

Cons
• Could face double taxation
• Limited selection of companies
• Unsponsored ADRs may not be SEC-compliant
• Investor’s may incur currency conversion fees
History of American Depositary Receipts
Before American depositary receipts were introduced in the
1920s, American investors who wanted shares of a non-U.S. listed
company could only do so on international exchanges—an unrealistic
option for the average person back then.
While easier in the contemporary digital age, purchasing shares
on international exchanges still has potential drawbacks. One particularly
daunting roadblock is currency-exchange issues. Another important
drawback is the regulatory differences between U.S. exchanges and
foreign exchanges.
Before investing in an internationally traded company, U.S.
investors have to familiarize themselves with the different financial
authority’s regulations, or they could risk misunderstanding important
information, such as the company’s financials. They might also need to
set up a foreign account, as not all domestic brokers can trade
internationally.
ADRs were developed because of the complexities involved
in buying shares in foreign countries and the difficulties associated with
trading at different prices and currency values.

J.P. Morgan’s (JPM) predecessor firm Guaranty Trust Co.

pioneered the ADR concept. In 1927, it created and launched the first
ADR, enabling U.S. investors to buy shares of famous
British retailer Selfridges and helping the luxury depart store
tap into global markets. The ADR was listed on the New York Curb
Exchange. A few years later, in 1931, the bank introduced the first
sponsored ADR for British music company Electrical & Musical
Industries (also known as EMI), the eventual home of the Beatles.
Today, J.P. Morgan and another U.S. bank BNY Mellon continue to
be actively involved in the ADR markets.
Example of ADRs
Between 1988 and 2018, German car manufacturer
Volkswagen AG traded OTC in the U.S. as a sponsored ADR under
the ticker VLKAY. In August 2018, Volkswagen terminated its ADR
program. The next day, J.P. Morgan established an unsponsored ADR
for Volkswagen, now trading under the ticker VWAGY.
Investors who held the old VLKAY ADRs had the option of
cashing out, exchanging the ADRs for actual shares of Volkswagen
stock trading on German exchanges or exchanging them for the new
VWAGY ADRs.
American depository receipts are attractive to U.S. investors
for several reasons. First, they are closely followed by U.S. investment
analysts. Second, companies represented by ADRs are required by
the SEC to file financial statements that are consistent with generally
accepted accounting principles in the United States. These statements
may not be available for other non-U.S. companies. Third, reliable
quotes on ADR prices are consistently available, with existing currency

values factored in to translate the price into dollars. A disadvantage,

however, is that the selection of ADRs is limited. Also, the ADR market
is less active than other stock markets, so ADRs are less liquid than
most listed U.S. stocks.
Global Depository Receipts (GDR)
The advent of GDRs in India has been mainly due to the balance
of payments crisis in the early ‘90s. At this time India did not have
enough foreign exchange balance even to meet the requirements of a
fortnight’s imports. International institutions were not willing to lend
because of non-investment credit rating of India. Out of compulsions,
rather than by choice, the government (accepting the World Bank
suggestions on tiding over the financial predicament) gave the permission
to allow fundamentally strong private corporate to raise funds in
international capital markets through equity or equity-related instruments.
The Foreign Exchange Regulation Act (FERA) was modified
to facilitate investment by foreign investors up to 51 per cent of the
equity-capital of the companies. Investment even beyond this limit is
also being permitted by the Government. Prior to this, the companies in
need of the foreign exchange component or resources for their projects
had to rely on the government of India or otherwise rely partly on the
government and partly on the financial institutions. These foreign currency
loans utilized by the companies (whether through the financial institutions
or through the government agency) were paid from the government
allocation from the IMF, World Bank or other Government credits.
This, in turn created liability for the remittance of interest and principal,
in foreign currencies which was to be met by way of earnings through
exports and other grants received by the government. However, with a
rapid deterioration in the foreign exchange reserves consequent to Gulf

War and its subsequent oil crisis, the companies were asked to get
their own foreign currencies which led to the advent of the GDRs.
The Instrument
As mentioned earlier, GDRs are essentially those instruments
which possess a certain number of underlying shares in the custodial
domestic bank of the company. That is, a GDR is a negotiable instrument
which represents publicly traded local-currency-equity share. By law,
a GDR is any instrument in the form of a depository receipt or certificate
created by the Overseas Depository Bank outside India and issued to
non-resident investors against the issue of ordinary shares or foreign
currency convertible bonds of the issuing company. Usually, a typical
GDR is denominated in US dollars whereas the underlying shares would
be denominated in the local currency of the Issuer.
GDRs may be at the request of the investor – converted into
equity shares by cancellation of GDRs through the intermediation of
the depository and the sale of underlying shares in the domestic market
through the local custodian. GDRs, per se, are considered as common
equity of the issuing company and are entitled to dividends and voting
rights since the date of its issuance. The company effectively transacts
with only one entity – the Overseas Depository – for all the transactions.
The voting rights of the shares are exercise d by the Depository as per
the understanding between the issuing company and the GDR holders.
Issuance of GDR
The following are the sequence of activities that take place during the
issuance of GDRs:
a. Shareholder Approval Needed:
The issuance of an equity instrument like the GDR needs the

mandate of the shareholders of the company issuing it. The terms

of the issue will have to be decided before such a mandate is
sought from the shareholders. There should be an authorization
from the Board of Directors for floating a Euro-issue and for calling
a general meeting for the purpose. A committee of directors is
generally constituted and conferred with necessary powers for
the approval of (i) the offering memorandum; (ii) Fixation of issue
price (iii) opening of bank account outside India and operation of
the said account and (iv) for notifying the stock exchange about
the date of the board meeting when the proposal will be considered
and also inform it about the decisions taken.
After all this, the shareholders should approve the issue by a special
resolution passed at a general meeting as per Section 81 of the
Companies Act, 1956. It stipulates that, if a company proposes
any issue of capital after two years from the formation of the
company or at any time after one year from the allotment of shares
that the company has made for the first time after its formation –
whichever is earlier – the company has to offer such issues first to
the shareholders of the company.
b. Appointment of Lead Manager:
Lead Manager is an important cog in the wheel of the Euro-issue
and is the vital link between the government and investors with the
issuers. Practically, it is the lead manager who is responsible for
the eventual success or failure of a Euro-issue when all the other
factors are same. Hence, the choice of a suitable lead manager is
as significant as any other issue activity. An ideal lead manager is
selected after preliminary meetings with merchant bankers.

The merchant bankers are evaluated on various parameters such as

(i) Marketing ability
(ii) Marketing research capability
(iii) Market making capability
(iv) Track record
(v) Competitive fee structure and
(vi) Placement skills.
A beauty parade, which is basically the presentations made by the
various merchant bankers, is held by the company to help it
decide on the final choice of the lead manager after they are filtered
by the above parameters.
The final appointment of lead manager is done after the approval
by the government. The lead manager advises the company in the
following areas after taking into consideration the needs of the
company, the industry in which the company is engaged, the
international monetary and securities markets, the general economic
conditions and the terms of the issue viz., quantum of issue, type
of security needed to be issued (GDR in this case), stages of
conversion, price of equity, shares on conversion, rate of interest,
redemption date etc.
c. Finalization of Issue Structure:
On completion of the formalities of issue structure in consultation
with the lead manager, the company should obtain the final approval
from the government. For this purpose, the company should furnish
the information about the entities involved in the GDR issue and
the following parameters to the government

i. Lead Manager xii. Indian Custodian

xiii. Isue structure and denomination of
ii. Co Lead Manager
underlying shares represented
iii. Currency
by the GDRs
iv. Issue Price (approximat range
xiv. Issue amount
in case of GDR)
xv. Green Shoe option
v. Form and Denomination
xvi. Warrants attached, if any
vi. Negative Pledge provisions
xvii. Listing modalities
vii. Taxation
xviii. Selling commission
viii. Commissions
xix. Underwriting commission
ix. Reimbursable expenses xx. Legal expenses, printing expenses,
x. Government Laws depository fees, and other out of
xi. Overseas Depository Institution pocket expenses.
xxi. Taxation procedure
The government, after considering all the above information will give a
final approval for the issue if satisfied.
The Documentation
Documentation for Euro equities is a complex and elaborate
process in the procedure of GDR launch. A typical Euro-issue consists
of the following main documents:
a. Prospectus
b. Depository agreement
c. Custodian agreement
d. Subscription agreement
e. Paying and conversion agency agreement
f. Trust deed
g. Underwriting agreement and
h. Listing agreement.

A brief discussion on the contents and the relevance of each of these

documents is given below:
a. Prospectus:
As in domestic equity market, the prospectus is a major document
containing all the relevant information concerning the issues – like
the investment considerations, terms and conditions, use of proceeds,
capitalization details, share information, industry review and overall
description of the issuing company. As a marketing strategy,
companies generally issue a preliminary prospectus which is referred
to as pathfinder which will judge the potential demand for the equity
that is being launched in the markets. The aspects that need to be
covered in the main prospectus may be grouped as follows
i. Financial Matters: Apart from the financials of the company, the
prospectus should include a statement setting out important
accounting policies of the company and a summary of significant
differences between Indian GAAP and the UK GAAP and the US
GAAP (in case of an ADR).
ii. Non- financial Matters: This may cover all aspects of management
with the information relating to their background, names of nominee
directors along with the names of the financial institutions which they
represent and the names of senior management team. All other non-
financial aspects that influence the working of the company need to
be mentioned in the prospectus.
iii. Issue Particulars: The issue size, the ruling domestic price, the number
of underlying shares for each GDR and other information relevant
for the issue as such, may be mentioned here.
iv. Other Information: Statement regarding application to a foreign stock
exchange for listing the securities and issuing of global certificates to
a specified nominee as operator of the Euro-Clear (international

clearing house in Euro-securities) system like Cedel (one of the major
clearing houses in Eurobond market clearing, handling and storing
the securities).
Option provided to the lead manager to cover over-allotments,
exercisable on or before the business day prior to the closing date
of subscribe for additional securities in the aggregate up to a specified
limit.
b. Depository Agreement:
This is the agreement between the issuing company and the overseas
depository providing a set of rules for withdrawal of deposits and
for their conversion into shares. Voting rights of a depository are
also defined. Usually, GDRs or Euro convertible bonds are admitted
to the clearing system, and settlements are made only by book entries.
The agreement lays down the procedure for the information
transmission to be passed onto the GDR holders.
c. Underwriting Agreement:
As in domestic equity market, underwriters play the role of ‘assurers’
for picking the GDRs at a predetermined price depending on the
market response. The agreement is for this purpose, between the
company (guided by its lead manager) and the underwriter.
d. Subscription Agreement:
The lead manager and the syndicated members form a part of the
investors who subscribe to GDRs or Euro convertible bonds as per
this agreement. There is no binding, however, on the secondary
market transaction on these entities i.e. market making facility.

e. Custodian Agreement:
It is an agreement between the depository and the custodian. In this
agreement the depository and the custodian determine the process
of conversion of underlying shares into depository receipts and vice
versa. For the process of conversion of the GDRs into shares,
(popularly termed as RE-materialization) shares have to be released
by the Custodian.
f. Trust Deed and Paying and Conversion Agreement:
While the trust deed is a standard document which provides for
duties and responsibilities of trustees, the paying and conversion
agreement enables the paying and conversion agency which performs
a typical banking function by undertaking to service the bonds until
the conversion, and arranging for conversion of bonds into GDRs
or shares, as necessary.
g. Listing Agreement:
As far as the listing is concerned, most of the companies which issue
a GDR prefer Luxembourg Stock Exchange as the listing
requirements in this exchange are by far, the simplest. The New
York Stock Exchange (NYSE) and the Tokyo Stock Exchange (TSE)
have the most stringent listing requirements. London Stock Exchange
and the Singapore Stock Exchange fit in the middle with relatively
fewer listing requirements than the NYSE and TSE. The listing agents
have the onus of fulfilling listing requirements of a chosen stock
exchange. The requirements of London Stock Exchange are
provided in the 48-hour documents. The 48- hour documents are
the final documents that have to be lodged at the exchange not later
than mid-day, at least two business days prior to the consideration
of the application for admission to listing.

These documents, among other things should include the following:

¾¾ An application for admission to listing.
¾¾ Declaration of compliance in the appropriate form issued
by the exchange.
¾¾ Three copies of the listing particulars / equivalent offering
document relating to the issue. The contents of these
documents should meet the relevant requirements.
¾¾ A copy of any shareholders’ resolution that is relevant to
the issue of such securities.
¾¾ A copy of the board resolution authorizing the issue, the
application for listing and the publication of the relevant
documents.
¾¾ In case of a new company, a copy of the incorporation
certificate, memorandum of certificate and articles of
association.
The Launch
Two of the major approaches for launching of a Euro-Issue
are Euro-Equity Syndication and Segmented Syndication. Euro-Equity
syndication attempts to group together the placement strengths of the
intermediaries, without any formal regional allocations. Segmented
syndication, on the other hand, seeks to form a geographically targeted
syndicated structure, so as to achieve broader distribution of paper by
approaching both institutional and retail investors. As compared to
Euro syndication, segmented syndication can be expected to achieve
orderly and coordinated placement by restricting the choice of syndicate
members with definite strengths in specific markets.

Marketing
It is not only the Indian issues which thrive on suave marketing,
but also the GDR and other International bond offerings. A judicious
mix of financials and marketing would help in raising the investors interest
in the issue. Most of the marketing activities are handled by the lead
manager in consonance with the advertising agencies. A back-up
material consisting of preliminary offering circular, recent annual report,
interim financial statements, copies of newspaper articles about the
business of the company and a review of the structure and performance
of the Indian stock market, among other things is prepared.
Road shows form a pre-dominant facet of the launch of any
GDR. They are a series of face-to- face presentations with fund managers
and analysts and is a vital part of marketing process. Road shows,
which involve much more than must inform about the company are
getting increasing attention from the investors and the fund managers.
Road shows for Euro equities acquire considerably greater degree of
risk than under any other financial instrument. Road Shows are backed
by the information of the financials and operations and a view regarding
the future profitability and growth prospects. This gives an opportunity
to the investors (generally, fund managers) to interact with the senior
management of the issuing company and understand the activities of
the issuer company which may eventually lead to the investment in the
company. These are normally conducted at the financial centres of the
globe like London, New York, Boston, Los Angeles, Paris, Edinburgh,
Geneva, Hong Kong, etc.
The back-up material prepared will support presentations made
by the company’s senior personnel inviting the fund managers to invest
in the company. The price that is preferred for a particular number of
shares is noted by the boo-runner at each of such presentations and the

eventual price that is most likely to find favour with the fund manager is
finalized. This will go a long way in making the issue to be accepted.
Pricing and Closing
This forms the most vital part of the whole process of a GDR
issue. The pricing is key to the overall performance of a GDR after the
same has been listed. The price is determined after the underwriter’s
response has been considered and an inference of the response may
be drawn.
The final price is determined after the Book Runner closes the
books after the completion of the Road Shows. The book-runner
keeps the books open for 1-2 weeks, for the potential investors to
start placing their orders/bids with details of price and quantity. After
analysing all the bids at the end of book-building period, lead managers,
in consultation with the issuer, will fix a particular price for the issue
which will be communicated back to the bidders/investors and a fresh
demand figure is arrived at. If there is excess demand, the company
can go in for ‘green shoe option’ where it can issue additional GDRs in
excess of target amount.
A tombstone advertisement will be issued in the financial press
to publicize syndicated loans and other funding deals. Following this,
the GDRs will get listed in the notified stock exchange signalling the
consummation of the process of the issue of stock exchange. The time
period that is generally needed for typical GDR issue is given in the
table 5.1. It is arranged sequentially so as to convey information on the
step by-step process that is followed.

Table 5.1: Indicative Time Table
Stage Administrative Time in weeks
i. Meeting between issuer and 1 and 2

Initial Decision
lead manager and planning of
an issue
ii. Issue structure finalized with
due regard to domestic
regulatory environment
iii. Draft documentation
iv. Due diligences process
v. Board meeting proceeded
by shareholder’s approval
vi. Fixing parties to issue
(including depository/
custodian)
i. Official approvals –steps 3 and 4
Approvals initiated
and drafts ii. Comfort and consent letters
finalization finalized with auditors
iii. Legal opinion formats
drafted and finalized
iv. Approvals obtained
Pre-launch i. Road show preparations and 7 and 8

presentations
formalities
ii. Pathfinder prospectus finalized
iii.Listing preparations in final
stages
i. Roadshows organized
Launch of
ii. Documentation circulated
issues among syndicate
iii. Investors contacted

Pricing and i. Final terms fixed

Closing ii. Allocation of securities to
investors
iii. Final prospectus to be kept
ready
iv. Final listing documents
lodged with stock exchange
v. Subscription agreement
signed
vi. Delivery of global
certificate
vii. Closing documents signed
viii. Payment to the issuer
ix. Tombstone advertisement
Source: Global Capital Markets: Shopping for finance; PR Joshi,

Tata Mc-Graw, 1996 ed.
Costs
The cost incurred by the company is proportional to the issue
size. The lead manager, justifiably, takes the lion’s share in the issue
expenses of the GDR. With the increased acceptance of marketing as
a vital tool for the success of the issue, the cost that is incurred on
marketing is fast increasing. The total expenses incurred by a GDR
issue are Underwriting Fee, Management Fee and Selling Commission.
Other expenses include lead manager’s expenses, printing costs,
accounting fees, listing fees, road show expenses, etc. There has,
however, been a considerable fall in the quality of the GDR issues made
by the Indian companies. The sole reason why some of the Indian

companies came out with a Euro-issue was their eagerness to flaunt the
GDR issue as a symbol of being well known in the international markets.
Some of the companies coming out with GDRs could not explain the
core business they are in and also whether they have judiciously utilized
the investment made by the GDR holders.
Foreign Currency Convertible Bonds (FCCB)
Foreign currency convertible bond (FCCB) is a Euro-bond
which can be converted into shares at the option of the investor. FCCBs
have a fixed coupon rate with a legal payment obligation. It has greater
flexibility with the conversion option - at the choice of the investor – to
equity. The price of the conversion of FCCB closely resembles the
trading price of the shares at the stock exchange. Also, the company
may incorporate a ‘call option’ at the choice of the issuer to obtain
FCCBs before maturity. This may be due to the adverse market
conditions, changes in the shareholding pattern, changes of tax laws
etc
Understanding Foreign Currency Convertible Bonds (FCCB)
A bond is a debt instrument that provides income to investors
in the form of regularly scheduled interest payments called coupons. At
the maturity date of the bond, the investors are repaid the full face value
of the bond. Some corporate entities issue a type of bond known as
convertible bonds.
A bondholder with a convertible bond has the option of
converting the bond into a specified number of shares of the issuing
company. Convertible bonds have a conversion rate at which the bonds
will be converted to equity. However, if the stock price stays below the
conversion price, the bond will not be converted. Thus, convertible
bonds allow bondholders to participate in the appreciation of the issuer’s

underlying shares. There are various types of convertible bonds, one of

which is the foreign currency convertible bond.
A company may choose to issue FCCBs in the currency of a
country with lower interest rates or a more stable economy than the
issuer’s home country.
Working of Foreign Currency Convertible Bonds
A foreign currency convertible bond (FCCB) is a convertible
bond that is issued in a foreign currency, which means the principal
repayment and periodic coupon payments will be made in a foreign
currency. For example, an American listed company that issues a bond
in India in rupees has, in effect, issued an FCCB.
Foreign currency convertible bonds are typically issued by
multinational companies operating in a global space and looking to raise
capital in foreign currencies. FCCB investors are usually hedge fund
arbitrators and foreign nationals. These bonds can be issued along with
a call option (whereby the right of redemption lies with the bond
issuer) or put options (whereby the right of redemption lies with
bondholder).
Special Considerations
A company may decide to raise money outside its home country
to gain access to new markets for new or expansionary projects. FCCBs
are generally issued by companies in the currency of those countries
where interest rates are usually lower than the home country or foreign
country economy is more stable than the home country economy. Due
to the equity side of the bond, which adds value, the coupon payments
on the bond are lower for the issuer than a straight coupon-bearing
plain vanilla bond, thereby, reducing its debt-financing costs. In addition,

a favourable move in the exchange rates can reduce the issuer’s cost of
debt, which is the interest payment made on bonds.
Since the principal has to be repaid at maturity, an adverse
movement in exchange rates in which the local currency weakens can
cause cash outflows on repayment to be higher than any savings in
interest rates, resulting in losses for the issuer. In addition, issuing bonds
in a foreign currency exposes the issuer to any political, economic, and
legal risks prevalent in the country. Furthermore, if the issuer’s stock
price declines below the conversion price, FCCB investors will not
convert their bonds to equity, which means the issuer will have to make
the principal repayments at maturity.
An FCCB investor can purchase these bonds at a stock
exchange, and has the option to convert the bond into equity or a
depositary receipt after a certain period of time. Investors can participate
in any price appreciation of the issuer’s stock by converting the bond
to equity. Bondholders take advantage of this appreciation by means
of warrants attached to the bonds, which are activated when the price
of the stock reaches a certain point.
External Commercial Borrowings
ECBs are commercial loans raised by eligible resident entities
from recognised non-resident entities and should conform to parameters
such as minimum maturity, permitted and non- permitted end-uses,
maximum all-in-cost ceiling, etc.
The framework for raising loans through ECB, comprises of the following
three tracks:
Track I: Medium term foreign currency denominated ECB with minimum
average maturity of 3/5 years.
Track II: Long term foreign currency denominated ECB with minimum
average maturity of 10 years.

Track III: Indian Rupee (INR) denominated ECB with minimum

average maturity of 3/5 years.
The ECB Framework enables permitted resident entities to borrow
from recognized non- resident entities in the following forms:
a. Loans including bank loans;
ii. Securitized instruments (e.g., floating rate notes and fixed rate
bonds, non-convertible, optionally convertible or partially
convertible preference shares / debentures);
iii. Buyers’ credit;
iv. Suppliers’ credit;
v. Foreign Currency Convertible Bonds (FCCBs);
vi. Financial Lease; and
vii. Foreign Currency Exchangeable Bonds (FCEBs)
ECBs has made it easy for the Indian eligible entities to access
foreign capital and meet its needs. ECBs are in simple words commercial
loans taken for a commercial purpose in form of bank loans, suppliers’
credit, buyers’ credit or securitized instruments, sought from foreign
lenders. The ECBs can be obtained through automatic route or approval
route or by combination of both the routes. Monitored by RBI, ECB is
a facility made available to Indian eligible entities to be able to seek
huge investment from outside India and allow for foreign capital flow in
India.
Policies for External Commercial Borrowing
RBI in order to ensure inflow of clean funds, has divided the
borrower as eligible entities and lenders as recognized non-residents,
and has further kept checks in form of forms of ECB, end- use
restriction, minimum maturity period etc.

Eligible Borrower and Recognized Lenders

The ECBs can be taken under Foreign Currency ECB (FCY
ECB) and Indian Currency ECB (INR ECB) by eligible borrowers
such as any entity which is eligible for seeking Foreign Direct Investment
(FDI) or specified entities like Port Trusts, Units in Special economic
zone (SEZ), Small Industries Development Bank of India (SIDBI) and
EXIM Bank of India. The ECBs can be obtained from ‘recognized
lenders’ i.e., any entity that is a member of the Financial Action Task
Force (FATF) and International Organization of Securities Commissions
(IOSCO). In addition to FATF and IOSCO, Multilateral and Regional
Financial Institutions where India is a member country, Foreign branches
/ subsidiaries of Indian banks (subject to applicable prudential norms)
and individuals if they are foreign equity holders or for subscription to
bonds/debentures listed abroad, are also accepted as recognized lenders
for obtaining ECBs.
End-use Restrictions
With time, RBI has relaxed the restriction on end-use of ECBs
raised and vide the latest circular dated July 30, 2019 use of ECB
proceeds is now permitted for working capital requirements, general
corporate purposes, repayment of rupee loans and on-lending for such
purposes, subject to limit and leverage requirements detailed in the
Master Direction. In view therefore, the major development in ECB
raised is with respect to permitted use of ECB for working capital
purpose and general corporate purpose with minimum average maturity
period (MAMP) of 10 years. Further, the ECB proceeds can also be
used for repayment of rupee loans availed domestically for capital
expenditure with MAMP of 7 years. The Non-Banking Financial
Company (NBFC) are also permitted to on-lend the ECBs obtained
for repayment of rupee loans availed domestically for capital expenditure
with MAMP of 7 years.
The Master Direction has also clearly mentioned the negative list for
which ECBs cannot be used as under:
1. Real estate activities.
2. Investment in capital market.
3. Equity investment.
4. Working capital purposes, except in case of ECB mentioned at
v(b) and v(c) above.
5. General corporate purposes, except in case of ECB mentioned at
v(b) and v(c) above.
6. Repayment of Rupee loans, except in case of ECB mentioned at
v(d) and v(e) above.
7. On-lending to entities for the above activities, except in case of
ECB raised by NBFCs as given under the Master Direction.
With favourable overseas conditions such as low interest rates
and liquidity, the ECB is expected to be the preferred choice of India
Inc., to bring investment/ loan for new projects, permitted use by RBI.
The overseas market is expected to be favourable market for the
foreseeable future, and therefore it is expected to lead to higher
borrowings by India Inc. With RBI’s check on the ECB, making industry
specific distinctions for automatic route and approval route, clearly
establishing the end-use restriction and minimum average maturity period
etc., it is expected that the ECBs are going to be the priority for bringing
investment in India.
With RBI allowing the use of ECB proceeds for repayment of
loans, the Indian GDP is expected to keep its stability intact and at the
same time allows the Indian Corporates to seek required funds (which

may not be allowed through local banks/ NBFC) from the overseas
market with lesser interest rates.
International Bonds
International Bonds International bonds are a debt instrument.
They are issued by international agencies, governments and companies
for borrowing foreign currency for a specified period of time. The issuer
pays interest to the creditor and makes repayment of capital. There are
different types of such bonds. The procedure of issue is very specific.
All these need some explanation here.
Types of International Bonds Foreign Bonds and Euro Bonds
International bonds are classified as foreign bonds and Euro
bonds. There is a difference between the two, primarily on four counts.
First, in the case of foreign bond, the issuer selects a foreign financial
market where the bonds are issued in the currency of that very country.
If an Indian company issues bond in New York and the bond is
denominated in a currency other than the currency of the country where
the bonds are issued. If the Indian company’s bond is denominated in
US dollar, the bonds will be used in any country other than the USA.
Then only it will be called Euro bond.
Secondly, foreign bonds are underwritten normally by the
underwriters of the country where they are issued. But the Euro bonds
are underwritten by the underwriters of multi nationality.
Thirdly, the maturity of a foreign bond is determined keeping in
mind the investors of a particular country where it is issued. On the
other hand, the Euro bonds are tailored to the needs of the multinational
investors. In the beginning, the Euro bond market was dominated by
individuals who had generally a choice for shorter maturity, but now the

institutional investors dominate the scenes who do not seek Euro bond
maturity necessarily to march their liabilities. The result is that the maturity
of Eurobonds is diverse. In England, Euro bonds with maturity between
8 and 12 years are known as intermediate Euro bonds.
Fourthly, foreign bonds are normally subjected to governmental
regulations in the country where they are issued. For example, in the
case of Yankee bonds (the bonds issued in the USA), the regulatory
thrust lies on disclosures. In some of the European countries, the thrust
lies on the resource allocation and on monetary control. Samurai bonds
(bonds issued in Japan) involved minimum credit rating requirements
prior to 1996. But the Euro bonds are free from the rules and regulations
of the country where they are issued. The reason is that the currency of
denomination is not the currency of that country and so it does not have
a direct impact on the balance of payments.
Eurobonds
The term ‘Euro’ originated in the fifties when the USA under
the Marshall Plan was assisting the European nations in the rebuilding
process a after the devastation caused by the Second World War. The
dollars that were in use outside the US came to be called as
“Eurodollars”. In This context the term ‘Euro’ signifies a currency outside
its home country. The term ‘Eurobonds’ thus refer to bonds issued and
sold outside the home country of the currency. For example, a dollar
denominated bond issued in the UK is a Euro (dollar) bond, similarly, a
Yen denominated bond issued in the US is a Euro (Yen) bond.
The Instruments
All Eurobonds, through their features can appeal to any class
of issuer or investor. The characteristics which make them unique and
flexible are,

a. No withholding of taxes of any kind on interest payments.

b. A fundamental requirement is that the bonds are in bearer form
with interest coupon attached,
c. The bonds are listed on one or more stock exchanges but issues
are generally traded in the over-the-counter market.
Typically, a Eurobond is issued outside the country of the currency
in which it IS denominated. It is like any other Euro instrument and
through intonational syndication and underwriting, the paper is sold
without any limit of geographical boundaries.
Eurobonds, are generally listed on world’s stock exchanges, usually
on the Luxembourg Stock Exchange. There were various
innovations in the structuring of bond issues during the eighties.
These structures used swap technique to switch from one currency
to another, or to acquire multi-currency positions. Another variation
was in the form of equity-related bonds as 181 convertibles or
bonds with equity warrants. Zero-coupon bonds were issued
capitalizing on the tax treatment. Bond issue structures can be
classified into two broad categories:
Fixed rate bonds (also referred as straights) and Floating-Rate
Notes (FRNs).
a. Fixed Rate Bonds / Straight Debt Bonds:
Straight Debt Bonds are fixed interest-bearing securities which
are redeemable at face value. These unsecured bonds which are floated
in domestic markets or international markets, are denominated in the
respective currency with interest rates fixed on the basis of a certain
formula applicable in a given market. The bonds issued in the Euro-
market referred to as Euro-bonds, have interest rates fixed with reference
to the creditworthiness of the issuer. The yields on these instruments
depend on short-term interest rates. LIBOR is the most commonly

used benchmark for measuring the yields on these bonds. The interest
rate on dollar denominated bonds is set at a margin over the US
treasury yields.
The redemption of straights is done by bullet payment, where
the repayment of debt will be in one lump sum at the end of the maturity
period, and annual servicing. Further, there is no tax deduction at source
on the income of these bonds. These bonds are listed either on London,
Luxembourg or Singapore stock exchanges. In addition to the fixed
rate bonds, there are the zero-coupon bonds which do not pay the
investors any interest and therefore, are not taxable on a year-to-year
basis. Instead, the differential between maturity value and the issue price
could be treated as capital gains and taxed at a lower rate accordingly.
The first zero-coupon bond was floated in Euromarkets in 1981 for
Pepsico which was made at a price of 67.5 per cent for a maturity of
three years, with repayment at 100 per cent on the maturity date. This
has provided a yield of 14.14 per cent to the investors.
b. Floating Rate Notes (FRNs):
FRNs can be described as a bond issue with a maturity period
varying from 5-7 years having varying coupon rates - either pegged to
another security or re-fixed at periodic intervals. Conventionally, the
paper is referred to as notes and not as bonds. The spreads or margin
on these notes will be above 6 months LIB OR for Eurodollar deposits.
The bulk of the issues in the seventies were denominated in US dollars.
Later, the concept was applied to other currencies, like Pound Sterling,
Deutsche Mark, European currency units and others. Extensive usage
of these FRNs is done by both American and Non-American Banks
who would borrow to obtain dollar without exhausting credit lines with
other banks. Thus, FRNs represent an additional way to raise capital

for them. To cater to the varying shifts in the investor preferences and
borrowers’ financial requirements, variations have been introduced in
the basic FRN concept.
FRNs have thus been restructured into the following types:
1. Flip-Flop FRNs:
The investors have the option to convert the paper into flat interest
paying instrument at the end of a particular period. The investor
could change his mind and convert the note into perpetual note
once again at maturity. World Bank had come out with a FRNs
issue with perpetual life and having a spread of 50 basis points
over the US treasury rate. Every 6 months the investors had the
option of converting the FRN into 3-month note with a flat 3-
month yield. The investor could also revert his decision and change
it to a perpetual note.
2. Mismatch FRNs:
These notes have semi-annual interest payments though the actual
rate is fixed monthly. This enables investors to benefit from
arbitrage arising on account of differentials in interest rates for
different maturities. They are also known as rolling rate FRNs.
3. Mini-Max FRNs:
These notes include both minimum and maximum coupons. The
investors will earn a minimum rate as well as a maximum rate on
these notes. Depending on the differential between these rates the
spreads are earned on these notes. These notes are also known
as collared FRNs.

4. Capped FRNs:
An interest rate cap is given over which the borrower is not required
to service the notes, even if Libor goes above that level. Typically,
the investors have margins higher than that is normally applicable.
5. VRN-Structured FRNs:
These represent long-dated paper with variable interest spreads,
with margins over Libor. The margins rise for longer maturities.
6. Perpetual FRNs:
These notes which are irredeemable are also known as perpetual
floaters or undated issues
Procedure
Coming out with a bond issue is the most complex and elaborate
of the procedures of all the funding programs. Bonds need to be carefully
designed and executed, especially as these are placed with international
clientele.
The success of the bond issue depends not so much on costs
as on the position and capabilities of the bidders for launching the issue.
The cheapest bid therefore, may not be the best bid because the track
record and current market standing of the bidders would have to be
carefully weighed while choosing the lead manager.
Therefore, the mandate of the bond issue has to be awarded
after proper deliberation on the modalities involved. The bids should
include all necessary information relating to the placement strategy,
market support operations, listing details, paying agency arrangements,
delivery and handling of notes and trustee arrangements.

After the receipt of a mandate, the mandated bank (referred to

as lead manager or arrangers) has to initiate steps for the formation of
a syndicate group to complete bond issue formalities. Since, it is the
key member of the syndicate group, it is responsible for a series of
tasks starting with the launching of the issue till its closure.
a. Syndication: In particular, the Arranger’s (lead managers) duties
commence with a credit appraisal of the issuer on the basis of a financial
and operational data. The lead manager has to organize detailed
negotiations with the issuer for the purposes of settling various terms
and conditions. A time table too has to be drawn for going’ through
various stages of bond issue floatation.
It is also the lead managers’ responsibility for drafting documents
with the help of legal counsels. Bond issue documentation comprises,
besides prospectus, subscription agreement, underwriting agreement,
selling agency agreement, paying agency agreement, listing agreement
and the trust deed. These agreements have the same kind of properties
as in the case of a GDR issue.
Traditionally, international markets have been following open
priced syndication procedures. Under this, the lead manager keeps
pricing open until the subscription agreement is actually signed. The
lead manager assesses not only the market mood but the precise level
at which an issue would be supported and subscriptions can be procured
in adequate measure.
International markets have also come up with an innovative
method of syndication referred to as bought-out deal process. Under
this system, pre priced issue (pre-printed by the lead manager and
co-management group) are presented to the market and the issuer knows
the exact issue ‘price and coupon rate before the former is launched in
the market.
b. Launching, Offering and Closing:

Placement of new bond issues in markets follows a standard
route. On receipt of various approvals and authorizations by the issuer,
news concerning bond issue floatation is carried through the appropriate
media. With the announcement of a bond issue launch, invitation telexes
are sent to underwriters and to selling group members inviting their
support. The main functions of underwriting is to take up the issue on
execution of the underwriting agreement.
Compared to underwriting, selling is organized in a different
manner. While underwriters take title to the issue so underwritten, selling
group members do not take title as they undertake to sell the issue
if support is obtained. The selling group, therefore, do not carry any
risk - in a technical sense compared to the underwriting group.
The next stage in bond issue floatation is the offering. During
this phase, terms consisting of coupon rate and issue price are finalized.
Pricing is determined on the basis of the underwriters’response, and is
undertaken one day before the offering. The lead managers, jointly
with co-managers, have to assess the mood and response of the market
and weigh the response of the underwriters accordingly.
The two-day period prior to the offer is, therefore, very crucial
and hectic discussions and negotiations are undertaken in order to arrive
at a correct bond issue pricing. During the offering period, the issuer
and the lead manager organize a sales campaign. Various markets are
tapped by means of road shows. These are in fact investor meetings
where the offering of a bond is formally presented to investors. Road
shows are organized at various centres and are important from the
point of view of placing the issue. The offering phase is concluded with
the actual sale of bonds, signing of necessary agreements and publicity
regarding the transaction coming to an end.
Listing
Bond issue are listed at one or more stock exchanges depending
upon the type of bond issue, the currency of denomination and the
desire of the issuer to seek a quotation at various centres. Generally,
the Eurobonds denominated in dollars are listed at London/ Luxembourg
Stock Exchanges, the bonds denominated ill French Franc at
Luxembourg Stock Exchange and those bonds denominated in DM at
German Stock Exchanges. Bonds issued in domestic markets like Japan,
Switzerland or Germany have to be listed as per the requirements.
Bond issue procedures are finally concluded with the tombstone
advertisement and bible compilation.
Clearing Arrangements
With a view to facilitating both new issue and secondary market
operations, clearing house arrangements have been made and systems
laid down for handling transactions. Eurobonds are usually handed over
to either the Euro clear system (Brussels) or Cedel (Luxembourg). The
two systems have been linked by what is known as an electric bridge.
Euroclear and Cedel follow two distinct practices, fungible and non-
fungible accounts, for concluding transactions between parties. While
the fungible accounts system is most popular in Euromarkets, the non-
fungible system is useful for control purposes. In a fungible account
system, details regarding the identity of the owners and location of
individual securities are not provided. Euroclear system handles trades
on fungible basis, whereas Cedel permits both procedures. The two
clearing systems have been providing various other facilities, apart from
settlement of secondary market trading transactions. For instance, finance
is provided by them for facilitating market-making operations.

Euro notes and Euro commercial papers

These instruments are short term unsecured promissory notes
issued by corporations and banks. Euro notes, the more general term,
encompasses note issuance facilities, those that are underwritten, as
well as those that are not underwritten. The companies wishing to come
out with shorter maturities have an option to issue Euro notes in the
European Markets. The important ones being Commercial Paper (CP),
Note Issuance Facilities (NIF) and Medium- Term Notes (MTNs).
Euro-Commercial Paper issued with maturity of up to one year,
are not underwritten and are unsecured. Note Issuance Facilities (NIFs)
are underwritten and have a maturity of up to one year. Standby NIFs
are those formally designated instruments which back Commercial
Paper to raise short-term finances. A variation of NIF is the Multiple
Component Facility (MCF), where a borrower is enabled to draw
funds in a number of ways, as a part of overall NIF program. These
options are referred to as short-term advances and banker’s
acceptances, and afford opportunities for choosing the maturity, currency
and interest rate basis. Medium-Term Notes, on the other hand, are
non-underwritten and are issued for maturities of more than one year
with several trances depending upon the preferred maturities.
It is to be noted that in similar circumstances, a typical CP
program allows for a series of note issues having regard to the maturity
of the overall program. The borrowings in the international capital
markets are in the form of Euro Loans which are basically loans from
the bank to the companies which need long-term and medium-term
funds. Broadly, two distinct practices of arranging syndicated credits
have emerged in Euromarkets, club loans and syndicated loans. The
Club Loan is a private arrangement between lending banks and a
borrower.
When the loan amounts are small and the parties are familiar
with each other; lending banks form a club and advance a loan hence
the name of club loan. Syndicated Euro credit, however, has a full-
fledged public arrangement for organizing a loan transaction. 159 It is
treated as an integral part of the financial market mechanism with a
wide network of banks participating in the transaction over the globe.
Typically, a syndicated loan is available for a maturity of seven years
with shorter period transactions having a maturity of 3 to 5 years.
Eurodollars
The term Eurodollar refers to U.S. dollar-denominated deposits
at foreign banks or at the overseas branches of American banks.
Because they are held outside the United States, Eurodollars are not
subject to regulation by the Federal Reserve Board, including reserve
requirements. Dollar-denominated deposits not subject to U.S. banking
regulations were originally held almost exclusively in Europe (hence,
the name Eurodollar). Now, they are also widely held in branches located
in the Bahamas and the Cayman Islands.
The fact that the Eurodollar market is relatively free of regulation
means such deposits can pay higher interest. Their offshore location
makes them subject to political and economic risk in the country of
their domicile; however, most branches where the deposits are housed
are in very stable locations.
The Eurodollar market is one of the world’s primary international
capital markets. They require a steady supply of depositors putting
their money into foreign banks. These Eurodollar banks may have
problems with their liquidity if the supply of deposits drops.
Deposits from overnight out to a week are priced based on the
fed funds rate. Prices for longer maturities are based on the

corresponding London Interbank Offered Rate (LIBOR). Eurodollar

deposits are quite large; they are made by professional counterparties
for a minimum of Rs.100,000 and generally for more than Rs.5 million.
It is not uncommon for a bank to accept a single deposit of Rs.500
million or more in the overnight market. A 2014 study by the Federal
Reserve Bank showed an average daily volume in the market of Rs.140
billion.
Most transactions in the Eurodollar market are overnight, which
means they mature on the next business day. With weekends and
holidays, an overnight transaction can take as long as four days. The
transactions usually start on the same day they are executed, with money
paid between banks via the Fedwire and CHIPS systems. Eurodollar
transactions with maturities greater than six months are usually done as
certificates of deposit (CDs), for which there is also a limited secondary
market.
History of the Eurodollar
The Eurodollar market dates back to the period after World
War II. Much of Europe was devastated by the war, and the United
States provided funds via the Marshall Plan to rebuild the continent.
This led to wide circulation of dollars overseas, and the development
of a separate, less regulated market for the deposit of those funds.
Unlike domestic U.S. deposits, the funds are not subject to the Federal
Reserve Bank’s reserve requirements. They are also not covered by
FDIC insurance. This results in higher interest rates for Eurodollars.
Many American banks have offshore branches, usually in the
Caribbean, through which they accept Eurodollar deposits. European
banks are also active in the market. The transactions for Caribbean
branches of U.S. banks are generally executed by traders physically

situated in U.S. dealing rooms, and the money is on loan to fund domestic
and international operations.
Eurocurrency Market
Euro-currency market, also known as Euro-dollar market, is
an international capital market which specializes in borrowing and
lending of currencies outside the country of issue. Thus, deposits in
dollars with a bank in London are Euro dollars. Similarly, French francs
held by banks in London are Euro-francs; pound-sterling held by banks
in Germany are Euro-sterling, and so on. They are all Euro-currencies.
Predominantly, the dealings in the market are in dollars and hence the
name Euro-dollar market is still in vogue.
The main centres of Euro-currency are London and a few other
places in Europe. The growth of the market has extended beyond
these limits and now it includes a few centres of Asia too, such as
Singapore. The centres in Asia are known as Asian-dollar n the terms
Euro-dollars and Euro-currency are used universally to denote all such
markets, including the Asian dollar market.
Special Features of the Market
The following are the special features of the Euro-currency market:
1. Transactions in each currency take place outside the country of
its issue. For example, dollars earned by a Japanese firm from
exports may be deposited with a bank in London. The London
bank is free to use the funds for lending to any other bank. The
bank may use it for lending to French Bank. Thus, the utility of the
currency is entirely outside the control of the central bank of the
country issuing the currency. For this reason, Euro-currencies are
also referred to as offshore Currencies

2. Even though the currency is utilised outside the country of its origin,
it has to be held only in the country of its issue. To continue our
example, the Japanese firm deposits its dollar earnings with a bank
in London. The London Bank will keep the funds in a New York
Bank in its own name. When the London Bank lends the amount
to the French Bank, it will give suitable instructions to the New
York Bank. On receipt of the instructions, the New York Batik
will debit the account of the London Bank and credit it to the
account of the French Bank. Thus, ultimately the settlement of all
dollar transactions takes place in New York. Similarly, settlement
of all Euro-sterling transactions is made in London, all Euro-French
franc transactions in Paris and so on.
3. Though Euro-currencies are outside the direct control of the
monetary authorities of their respective countries of issue, they
are subject to some form of indirect control. This is because the
settlement of all transactions has to take place only in the country
of issue. If the country of issue imposes any restrictions, the
conversion of balances in the currency held outside the country
into another currency would also be affected. As already stated,
conversion into another currency would involve clearing in the
country of issue at some point of the transaction. This automatically
subjects them to the restriction.
4. Euro-currency market is not a foreign exchange market. It is a
market for deposits with and between banks (inter-bank deposits)
and for loans by banks to the non-bank public. It is a market in
which foreign currencies are lent and borrowed as distinct from
the foreign exchange market, where they are bought and sold. It
consists of a pool of predominantly short- term deposits which
provide the big single source of funds that commercial banks

transform into medium and occasionally long-term international

loans or Euro-credits.
5. The transactions in the market involve huge amounts running into
millions of dollars. The large-scale financing has led to the
development of syndications of loans, where a large number of
banks participate in the lending operations.
6. Euro currency is a market is a highly competitive market with free
access for new institutions in the market. Consequently, the margin
between the interest rates on deposits and adv has narrowed down
considerably.
7. A special feature is the concept of ‘floating rates of interest’. The
rate of interest is linked to a base rate, usually the London Inter-
Bank Offered Rate (LIBOR). The interest on the deposit or the
advance would be reviewed periodically and changed in
accordance with change, if any, in LIBOR.
8. US dollar remains the leading currency traded in the Euro-currency
market, even though its share is declining. Other currencies traded
in the market on large scale are Deutsche mark, Japanese Yen,
Pound Sterling and Swiss Franc.
9. The Euro-currency market can broadly be divided into four
segments:
(i) Euro-credit markets, where international group of banks
engage in lending for medium and long term;
(ii) Euro-bond market, where banks raise funds on behalf of
international borrowers by issuing bonds; and
(iii) Euro-currency (deposits) market, where banks accept
deposits, mostly for short term.

(iv) Euro-notes market, where corporate raise funds. The division

is not watertight and the different segments overlap each
other.
Interest Rate in Euro-Currency Markets
The interest rates in Euro-currency markets are determined by a
multitude of factors which affect the demand and supply conditions
of the currency concerned. Some of the factors are:
(i) volume of world trade transacted in the currency,
(ii) domestic interest rates,
(iii) domestic monetary policy and reserve requirements.
(iv) Domestic government regulation, and
(v) relative strength of the currency in the foreign exchange
market.
In practice, domestic interest rates act as a floor to Eurocurrency
rates because the funds flow into Eurocurrency market seeking higher
interest. Although the Eurocurrency market operates in a number of
centres around the world, interest rates for a particular currency are
consistent. Any temporary variations at different markets are quickly
eliminated by international arbitrage.
Interest in Eurocurrency market is generally a floating rate of
interest. Periodically, the interest rate will change with reference to a
benchmark rate like LIBOR. For instance, the interest on a Euro-bond
for five years may be fixed at ISO basis points over Libor. (One basis
point is 1/100 of 1 per cent. The Libor at the time of issue plus 1.5 per
cent will be applicable for six months. At the end of this period, Libor
then prevailing will be reckoned and the interest for the next six months

will be based on the Libor then prevailing. This vi1l be repeated every
six months.
LIBOR is the ‘London Inter-Bank Offered Rate’ and represents
the rate’ which banks in London will lend a currency to other banks for
a specific maturity. Since London is a major Eurocurrency market. Libor
is used as the basis for most Eurocurrency transactions) Libor varies
for different maturities. Thus, we have 1 month Libor, 3 months Libor,
6 months Libor etc. Rates quoted by different banks may vary slightly,
the bigger banks offering lower rates. In respect of a particular contract
based on Libor, say a Eurobond issue, the rate is fixed by nominating
reference banks. The reference banks may be from among those
syndicating the issue. Or, to maintain neutrality, they may be banks
outside the syndicate.
The rates quoted by these banks at a stipulated time, often 11
AM London time, two business days before start of the due date, is
taken as the basis. The average of such rates is rounded off to the
nearest 1/8 per cent.
LIBID is the ‘London Interbank Bid’ rate. It is the rate at which
banks accept euro deposits.
Bid rates are lower than offered rates usually by 1/8 to 1/4 per cent.
LIMEAN is the average of Libor and Libid. Prime Rate is the
rate of interest charged by first class banks in USA on advances to
their first-class borrowers. For example, it may relate to an advance
made to a multinational corporation with a very high credit rating. This
rate is usually a couple of per centage points higher than the discount
and Federal funds rate. While it follows the same trends, it is determined
rate calculated from money market rates, especially from the 90 days
Certificate of Deposit rate.

Every bank in the USA announces independently its prime rate,

but this tends to influence the rate of other banks also. Similarly, the
prime rate has influence over the Eurodollar rate and is also influenced
by it. A change in the prime rate is followed by a change in the
Eurocurrency rate and vice versa. SIBOR represents the Singapore
interbank Offered Rate Similar to Libor, it is the rate at which principal
banks in Singapore offer to lend Asian dollars and other currencies to
other banks. Sibor forms the basis for interest rate on Asian dollar and
syndicated loans.
Most of the lending in Euro-currency markets takes the form
of Euro-credit. Eurocredits are medium and long-term loans provided
by international group of banks in currencies which need not be those
of the lenders or borrowers. Euro- credit belongs to wholesale sector
of the international capital market and normally involves large amounts.
Role of Euro Currency Market in International Financial System:
The Euro-currency market has been playing an important role
in international financial system. Investing and borrowing US dollars is
the core function of the Euro-currency market. It transfers short and
medium terms funds throughout the world, thereby increasing
international capital mobility. It not only enables individual banks to
improve their portfolio allocation, but also provides important services
to the non-bank private sector.
The Euro-currency market attracts funds because it offers higher
interest rates, greater flexibility of maturities, and a wider range of
investment qualities than other short-term capital markets. It attracts
borrowers because it lends funds at relatively low interest rates.

It is competitive in the interest rates it charges and receives,

both because of the economies of scale afforded by concentrating on
wholesale transactions, and because the Euro-banks are not subject to
the regulations which tend to raise costs in domestic banking.
Commercial banks, central banks, government treasuries, international
banks like the Bank of International Settlement, and multinational
corporations are the borrowers and lenders in the Euro-currency
market.
Effects of Euro Currency Market: Positive Effects:
The following have been the economic consequences of the Euro-
currency market:
1. The expansion of the Euro-currency market has greatly increased
international capital mobility and has helped in easing the global
liquidity problem.
2. It has helped in integrating international capital markets.
3. It has played an effective role in recycling funds from countries
having surplus balance of payments to those having deficit balance
of payments.
4. International flows of Euro-currencies have improved economic
efficiency by reducing interest differential among nations.
5. The Euro-currency market has also resolved the problems of
countries whose policy objectives aim at controlling international
capital movements by transferring their currencies from and to
Euro-banks.
6. It has helped in financing BOP deficits and surpluses of countries
through lending and borrowing their currencies in exchange for
other currencies from the Euro-currency market.
Adverse Effects:
However, these flows of Euro-currencies have three adverse effects:
First, when the monetary authority of a country is trying to curb
inflation through a restrictive monetary policy, an inflow of short-term
capital defeats such a policy. Again when there is an outflow of capital
and the country is following an easy monetary policy to combat
unemployment, such a policy again becomes ineffective. This is because
the Euro-currency market does not operate under the regulations of
any authority.
Second, Euro-currencies provide an enormous fund of liquid
resources which are used for speculative capital movements. These
expose the economies of the concerned countries to severe strains of
sudden and large withdrawals of credits. Such financial upheavals and
disturbances also affect the international monetary system as a whole,
especially when the countries involved are not protected by exchange
controls or trade barriers.
Third, according to Milton Friedman, “The Euro-currency
market has almost surely raised the world’s nominal money supply
(expressed in dollar equivalents) and has thus made the world
price level (expressed in dollar equivalents) higher than otherwise it
would be.”

Financial Markets

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Markets

Uploaded by

Copyright:

Available Formats

UNIVERSITY OF CALICUT

SCHOOL OF DISTANCE EDUCATION

2019 Admission onwards

Module I Financial Markets

Module II Money Market

Module III Capital Market

Module IV Derivatives Market

Module V Global Financial Markets

School of Distance Education, University of Calicut 4

Module I: Financial Markets

Functions of financial markets-Types of financial markets-

Functions of money market-Instruments of the money market-

Functions of capital market-Primary market-Instruments of the

Module IV: Derivatives Market

Types of derivatives-Participants in the derivative markets-Uses

Instruments- American Depository Receipts (ADR)-Global

School of Distance Education, University of Calicut 6

Financial system is an integral part of modern economy.

7 School of Distance Education, University of Calicut

School of Distance Education, University of Calicut 8

9 School of Distance Education, University of Calicut

Financial Institutions or Intermediaries are all kinds of

They may be in the organised sector or in the unorganised sector.

(i) Capital market intermediaries.

(ii) Money market intermediaries.

Capital market intermediaries

Money market intermediaries

Financial institutions may be Regulatory, Intermediaries,

School of Distance Education, University of Calicut 10

11 School of Distance Education, University of Calicut

II. Financial Instruments

The stages of development of the Financial System can be judged

Can be classified generally as -

2. Debt based, representing a loan made by an investor to the

3. Foreign exchange instruments comprise a third, unique type of

Features of Financial instruments

School of Distance Education, University of Calicut 12

6. Have specified maturity period

(i) Primary or direct securities.

(ii) Secondary or indirect securities.

(ii) Medium-term securities.

(iii) Long-term securities.

13 School of Distance Education, University of Calicut

Short-term securities are those which mature within a period

III. Financial Services

Financial service is part of financial system that provides different

School of Distance Education, University of Calicut 14

forms of financial or market inter mediation including the distribution of

The financial system encompasses the financial infrastructure

The structure of the world’s financial markets and institutions

15 School of Distance Education, University of Calicut

growth. Furthermore, several recent studies conclude that the

Functions of Financial Markets

School of Distance Education, University of Calicut 16

17 School of Distance Education, University of Calicut

essential to promoting economic efficiency. Financial Markets

A primary market is a financial market in which new issues of a

School of Distance Education, University of Calicut 18

The New York Stock Exchange, NASDAQ (National

When an individual buys a security in the secondary market,

19 School of Distance Education, University of Calicut

financial capital it can raise. Conditions in the secondary market are

2. Money and Capital Markets

Another way of distinguishing between markets is on the basis