Additional Lecture Notes:

Types of Financial Institutions

 Commercial Banks
A commercial bank is a type of financial institution that accepts deposits, offers checking
account services, makes business, personal, and mortgage loans, and offers basic financial
products like certificates of deposit (CDs) and savings accounts to individuals and small
businesses. A commercial bank is where most people do their banking, as opposed to an
investment bank.
 Investment Banks
Investment banks specialize in providing services designed to facilitate business operations,
such as capital expenditure financing and equity offerings, including initial public offerings
(IPOs). They also commonly offer brokerage services for investors, act as market makers for
trading exchanges, and manage mergers, acquisitions, and other corporate restructurings.
 Insurance Companies
Among the most familiar non-bank financial institutions are insurance companies. Providing
insurance, whether for individuals or corporations, is one of the oldest financial services.
Protection of assets and protection against financial risk, secured through insurance products, is
an essential service that facilitates individual and corporate investments that fuel economic
growth.
 Brokerage Firms
Investment companies and brokerages, such as mutual fund and exchange-traded fund (ETF)
provider Fidelity Investments, specialize in providing investment services that include wealth
management and financial advisory services. They also provide access to investment products
that may range from stocks and bonds all the way to lesser-known alternative investments,
such as hedge funds and private equity investments.

A nonbank financial institution (NBFI) is a financial institution that does not have a full banking
license and cannot accept deposits from the public. However, NBFIs do facilitate alternative
financial services, such as investment (both collective and individual), risk pooling, financial
consulting, brokering, money transmission, and check cashing. NBFIs are a source of consumer
credit (along with licensed banks).

Risk pooling institutions

Insurance companies underwrite economic risks associated with death, illness, damage to or
loss of property, and other risk of loss. They provide a contingent promise of economic
protection in the case of loss. There are two main types of insurance companies: life insurance
and general insurance.
 General insurance is further divided into two categories: market and social insurance.
Social insurance is against the risk of loss of income due to sudden unemployment,
disability, illness, and natural disasters. Because of the unpredictability of these risks,
the ease at which the insured can hide pertinent information from the insurer, and the
presence of moral hazard, private insurance companies frequently do not provide social
insurance, a gap in the insurance industry which government usually fills.
 Social insurance is more prevalent in industrialized Western societies where family
networks and other organic social support groups are not as prevalent.
  Market insurance is privatized insurance for damage or loss of property. General
insurance companies take a single premium payment. In return, the companies will
make a specified payment contingent on the event that it is being insured against.
Examples include theft, fire, damage, natural disaster, etc.

Contractual savings institutions

Contractual savings institutions (also called institutional investors) provide the opportunity for
individuals to invest in collective investment vehicles in a fiduciary rather than a principle role.
Collective investment vehicles invest the pooled resources of the individuals and firms into
numerous equity, debt, and derivatives promises
.
The two main types of mutual funds are open-end and closed-end funds. Open-end funds
generate new investments by allowing the public buy new shares at any time. Shareholders can
liquidate their shares by selling them back to the open-end fund at the net asset value. Closed-
end funds issue a fixed number of shares in an IPO. The shareholders capitalize on the value of
their assets by selling their shares in a stock exchange.

Mutual funds can be delineated along the nature of their investments. For example, some
funds make high-risk, high return investments, while others focus on tax-exempt securities. Still
others specialize in speculative trading (i.e. hedge funds), a specific sector, or cross-border
investments. Pension funds are mutual funds that limit the investor’s ability to access their
investment until after a certain date. In return, pension funds are granted large tax breaks in
order to incentivize the working public to set aside a percentage of their current income for a
later date when they are no longer amongst the labor force (retirement income).

Other nonbank financial institutions

Market makers are broker-dealer institutions that quote both a buy and sell price for an asset
held in inventory. Such assets include equities, government and corporate debt, derivatives,
and foreign currencies. Once an order is received, the market maker immediately sells from its
inventory or makes a purchase to offset the loss in inventory. The difference in the buying and
selling quotes, or the bid-offer spread, is how the market-maker makes profit. Market makers
improve the liquidity of any asset in their inventory.

Specialized sectoral financiers provide a limited range of financial services to a targeted sector.
For example, leasing companies provide financing for equipment, while real estate financiers
channel capital to prospective homeowners. Leasing companies generally have two unique
advantages over other specialized sectoral financiers. They are somewhat insulated against the
risk of default because they own the leased equipment as part of their collateral agreement.
Additionally, leasing companies enjoy the preferential tax treatment on equipment investment.
Other financial service providers include brokers (both securities and mortgage), management
consultants, and financial advisors. They operate on a fee-for-service basis. For the most part,
financial service providers improve informational efficiency for the investor. However, in the
case of brokers, they do offer a transactions service by which an investor can liquidate existing
assets.
Role in financial system
NBFIs supplement banks in providing financial services to individuals and firms. They can
provide competition for banks in the provision of these services. While banks may offer a set of
financial services as a package deal, NBFIs unbundle these services, tailoring their services to
particular groups. Additionally, individual NBFIs may specialize in a particular sector, gaining an
informational advantage. By this unbundling, targeting, and specializing, NBFIs promote
competition within the financial services industry.
Having a multi-faceted financial system, which includes non-bank financial institutions, can
protect economies from financial shocks and recover from those shocks. NBFIs provide multiple
alternatives to transform an economy's savings into capital investment, which act as backup
facilities should the primary form of intermediation fail.
However, in countries that lack effective regulations, non-bank financial institutions can
exacerbate the fragility of the financial system. While not all NBFIs are lightly regulated, the
NBFIs that comprise the shadow banking system are. In the run-up to the recent global financial
crisis, institutions such as hedge funds and structured investment vehicles, were largely
overlooked by regulators, who focused NBFI supervision on pension funds and insurance
companies. If a large share of the financial system is in NBFIs that operate largely unsupervised
by government regulators and anybody else, it can put the stability of the entire system at risk.
Weaknesses in NBFI regulation can fuel a credit bubble and asset overpricing, followed by asset
price collapse and loan defaults.

Banking financial institutions

Banks, more precisely – retail or commercial banks, fall under the category of banking financial
institutions. A bank is a financial intermediary with a purpose to act as a middleman between
suppliers of funds or depositors and borrowers. The main task of a bank is to accept deposits and
use these funds later on to offer loans to its customers. Another duty of a bank is to act as a
payment agent, which is done by offering a host of payment services, such as credit and debit
cards, direct deposit facilities, cheques and bank drafts. A bank makes money by investing the
deposits in financial securities and assets, but mostly by lending the funds further to its
customers. The primary reasons for depositing money in banks are convenience, safety and
interest income.

Non-banking financial institutions

The other type of financial institutions includes investment banks, insurance companies,
investment funds and other. A range of financial services offered by non-banking financial
institutions differ from those of a bank. The main difference between both is that non-banking
financial institutions cannot accept deposits into savings and demand deposit accounts, while it is
Meanwhile, they businesses
one of the core offer a variety of otherfinancial
for banking services.institutions.
For example, investment banks offer services
to
their clients such as underwriting of debt and share issues, corporate advisory, securities
trading and derivative transactions and other investment services. Insurance companies offer a
protection against specific losses in exchange for an insurance premium. Pension and mutual
funds are savings institutions where investors are able to invest their funds in collective
investment vehicles. There are financial services that are provided by both banking and non-
banking financial institutions, such as granting loans, financial consultancy, leasing of
equipment and investment in financial securities.
Banks: The central and commercial banks are the most well-known financial intermediaries
simplifying the lending and borrowing process, along with providing various other services to its
customers on a large scale.

Credit Unions: These are the cooperative financial units which facilitate lending and borrowing
of funds to provide financial assistance to its members.

Non-Banking Finance Companies: A NBFC is a financial company engaged in activities such as

advancing loans to its clients at a very high rate of interest.

Stock Exchanges: The stock exchange facilitates the trading of securities and stocks, and in
every trading activity, it charges the brokerage from each party which is its profit.

Mutual Fund Companies: The mutual fund organizations club the amount collected from
various investors. These investors have identical investment objectives and risk-taking ability.
The funds are then collectively invested in the securities, bonds, and other investment options,
to ensure a capital gain in the long run.

Insurance Companies: These companies provide insurance policies to the individuals and
business entities to secure them against accident, death, risk, uncertainties and default. For this
purpose, they accept deposits in the form of premium, which is pooled into profitable
investments to gain returns. The insured person can claim the money in case of any mishap as
per the agreement.

Financial Advisers or Brokers: The investment brokers also collect the funds from various
investors to invest it in the securities, bonds, equities, etc. The financial advisers even provide
guidance and expert opinions to the investors.

Investment Bankers: These banks specialize in services like initial public offerings (IPO), other
equity offerings, proving for mergers and acquisitions, institutional client’s broker services,
underwriting debts, etc. As a result of constant mediation, between the investor or public and
the companies issuing securities.

Escrow Companies: It is a third party acting as an intermediary and responsible for getting all
the conditions fulfilled at the time of loan provided by one party to the other for the real estate
mortgage.

Pension Funds: The government entities initiate a pension fund. A certain amount is deducted
from the salary of the employees each month. This collected sum is then invested in different
schemes to gain profits. The investor’s fund is returned with interest after their retirement.

Building Societies: These financial intermediaries are similar to the credit unions, owned and
facilitating mortgage loans and demand deposits to its members.

Collective Investment Schemes: Under this scheme, the various investors with common
investment objective come together to pool their funds and collectively invest this amount into
a
profitable investment option. Later they distribute the interest among themselves as per the
agreement.

The main components of capital market are: 1. Primary Market 2. Secondary Market
1. Primary Market (New Issue Market):
Primary market is also known as new issue market. As in this market securities are sold for the
first time, i.e., new securities are issued from the company. Primary capital market directly
contributes in capital formation because in primary market company goes directly to investors
and utilizes these funds for investment in buildings, plants, machinery etc. The primary market
does not include finance in the form of loan from financial institutions because when loan is
issued from financial institution it implies converting private capital into public capital and this
process of converting private capital into public capital is called going public. The common
securities issued in primary market are equity shares, debentures, bonds, preference shares
and other innovative securities.

2. Secondary Market (Stock Exchange):

The secondary market is the market for the sale and purchase of previously issued or
secondhand securities. In secondary market securities are not directly issued by the company to
investors. The securities are sold by existing investors to other investors. Sometimes the
investor is in need of cash and another investor wants to buy the shares of the company as he
could not get directly from company. Then both the investors can meet in secondary market
and exchange securities for cash through intermediary called broker.

In secondary market companies get no additional capital as securities are bought and sold
between investors only so directly there is no capital formation but secondary market indirectly
contributes in capital formation by providing liquidity to securities of the company.

If there is no secondary market then investors could get back their investment only after
redemption period is over or when company gets dissolved which means investment will be
blocked for a long period of time but with the presence of secondary market, the investors can
convert their securities into cash whenever they want and it also gives chance to investors to
make profit as securities are bought and sold at market price which is generally more than the
original price of the securities.

This liquidity offered by secondary market encourages even those investors to invest in
securities who want to invest for small period of time as there is option of selling securities at
their convenience.

THE METHOD OF FLOATATION OF SECURITIES IN PRIMARY MARKET:

1. Public Issue through Prospectus:
Under this method company issues a prospectus to inform and attract general public. In
prospectus company provides details about the purpose for which funds are being raised, past
financial performance of the company, background and future prospects of company. The
information in the prospectus helps the public to know about the risk and earning potential of
the company and accordingly they decide whether to invest or not in that company.
2. Offer for Sale:
Under this method new securities are offered to general public but not directly by the company
but by an intermediary who buys whole lot of securities from the company. Generally the
intermediaries are the firms of brokers.
3. Private Placement:
Under this method the securities are sold by the company to an intermediary at a fixed price
and in second step intermediaries sell these securities not to general public but to selected
clients at higher price. The issuing company issues prospectus to give details about its
objectives, future prospects so that reputed clients prefer to buy the security from
intermediary. Under this method the intermediaries issue securities to selected clients such as
UTI, LIC, General Insurance, etc.
4. Right Issue (For Existing Companies):
This is the issue of new shares to existing shareholders. It is called right issue because it is the
pre- emptive right of shareholders that company must offer them the new issue before
subscribing to outsiders. Each shareholder has the right to subscribe to the new shares in the
proportion of shares he already holds. A right issue is mandatory for companies under
Companies’ Act.
20.5. e-IPOs, (electronic Initial Public Offer):
It is the new method of issuing securities through on line system of stock exchange. In this
company has to appoint registered brokers for the purpose of accepting applications and
placing orders. The company issuing security has to apply for listing of its securities on any
exchange other than the exchange it has offered its securities earlier. The manager coordinates
the activities through various intermediaries connected with the issue.

Other Examples of Financial Markets:

Bond market:
The bond market—often called the debt market, fixed-income market, or credit market—is the
collective name given to all trades and issues of debt securities. Governments typically issue
bonds in order to raise capital to pay down debts or fund infrastructural improvements.
Publicly-traded companies issue bonds when they need to finance business expansion projects
or maintain ongoing operations.
The bond market is broadly segmented into two different silos: the primary market and the
secondary market. The primary market is frequently referred to as the "new issues" market in
which transactions strictly occur directly between the bond issuers and the bond buyers. In
essence, the primary market yields the creation of brand-new debt securities that have not
previously been offered to the public.

In the secondary market, securities that have already been sold in the primary market are then
bought and sold at later dates. Investors can purchase these bonds from a broker, who acts as
an intermediary between the buying and selling parties. These secondary market issues may be
packaged in the form of pension funds, mutual funds, and life insurance policies—among many
other product structures.

Types of Bond Markets

The general bond market can be segmented into the following bond classifications, each with
its own set of attributes.
Corporate Bonds
Companies issue corporate bonds to raise money for a sundry of reasons, such as financing
current operations, expanding product lines, or opening up new manufacturing facilities.
Corporate bonds usually describe longer-term debt instruments that provide a maturity of at
least one year.

Government Bonds
National-issued government bonds (or Treasuries) entice buyers by paying out the face
value listed on the bond certificate, on the agreed maturity date, while also issuing periodic
interest payments along the way. This characteristic makes government bonds attractive to
conservative investors.

Municipal Bonds
Municipal bonds—commonly abbreviated as "muni" bonds—are locally issued by states, cities,
special-purpose districts, public utility districts, school districts, publicly-owned airports and
seaports, and other government-owned entities who seek to raise cash to fund various
projects.

Mortgage-Backed Bonds
These issues, which consist of pooled mortgages on real estate properties, are locked in by the
pledge of particular collateralized assets. They pay monthly, quarterly, or semi-annual interest.

Emerging Market Bonds

Issued by governments and companies located in emerging market economies, these bonds
provide much greater growth opportunities, but also greater risk, than domestic or developed
bond markets.

Commodity market
A commodity market is a marketplace for buying, selling, and trading raw materials or primary
products. There are currently about 50 major commodity markets worldwide that facilitate
trade in approximately 100 primary commodities.

Commodities are often split into two broad categories: hard and soft commodities. Hard
commodities include natural resources that must be mined or extracted—such as gold, rubber,
and oil, whereas soft commodities are agricultural products or livestock—such as corn, wheat,
coffee, sugar, soybeans, and pork.

Investors can gain exposure to commodities by investing in companies that have exposure to
commodities or investing in commodities directly via futures contracts.

Stock market
A stock market is a place where investors go to trade equity securities, such as common stocks,
and derivatives—including options and futures. Stocks are traded on stock exchanges. Buying
equity securities, or stocks, means you are buying a very small ownership stake in a company.
While bondholders lend money with interest, equity holders purchase small stakes in
companies on the belief that the company performs well and the value of the shares purchased
will increase.
The primary function of the stock market is to bring buyers and sellers together into a fair,
regulated, and controlled environment where they can execute their trades. This gives those
involved the confidence that trading is done with transparency, and that pricing is fair and
honest. This regulation not only helps investors, but also the corporations whose securities are
being traded. The economy thrives when the stock market maintains its robustness and overall
health.

Just like the bond market, there are two components to the stock market. The primary market
is reserved for first-run equities: initial public offerings (IPOs) will be issued on this market. This
market is facilitated by underwriters, who set the initial price for securities. Equities are then

Derivative market:
 Just like shares, Derivatives are also traded in stock exchanges.
 Derivatives are a type of security, whose value is derived from an underlying asset.
 These underlying assets can be stocks, bonds, commodities or currency.
 The popularity of derivative can easily be understood by daily turnover in the derivative
segment on the exchange, which is much higher than turnover in the cash segment on
the same exchange.
 Derivatives can either be exchange-traded or traded over the counter (OTC).
 Exchange refers to the formally established stock exchange wherein securities are
traded and they have a defined set of rules for the participants.

Use of Derivatives:
Derivative contracts like futures and options trade freely on exchanges and can be employed to
satisfy a variety of needs which includes the following-

a) Hedge your securities

The derivative contracts can be used to hedge your securities from price fluctuations. The shares
which you possess can be protected on the downside by entering into a derivative contract.

b) Transfer of risk

This is the most important use of derivative which helps in transferring risk from risk-averse
people to a risk-seeking investor.

c) Benefit from arbitrage opportunities

Arbitrage trading simply means buying low in one market and selling high in another market.

Participants in the derivative market

The participants in the derivative markets can be segregated into three categories namely-

a) Hedgers
These are traders who wish to protect themselves from the risk or uncertainty involved in price
movement.
For example, you can enter into an options contract (a part of the derivative strategy) by
paying a small price or premium and reduce your losses.
Moreover, it would help you benefit whether or not the price falls. This is how you can hedge
your risk and transfer it to someone who is willing to take the risk.

b) Speculators
They are extremely high-risk seekers who anticipate future price movement in the hope of
making large and quick gains.

c) Arbitrageurs
Arbitrage is a low-risk trade which involves buying of securities in one market and simultaneous
selling it in another market. This happens when same securities are trading at different prices in
two different markets.For instance, say the cash market price of a share is Rs 100 and it is
trading at Rs 110 per share on the futures market. An arbitrageur observes the same and
bought 50 shares @ Rs 100 per share in the cash market and simultaneously sells 50 shares
@Rs 110 per share, thus gaining Rs 10 per share.

Types of derivative contracts

There are four types of derivative contracts which include forwards, futures, options, and swaps.

Since swaps are complex instruments which we cannot trade in the stock market, so we’ll focus
on the first three.

a) Forward contracts
They are customized contractual agreements between two parties where they agree to trade a
particular asset at an agreed upon price and at a particular time in future.

b) Futures contracts
These are standardized version of the forward contract which takes place between two parties
where they agree to trade a particular contract at a specified time and at an agreed upon price.

c) Options
It is an agreement between a buyer and a seller which gives the buyer the right but not the
obligation to buy or sell a particular asset at a later date at an agreed-upon price.

Following are the differences between money market vs capital market:

Borrowing Term

Lending and borrowing in the money market is for the short-term. In the capital market,
investors lend and borrow securities for medium term to long-term.

Participants

Usual participants in the money market are central banks, commercial banks, mutual funds,
financial institutions and chit funds. Capital market, on the other hand, involves stock
brokers, retail investors, mutual funds, underwriters, insurance companies and stock
exchanges.

Instruments

Popular instruments in the money market are commercial papers, T-bills, call money,
promissory notes and so on. Capital markets typically deal in bonds,
debentures, preference shares and so on.

Structure

Capital markets are more formal than the money market. Compared to capital markets, money
markets are more informal. Also, capital markets are more organized than the money market.

Classification

There are two types of capital markets – Primary Market and Secondary Market. There is
no such classification in the money market.

Liquidity

Since money market deals with short-term instruments, it is more liquid. Capital market deals in
medium to long-term time frame, thus liquidity is less.

Risk Factor

Money market usually involves less risk as the market is liquid and funds are for the short-
term. Due to long-term maturity and comparatively less liquidity, the risk in the capital market
is more.

Purpose

It helps borrowers to meet their short-term funding requirements. Due to its long-term
nature, the capital market works more towards stabilizing the economy by mobilizing the
savings.

Returns

Since the time duration is short and the risk is less, returns in the money market are also less.
Return in the capital market is more as the investment is for more duration.

Relevance to Economy

Money market helps to boost liquidity in an economy. Capital market, on the other hand,
converts savings into productive investments.
Maturity Period

Money market instruments have a max maturity period of one year. In the capital market, there is
no specified maturity period for the instruments, but it is always more than a year.
Relation with Country’s Central Bank

Money market and Central bank work closely with each other. Central bank’s policies
influence the working of the capital markets, but there is no direct relation between the two.
As you now know that the primary function of both markets is to ensure an adequate level of
funding. Which market (money market vs capital market) does investor access depend on
their funding needs and time duration they want the funds for.1–3