MODULE.

FINANCIAL SYSTEM
In its simple meaning the term ‘finance’ refers to monetary resources & the term ‘financing’
refers to the activity of providing required monetary resources to the needy persons and institutions.
The term ‘financial system’ refers to a system that is concerned with the mobilization of the savings
of the public and providing of necessary funds to the needy persons and institutions for enabling the
production of goods and/or for provision of services. Thus, a financial system can be understood as a
system that allows the exchange of funds between lenders, investors, and borrowers. In other words,
the system that facilitates the movement of finance from the persons who have surplus funds to the
persons who need it is called as financial system.

Components/Constituents/Elements/Parts of Financial System

1. Financial Assets

2. Financial Intermediaries/Financial Institutions

3. Financial Markets

4. Financial Rates of Return

5. Financial Instruments and

6. Financial Services

Functions/Importance/Objectives/Advantages of Financial System

1. Provision of liquidity

2. Mobilization of savings

3. Size transformation/Capital formation

4. Maturity transformation

5. Risk transformation

6. Lowering of cost of transaction

7. Payment mechanism

8. Assisting new projects

9. Enable better decision making

10. Meet short and long term financial needs

11. Provide necessary finance to the Government

12. Accelerate the process of economic growth of the country

Features/Characteristics of Financial System

1. Financial system acts as a bridge between savers and borrowers

2. It consists of a set of inter-related activities and services

3. It consists of both formal and informal financial sectors. The existence of both formal and informal
system is also called as financial dualism.

4. It formulates capital, investment and profit generation

5. It is universally applicable at firm level, regional level, national level and international level

6. It consists of financial institutions, financial markets, financial services, financial instruments,

financial practices and financial transactions.

FINANCIAL MARKETS
The group of individuals and corporate institutions dealing in financial transactions are termed as
financial markets. The centers or arrangements that facilitate buying and selling of financial assets,
claims and services are the constituents of financial market. Basically they are classified into two
categories:

1. Unorganized Market

2. Organized Market

Unorganized Market

The sector that is not governed by any statutory or legal authority is known as unorganized sector.
This sector consists of the individuals and institutions for whom there are no standardized rules and
regulations governing their financial dealings. They are not under the supervision and control of RBI
or any other regulatory body. Local money lenders, Pawn brokers, Traders, Landlords, Indigenous
bankers, etc., who lend money are in the unorganized sector.

Organized Market

The sector that is governed by some statutory or legal authority is known as organized sector. This
sector consists of the institutions for whom there are standardized rules and regulations governing
their financial dealings. They are under the supervision and control of RBI and other statutory bodies.
They are further classified into two:

A. Capital Market

B. Money Market

C. Foreign Exchange Market

FINANCIAL ASSETS

Financial assets refer to the cash or cash equivalents that are used for production or
consumption or for further creation of assets. Cash, Bank Deposits, Shares, Debentures, Investment in
Gold, Land & Buildings, Contractual right to receive cash or another financial asset, etc., are called as
financial assets.
Classification of Financial Assets

Financial assets are classified in two ways

1. On the basis of marketability

2. On the basis of nature

Classification of Financial Assets on the basis of marketability

1. Marketable – The financial assets that can be bought and sold are called as marketable financial
assets. They include Shares, Government Securities, Bonds, Mutual Funds, Units of UTI, Bearer
Debentures

2. Non-marketable – The financial assets that cannot be bought and sold are called as nonmarketable
finance assets. They include Bank Deposits, Provident Funds, LIC Policies, Company Deposits, Post
Office Certificates

Classification of Financial Assets on the basis of nature

1. Money or Cash Asset – Coins, Currency Notes, Bank Deposits

2. Debt Asset – Debenture & Bonds

3. Stock Asset – Equity Shares & Preference Shares

FINANCIAL INTERMEDIARIES/FINANCIAL INSTITUTIONS

It is classified into categories:-

a. Banking Institution:-
It includes commercial banks, private bank and foreign banks are operating in India.
There are 12 Commercial Banks of Public Sector further, we have Development Banks
(ICICI, IDBI), Agriculture Bank (RRB, Cooperative Banks, NABARD).

b. Non-Banking Institution: -
These are established to mobilise saving in different modes. These institutions do
not offer banking services such as accepting deposit and Lending Loans. For example
LIC, UTI, GIC.
Financial institutions are financial intermediaries. They intermediate between savers
and investors. They lend money. They also mobilise savings. The various financial
intermediaries, their performing areas and respective roles are given in following table:
Different kinds of organizations/institutions which intermediate and facilitate financial
transactions of both individual and corporate customers are called as financial intermediaries or
financial institutions.
 MODULE. II
Money Market
Money Market refers to the market for short term finance. Financial assets which have a short period
of maturity are dealt in this market. Near money like Trade Bills, Promissory Notes, Short term
Government Papers, etc., are traded in this market.

Functions of Money Market

1. It meets the short-term financial needs of various borrowers like individuals, institutions and
governments

2. It provides liquidity to investors and savers of money

3. It provides a platform for dealing in short-term securities which have a maturity period of less than
one year

Significance / Objectives / Importance of money market

1. Provide a parking place for short term surplus funds mainly of commercial banks

2. Provide room for overcoming short term deficits

3. Facilitate development of trade and industry

4. Facilitate development of capital market

5. Facilitate smooth functioning of commercial banks

6. Enable central bank to influence and regulate liquidity in the economy

7. Provide non-inflationary finance to the government

8. Enable formulation and revision of monetary policy

9. Provide a reasonable access to borrowers of short term funds to meet their requirements quickly,
adequately and at reasonable costs.

Features of money market

1. Money market is a market for lending and borrowing of short term funds

2. It deals with financial assets having a maturity period of a maximum of one year

3. It deals with only those assets which can be converted into cash immediately without any loss and
with minimum transaction cost

4. It provides liquidity to lenders

5. It includes all individuals, institutions and intermediaries dealing with short term funds

6. The transaction takes place through telephone, mail, etc

7. Transactions are conducted without the help of brokers

8. It consists of a verity of specialized markets like Call money market, Acceptance market, Bill
market, etc.

The money market comprises of the following:

1. Call money market

2. Commercial bills market

3. Treasury bills market

4. Short-term loan market

1. Call money market

The market where finance is provided just against a call made by the borrower is called call
money market. In this market finance is provided for an extremely short period of time. The main
borrowers of this loan are commercial banks and dealers in stock exchanges. The period of loan may
be as short as one day and may extend to a maximum of fourteen days. Since the loan can be raised
just by making a call & may need to be repaid immediately on receiving a call from the lender, this
market is termed as call money market. The loan may be repaid either at the option of the borrower or
at the option of the lender. The distinguishing feature of call money market is that the interest rates
vary from day to day and even from hour to hour.

Major Participants of Call money market

1. Commercial banks which deal in this market to meet requirement of large payments, Statutory
Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR)

2. Stock brokers and speculators who deal in stock exchanges and bullion markets

3. Commercial bills market who are required to meet the matured bills

4. The Discount and Finance House of India (DFHI) and the Securities Trading Corporation of India
(STCI) which activates the call market

5. The individuals of very high financial status who deal in this market for trade purposes and to save
interest on overdraft or cash credit facility

The above participants are classified into two categories viz., (1) those who can act as lenders
as well as borrowers and (2) those who can act only as lenders. All commercial banks, co-operative
banks, DFHI, STCL, can act as lenders as well as borrowers. LIC, GIC, UTI, IDBI, NABARD, MF,
etc., can act only as lenders.

Advantages of call money market

1. High liquidity
2. High profitability

3. Maintenance of SLR and CRR

4. High safety

5. Most cheap as brokerage is not required to be paid

6. Help RBI (central bank) to formulate or modify monetary policy as and when required

Drawbacks of call money market in India

1. Confinement of market only to big industrial and commercial centers

2. Lack of integration among markets spread across the country

3. High volatility in the interest rates

2. Commercial Bills Market or Discount Market

The market where finance is provided by discounting of commercial bills is called as
commercial bills market. ‘Commercial bills’ refer to the bills of exchange arising out of genuine trade
transactions. Section 5 of the Negotiable Instruments Act defines a bill of exchange as “an instrument
in writing containing an unconditional order, signed by the maker, directing a certain person to pay a
certain sum of money only to, or to the order of a certain person or to the bearer of the instrument”.
Finance against bills of exchange is provided by many commercial banks by discounting the bills
before their maturity. The process of taking over of a bill of exchange for a lesser value than the face
value is called as discounting of bills. In India this market is not very well developed and hence, it
does not have a secondary market.

Types of Bills of Exchange

1. Demand Bills – These are the bills payable immediately as soon as they are presented. The time of
payment is not specified in these bills. These are also called as ‘Sight bills’ as they are payable at
sight and not at the expiry of a specified period.

2. Usance Bills – These are the bills payable at the expiry of a specified period. The time of payment
is specified in these bills. These are also called as ‘Time bills’ as they are payable after the expiry of a
specified period like three months, four months, etc.,

3. Documentary Bills – These are the bills that accompany the documents of title to goods like
Railway receipt, Lorry receipt, Bill of lading, etc.,

4. Clean Bills – These are the bills that do not accompany the documents of title to goods.

5. Inland Bills – These are the bills that are drawn upon a person residing in India and are payable in
India.

6. Foreign Bills – These are the bills that are originated or drawn outside India upon a person either
outside India or a person residing in India and are payable either in India or outside India.

7. Export Bills – These are the bills that are drawn by Indian exporters on importers of other country.
8. Import Bills – These are the bills that are drawn by Exporters of other country on the Indian
importers.

9. Indigenous Bills – These are the bills that are drawn by indigenous bankers according to native

custom or usage of trade. The popular name of these bills is ‘Hundi”. The hundis are known by

different names like Shah Jog, Nam Jog, Jokhani, Termain Jog, Darshani Jog, Dhani Jog, etc.

10. Accommodation Bills – These are the bills that are drawn for the purpose of mutual financial

needs of the parties and are not supported by a genuine trade transaction. They are also called as Kite
bills & Wind bills.

Advantages of Commercial Bills

1. Provision of liquidity

2. Certainty of payment

3. Ideal investment

4. Simple legal remedy

5. High and quick yield

6. Easy central bank control

Drawbacks of Commercial Bills

1. Absence of bill culture

2. Absence of rediscounting facility

3. Stamp duty and inadequate availability of stamp papers

4. Absence of secondary market

5. Difficulty in ascertaining genuine trade bills

6. Limited foreign trade

7. Absence of acceptance services

8. No encouragement by banks for rediscounting.

3. Treasury bills market

The market where finance is provided against the treasury bills is called as treasury bills
market. The term ‘treasury bill’ refers to the promissory notes or finance bills issued by the
government for its short term finance requirements. RBI is the only agency which issues these bills on
behalf of the Government. These bills are issued through auction and do not require any endorsement
or acceptance since it is a claim against the government. Since, its repayment is guaranteed by the
government, it is considered as one of the most safe and liquid financial asset. Generally, the treasury
bills have a maturity period of 91 days or 182 days or 364 days. These bills are considered as one of
the important means of parking temporary surpluses of various financial intermediaries. There are two
types of treasury bills, viz., (a) Ordinary or Regular bills and (b) ‘Ad hoc’ bills.

a) Ordinary treasury bills are issued to the general public, banks and other financial institutions with a
view of raising resources for the central government to meet its short-term financial needs.

b) Ad hoc treasury bills are issued only in favour of RBI. They are not sold in the money market.

Major Participants of Treasury Bills Market

1. RBI which issues treasury bills on behalf the government

2. Commercial banks which deal in this market to meet requirement of Statutory Liquidity Ratio
(SLR) and Cash Reserve Ratio (CRR) and account for nearly 90% of the transactions in this market.

3. The Discount and Finance House of India (DFHI) and the Securities Trading Corporation of India
(STCI) which activates the treasury bills market

4. Other financial institutions like LIC, GIC, UTI, IDBI, ICICI, IFCI, NABARD, etc.,

5. Corporate customers and the individuals of very high financial status

Advantages of Treasury Bills

1. Highest Safety

2. Most Liquid

3. Ideal for short-term investment

4. Ideal for fund management as they are traded in the secondary market

5. Ideal for meeting Statutory Liquidity Requirement of commercial banks

6. Ideal for meeting Cash Reserve Requirement of commercial banks

7. Ideal source of fund for the government for its short term requirement

8. Ideal non-inflationary monetary tool for control of economic conditions by the government

9. Ideal for using the bills for hedging purpose. (taking advantage of high interest rate in one
investment by substituting it in another investment is called as hedging)

Defects of Treasury Bills

1. Interest rate is very less compared to other securities

2. Competitive bidding is less among the participants

3. Less trading activity since the holders generally keep the treasury bills till maturity
4. Certificate of Deposits
Certificates of Deposit (CDs) is a negotiable money market instrument and issued in
dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other eligible
financial institution for a specified time period. Guidelines for issue of CDs are presently governed by
various directives issued by the Reserve Bank of India, as amended from time to time. CDs can be
issued by (i) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area
Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by RBI to raise
short-term resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs
depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by
RBI, i.e., issue of CD together with other instruments viz., term money, term deposits, commercial
papers and intercorporate deposits should not exceed 100 per cent of its net owned funds, as per the
latest audited balance sheet
Features of CDs
1. These are unsecured promissory notes issued by banks or financial institutions.
2. These are short term deposits of specific maturity similar to fixed deposits.
3. These are negotiable (freely transferable by endorsement and delivery)
4. These are generally risk free.
5. The rate of interest is higher than that on T-bill or time deposits
6. These are issued at discount
7. These are repayable on fixed date.
8. These require stamp duty.

5. Commercial Paper
CP is an unsecured promissory note privately placed with investors at a discount rate to face
value determined by market forces. CP is freely negotiable by endorsement and delivery
6. Repurchase Agreements (REPO)
REPO is basically a contract entered into by two parties (parties include RBI, a bank or
NBFC. In this contract, a holder of Govt. securities sells the securities to a lender and agrees
to repurchase them at an agreed future date at an agreed price. At the end of the period the
borrower repurchases the securities at the predetermined price. The difference between the
purchase price and the original price is the cost for the borrower. This cost of borrowing is
called repo rate.
.
7. Money Market Mutual Funds (MMMFs)
Money Market Mutual Funds mobilise money from the general public. The money collected
will be invested in money market instruments. The investors get a higher return. They are
more liquid as compared to other investment alternatives.
8. American depository receipt and Global depository receipt
ADRs are instruments in the nature of depository receipt and certificate. These instruments
are negotiable and represent publicly traded, local currency equity shares issued by non -
American company.
Components / Constituents / Composition of Money Market (Structure of
Money Market)
Money market consists of a number of sub markets. All submarkets collectively constitute the
money market. Each sub market deals in a particular financial instrument. The main
components or constituents or sub markets of a money markets are as follows :
1. Call money market
2. Commercial bill market
3. Treasury bill markets
4. Certificates of deposits market

5. Commercial paper market

6. Acceptance market
7. Collateral loan market
(Details of the above components already explained under the sub title ‘money market
instruments’ except the following)
Commercial Bills and its market
When goods are sold on credit, the seller draws a bill of exchange on the buyer for the
amount due. The buyer accepts it immediately. This means he agrees to pay the amount
mentioned therein after a certain specified date. After accepting the bill, the buyer returns it
to the seller. This bill is called trade bill. The seller may either retain the bill till maturity or
due date or get it discounted from some banker and get immediate cash. When trade bills are
accepted by commercial banks, they are called commercial bills.
Features of Commercial Bills
1. These are negotiable instruments.
2. These are generally issued for 30 days to 120 days. Thus these are short term credit
instruments.
3. These are self liquidating instruments with low risk.
4. These can be discounted with a bank. When a bill is discounted with a bank, the holder
gets immediate cash. This means bank provides credit to the customers. The credit is
repayable on maturity of the bill. In case of need for funds, the bank can rediscount the bill in
the money market and get ready money.
5. These are used for settling payments in the domestic as well as foreign trade.
6. The creditor who draws the bill is called drawer and the debtor who accepts the bill is
called drawee.
Types of Bills
Many types of bills are in circulation in a bill market. They may be broadly classified
as follows:-
1. Demand Bills and Time Bills: - Demand bill is payable on demand. It is payable
immediately on presentation or at sight to the drawing. Demand bill is also known as sight
bill. Time bill is payable at a specified future date. Time bill is also known as usance bill.
2. Clean Bills and Documentary Bills: - When bills have to be accompanied by documents
of title to goods such as railway receipts, bill of lading etc. the bills are called documentary
bills. These may be further classified into documents against payment (D/P) and documents
against acceptance (D/A). In case of D/A bills, the documents accompanying bills have to be
delivered to the drawee immediately after his acceptance of the bill. Thus a D/A bill becomes
a clean bill immediately after acceptance. On the other hand, the documents have to be
handed over to the drawee only against payment in the case of D/P bills. When bills are
drawn without accompanying any document, they are called clean bills. In such a case,
documents will be directly sent to the drawee.
3. Inland and Foreign Bills: Inland bills are bills drawn upon a person resident in India and
are payable in India. Foreign bills are bills drawn outside India and they may be payable
either in India or outside India.
4. Accommodation Bills and Supply Bills: In case of accommodation bills, two parties draw
bills on each other purely for the purpose of mutual financial accommodation. These bills are
then discounted with the bankers and the proceeds are shared among themselves. On the due
dates, the parties make payment to the bank. Accommodation bills are also known as ‘wind
bills’ or ‘kite bills’. Supply bills are those drawn by suppliers or contactors on the Govt.
departments for the goods supplied to them. These bills are not considered as negotiable
instruments.
Acceptance Market
Acceptance Market is another component of money market. It is a market for banker’s
acceptance. The acceptance arises on account of both home and foreign trade. Bankers
acceptance is a draft drawn by a business firm upon a bank and accepted by that bank. It is
required to pay to the order of a particular party or to the bearer, a certain specific amount at a
specific date in future. It is commonly used to settle payments in international trade. Thus
acceptance market is a market where the bankers’ acceptances are easily sold and discounted.
Collateral Loan Market
Collateral loan market is another important sector of the money market. The collateral loan
market is a market which deals with collateral loans. Collateral means anything pledged as
security for repayment of a loan. Thus collateral loans are loans backed by collateral
securities such as stock, bonds etc. The collateral loans are given for a few months. The
collateral security is returned to the borrower when the loan is repaid. When the borrower is
not able to repay the loan, the collateral becomes the property of the lender. The borrowers
are generally the dealers in stocks and shares.
Features or Defects of the Indian Money Market
The features or defects of the Indian money market are as follows:
1. Existence of unorganised segment:
The unorganised segment comprises of indigenous bankers, moneylenders etc. This
unorganised sector does not follow the rules and regulations of the RBI. Besides, a higher
rate of interest prevails in the unorganised market.
2. Lack of integration:
Another important drawback of the Indian money market is that the money market is
divided into different sections. Unfortunately these sections are loosely connected to each
other.
3. Disparities in interest rates:
Too many interest rates are prevailing in the market. For example, borrowing rates of
Govt. lending rate of commercial banks, the rates of co-operative banks and rates of financial
institutions. This disparity in interest rates is due to lack of mobility of funds from one
segment
to another.
4. Seasonal diversity of money market:
The demand for money in Indian money market is of seasonal in nature.
5. Absence of bill market: The bill market in India is not well developed. There is a great
paucity of sound commercial bills of exchange in our country.
6. Limited instruments: The supply of short term instruments like commercial bills, treasury
bills etc. are very limited and inadequate.
7. Restricted secondary market: Secondary market for money market
instruments is mainly restricted to rediscounting of commercial bills and
treasury bills.
8. No contact with foreign money markets: Indian money market has little contract with
money markets in other countries. In totality it can be concluded that Indian money market is
relatively

Players or Participants in the Indian Money Market

The following are the players in the Indian money market:
1. Govt.
2. RBI
3. Commercial banks
4. Financial institutions like IFCI, IDBI, ICICI, SIDBI, UTI, LIC etc.
5. Discount and Finance House of India.
6. Brokers
7. Mutual funds
8. Public sector undertakings
9. Corporate units

Recent Developments in the Indians Money Market

In recent years, the Indian money market is undergoing structural changes. Several
measures have been taken to transform the restricted and narrow market to an active and
broad market. The recent developments in the Indian money market are
as follows:
1. Integration of unorganised sector with the organised sector
2. Widening of call money market
3. Introduction of innovative instruments
4. Introduction of negotiable dealing system
5. Offering of market rates of interest
6. Satellite system dealership
7. Promotion of bill culture
8. Introduction of money market mutual funds
9. Setting up of credit rating agencies
10.Adoption of suitable monetary policy
11.Establishment of Discount and Finance House of India (DFHI)
12.Setting up of Securities Trading Corporation of India Ltd. (STCI)
Money market is a need based market where the demand for and supply of money are major
factors determining the terms and conditions of operations. Money market provides a
platform for the players in financial market to meet the short term fund requirements. It also
helps the participants to keep an optimum balance between liquidity and profitability.

RBI regulation on money market

Master Circular on Call/Notice Money Market Operations
1. Introduction
The money market is a market for short-term financial assets that are close substitutes
of money. The most important feature of a money market instrument is that it is liquid and
can be turned over quickly at low cost and provides an avenue for equilibrating the short-term
surplus funds of lenders and the requirements of borrowers. The call/notice money market
forms an important segment of the Indian money market. Under call money market, funds are
transacted on overnight basis and under notice money market, funds are transacted for the
period between 2 days and 14 days.
2. Participants
Participants in call/notice money market currently include banks, Primary Dealers
(PDs), development finance institutions, insurance companies and select mutual funds
(Annex I). Of these, banks and PDs can operate both as borrowers and lenders in the market.
Non-bank institutions, which have been given specific permission to operate in call/notice
money market can, however, operate as lenders only (Table 1).
Borrowing Lending
1. Scheduled Commercial Banks 1. Scheduled Commercial Banks
2. Co-operative Banks 2. Co-operative Banks
3. Primary Dealers (PDs) 3. Primary Dealers (PDs)
4. Select all-India Financial Institutions
5. Select Insurance Companies
6. Select Mutual Funds

3. Prudential Limit
3.1 The Narasimham Committee (1998) recommended that call/notice money market
in India
should be made purely an inter-bank market. Accordingly, RBI initiated the process of
phasing out of non-bank institutions (i.e., all-India Financial Institutions, Insurance
companies and Mutual Funds) from call/notice money market in a gradual manner since May
5, 2001. Further, in order to preserve integrity of the financial market as also to achieve
balanced development of various segments of money market, RBI has put in place prudential
limits in respect of both borrowing and lending in call/notice money market for banks and
PDs since October 5, 2002.
3.2 No new non-bank institutions are permitted to operate (i.e., lend) in the call/notice
money market with effect from May 5, 2001.
3.3 In case any eligible institution has genuine difficulty in deploying its excess
liquidity, RBI may consider providing temporary permission to lend a higher amount in
call/notice money market for a specific period on a case-by-case basis.
4. Interest Rate
Eligible participants are free to decide on interest rates in call/notice money market.
5. Reporting Requirement
To facilitate monitoring of an entity's operations in call/notice money market on a
daily basis, the daily return should be submitted on a daily basis to the Monetary Policy
Department, Reserve Bank of India, Central Office, Mumbai by 2.30 P. M. on weekdays and
1.30 P.M. on Saturdays (Annex II).
5.2 It is also mandatory for all Negotiated Dealing System (NDS) members to report all
their call/notice money market deals on NDS. Deals should be reported within 15 minutes on
NDS, irrespective of the size of the deal or whether the counterparty is a member of the NDS
or not.
5.3 In case, there is repeated non-reporting of deals by an NDS member, it will be
considered whether non-reported deals by that member should be treated as invalid with
effect from a future date.
 MODULE.III
Capital Market
Meaning
Capital market simply refers to a market for long term funds. It is a market for buying
and selling of equity, debt and other securities. Generally, it deals with long term securities
that have a maturity period of above one year. Capital market is a vehicle through which long
term finance is channelized for the various needs of industry, commerce, govt. and local
authorities. According to W.H. Husband and J.C. Dockerbay, “the capital market is used to
designate activities in long term credit, which is characterised mainly by securities of
investment type”.
Capital market may be defined as an organized mechanism for the effective and smooth
transfer of money capital or financial resources from the investors to the entrepreneurs.
Functions of a Capital Market
The functions of an efficient capital market are as follows:
1. Mobilise long term savings for financing long term investments.
2. Provide risk capital in the form of equity or quasi-equity to entrepreneurs.
3. Provide liquidity with a mechanism enabling the investor to sell financial assets.
4. Improve the efficiency of capital allocation through a competitive pricing mechanism.
5. Disseminate information efficiently for enabling participants to develop an informed
opinion about investment, disinvestment, reinvestment etc.
6. Enable quick valuation of instruments – both equity and debt.
7. Provide insurance against market risk through derivative trading and default risk through
investment protection fund.
8. Provide operational efficiency through: (a) simplified transaction procedures, (b) lowering
settlement times, and (c) lowering transaction costs.
9. Develop integration among: (a) debt and financial sectors, (b) equity and debt instruments,
(c) long term and short term funds.
10. Direct the flow of funds into efficient channels through investment and disinvestment and
reinvestment.

Components of Capital Market

There are four main components of capital market. They are:
1. Primary market
2. Secondary Market (Details are given in last module)
3. Government Securities Market (Gilt Edged Security Market)
4. Financial Institutions
These components of capital market may be discussed in detail in the following pages:
Primary Market /New Issue Market (NIM)
When a company wishes to raise long term capital, it goes to the primary market.
Primary market is an important constituent of a capital market. In the primary market the
security is purchased directly from the issuer. The primary market is a market for new issues.
It is also called new issue market. It is a market for fresh capital. It deals with the new
securities which were not previously available to the investing public. Corporate enterprises
and Govt. raises long term funds from the primary market by issuing financial securities.
Both the new companies and the existing companies can issue new securities on the primary
market. It also covers rising of fresh capital by government or its agencies. The primary
market comprises of all institutions dealing in fresh securities. These securities may be in the
form of equity shares, preference shares, debentures, right issues, deposits etc. In short,
primary market is a market where the securities are offered to the investing public for the first
time.

Government Securities Market

Govt. securities are also known as Gilt-edged securities. Gilt refers to gold. Thus
govt. securities or gilt-edged securities are as pure as gold. This implies that these are
completely risk free (no risk of default). Govt. securities market is a market where govt.
securities are traded. It is the largest market in any economic system.Therefore, it is the
benchmark for other market. Government securities refer to the marketable debt issued by the
government of semi-government bodies. A government security is a claim on the
government. It is a totally secured financial instrument ensuring safety of both capital and
income. That is why it is called giltedged security or stock. Central Government securities are
the safest among all securities. Government securities are issues by:
➢ Central Government
➢ State Government
➢ Semi-Government authorities like local government authorities, e.g., city corporations
and municipalities
➢ Autonomous institutions, such as metropolitan authorities, port trusts, development
trusts, state electricity boards.
➢ Public Sector Corporations
➢ Other governmental agencies, such as SFCs, NABARD, LDBs, SIDCs, housing

Characteristics of Gilt-edged Securities Market

Gilt-edged securities market is one of the oldest markets in India. The market in
these securities is a significant part of Indian stock market.

Characteristics of government securities market are as follows:

1. Supply of government securities in the market arises due to their issue by the Central,
State of Local governments and other semi-government and autonomous institutions
explained above.
2. Government securities are also held by Reserve Bank of India (RBI) for purpose and
sale of these securities and using as an important instrument of monetary control.
3. The securities issued by government organisations are government guaranteed
securities and are completely safe as regards payment of interest and repayment of
principal.
4. Gilt-edged securities bear a fixed rate of interest which is generally lower than interest
rate on other securities.
5. These securities have a fixed maturity period.
6. Interest on government securities is payable half-yearly.
7. Subject to the limits under the Income Tax Act, interest on these securities is exempt
from income tax.
8. The gilt-edged market is an ‘over-the-counter’ market and each sale and purpose has
to be negotiated separately.
9. The gilt-edged market is basically limited to institutional investors.

Commercial and Industrial (C&I) Loan

A commercial and industrial (C&I) loan is any loan made to a business or corporation, as
opposed to an individual. Commercial and industrial loans provide either working capital or
finance capital expenditures such as machinery or a piece of equipment. This type of loan is
usually short-term in nature and is almost always backed by some collateral.
Mortgage Market
The mortgage market is the underlying structure that supports home lending through
mechanisms that help with the free flow of funds so that lending can continue. While that definition
covers what it is, it’s necessary to break things down a little bit further.

Let’s take this from the beginning. A mortgage is any loan that pledges a piece of real estate
as collateral. You can have mortgages associated with buildings and pieces of land, but the everyday
consumer is probably most familiar with the mortgage as a home loan.

The mortgage market is split into two main components: a primary mortgage market and a
secondary mortgage market. The primary market is the one consumers interact with. In this market,
you obtain a mortgage through a bank or a specialized mortgage originator like Rocket Mortgage

The secondary mortgage market enables investors to buy mortgage-backed securities (MBS),
entitling them to principal and interest from mortgage payments. These MBS are often made available
by major mortgage investors like Fannie Mae, Freddie Mac, the FHA and VA. These agencies
provide investor protection, by guaranteeing future payments in the event of default.

Credit guarantee market

credit guarantee means an arrangement by which any person guarantees to discharge the
monetary liability of another person, irrespective of its form, but does not, unless
otherwise prescribed, include an undertaking or promise to 15 satisfy the obligation of
another consumer in respect of a credit arrangement

The Credit Guarantee Fund Scheme for Micro and Small Enterprises (CGMSE) was
launched by the Government of India to make available collateral-free credit to the micro and small
enterprise sector. Both the existing and the new enterprises are eligible to be covered under the
scheme. The Ministry of Micro, Small and Medium Enterprises and Small Industries Development
Bank of India (SIDBI), established a Trust named Credit Guarantee Fund Trust for Micro and Small
Enterprises (CGTMSE) to implement the Credit Guarantee Fund Scheme for Micro and Small
Enterprises. The scheme was formally launched on August 30, 2000 and is operational with effect
from 1st January 2000. The corpus of CGTMSE is being contributed by the Government and SIDBI
in the ratio of 4:1 respectively and has contributed Rs.1906.55 crore to the corpus of the Trust up to
March 31,2010. As announced in the Package for MSEs, the corpus is to be raised to Rs.2500 crore
by the end of 11th Plan.

Bond market

The bond market (also debt market or credit market) is a financial market where participants can
issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary
market. This is usually in the form of bonds, but it may include notes, bills, and so for public and
private expenditures. The bond market has largely been dominated by the United States, which
accounts for about 39% of the market. As of 2021, the size of the bond market (total debt outstanding)
is estimated to be at $119 trillion worldwide and $46 trillion for the US market, according
to Securities Industry and Financial Markets Association(SIFMA).
Bonds and bank loans form what is known as the credit market. The global credit market in aggregate
is about three times the size of the global equity market. Bank loans are not securities under the
Securities and Exchange Act, but bonds typically are and are therefore more highly regulated. Bonds
are typically not secured by collateral (although they can be), and are sold in relatively small
denominations of around $1,000 to $10,000. Unlike bank loans, bonds may be held by retail investors.
Bonds are more frequently traded than loans, although not as often as equity.
Development financial institution (DFI)
A development financial institution (DFI), also known as a development bank or
development finance company (DFC), is a financial institution that provides risk capital for economic
development projects on a non-commercial basis.

DFI: Background & Present Status

➢ Development banks are different from commercial banks, which mobilize short- to medium-
term deposits and lend for similar maturities to avoid a maturity mismatch.
➢ In India, the first DFI was operationalized in 1948 with the setting up of the Industrial
Finance Corporation (IFC).
➢ DFIs in India like Industrial Development Bank of India (IDBI), Industrial Credit and
Investment Corporation of India (ICICI) and IFCI did play a significant role in aiding
industrial development in the past with the best of the resources made available to them.
➢ However, after 1991 reforms, the concessional funding they were getting from Reserve
Bank of India (RBI) and the government was no longer available in the subsequent years.
o As a consequence, IDBI and ICICI had to convert themselves into universal banks.
➢ While these DFIs disappeared, a new set of institutions like IDFC (1997), IIFCL (2006) and
more recently, National Investment and Infrastructure Fund (NIIF) (2015) emerged to focus
on funding infrastructure.
➢ In budget 2021, with the initial capital base of ₹20,000 crore as committed by the
government, the new DFI, assuming a leverage of around 7 times, can lend up to ₹1.4
trillion.
Need for DFI
➢ Infrastructure Building: Inadequate and inefficient infrastructure leads to high transaction
costs, which in turn stunts an economy’s growth potential.
o Therefore, DFIs makes sense as the Centre government envisages mobilizing
nearly ₹100 lakh crore for the ambitious National Infrastructure Pipeline.
➢ International Precedent: Irrespective of the level of development, countries across the
world have set up development banks to finance key infrastructure and manufacturing
projects.
o For instance, the European Investment Bank (EIB) acts like a DFI for Europe.
➢ Lack of Finance for Infrastructure: Although India has a long-term debt market for the
government securities and corporate bonds cut, it is still out of reach of retail investors and
unable to meet the large infrastructure financing needs.
➢ Economic Crisis Triggered By Covid-19 Pandemic: The Covid-19 pandemic has
exacerbated inequality, the poverty gap, unemployment, and the economy’s slowing down.
o Thus, infrastructure building through DFIs can help in quick economic recovery.
IFCI Ltd
IFCI, previously Industrial Finance Corporation of India, is a development finance
institution under the jurisdiction of Ministry of Finance, Government of India . Established in 1948 as
a statutory corporation, IFCI is currently a company listed on BSE and NSE. IFCI has seven
subsidiaries and one associate.
It provides financial support for the diversified growth of Industries across the spectrum. The
financing activities cover various kinds of projects such as airports, roads, telecom, power, real estate,
manufacturing, services sector and such other allied industries. During its 70 years of existence,
mega-projects like Adani Mundra Ports, GMR Goa International Airport, Salasar Highways, NRSS
Transmission, Raichur Power Corporation, among others, were set up with the financial assistance of
IFCI.
The company has played a pivotal role in setting up various market intermediaries of repute in several
niche areas like stock exchanges, entrepreneurship development organisations, consultancy
organisations, educational and skill development institutes across the length and breadth of the
country.

SFC – State Finance Corporation

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.

Industrial Credit and Investment Corporation of India (ICICI)

Industrial Credit and Investment Corporation of India (ICICI) is a financial institution in

India and was established in 1955 as a public limited company. The Indian Company Act governs
it. ICICI is incorporated for developing medium and small industries of the private sector.
Infrastructure Development Finance Company Limited (IDFC)
Infrastructure Development Finance Company Limited, more commonly known
as IDFC, is a finance company based in India under Department of Financial Services,
Government of India.[1] It provides finance and advisory services for infrastructure projects as well
as asset management and investment banking.
IDFC was incorporated on 30 January 1997 with its registered office in Chennai and started
operations on 9 June 1997. In August 2005, the company's equity shares were listed at the National
Stock Exchange of India (NSE) and Bombay Stock Exchange (BSE) after an initial public offering.
Small Industries Development Bank of India (SIDBI)
Small Industries Development Bank of India (SIDBI) is the apex regulatory body for
overall licensing and regulation of micro, small and medium enterprise finance companies in India. It
is under the jurisdiction of Ministry of Finance , Government of India headquartered at Lucknow and
having its offices all over the country. Its purpose is to provide refinance facilities to banks and
financial institutions and engage in term lending and working capital finance to industries, and serves
as the principal financial institution in the Micro, Small and Medium Enterprises (MSME) sector.
SIDBI also coordinates the functions of institutions engaged in similar activities. It was established on
2 April 1990, through an Act of Parliament. It is headquartered in Lucknow. SIDBI is one of the
four All India Financial Institutions regulated and supervised by the Reserve Bank of India; other
three are India Exim Bank,NABARD and NHB. But recently NHB came under government control
by taking more than 51% stake. They play a statutory role in the financial markets through credit
extension and refinancing operation activities and cater to the long-term financing needs of the
industrial sector.[3]
SIDBI is active in the development of Micro Finance Institutions through SIDBI Foundation for
Micro Credit, and assists in extending microfinance through the Micro Finance Institution (MFI)
route.[4] Its promotion & development program focuses on rural enterprises promotion and
entrepreneurship development.
Non-banking financial institution (NBFI) or non-bank financial
company (NBFC)
A non-banking financial institution (NBFI) or non-bank financial company (NBFC) is
a financial institution that does not have a full banking license or is not supervised by a national or
international banking regulatory agency. NBFC facilitate bank-related financial services, such
as investment, risk pooling, contractual savings, and market brokering.[1]Examples of these
include insurance firms, pawn shops, cashier's check issuers, check cashing locations, payday
lending, currency exchanges, and microloan organizations.[2][3]Alan Greenspan has identified the role
of NBFIs in strengthening an economy, as they provide "multiple alternatives to transform an
economy's savings into capital investment which act as backup facilities should the primary form of
intermediation fail."
Operations of non-bank financial institutions are not covered under a country's banking regulations.
 MODULE.IV
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.
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 insurancecompany/
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 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.
5. 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.

Book Building
Book Building is basically a process used in Initial Public Offer (IPO) for efficient
price discovery. It is a mechanism where, during the period for which the IPO is open, bids
are collected from investors at various prices, which are above or equal to the floor price.
The offer price is determined after the bid closing date.
More About Book Building
Book Building is essentially a process used by companies raising capital through Public
Offerings-both Initial Public Offers (IPOs) and Follow-on Public Offers (FPOs) to aid price
and demand discovery. It is a mechanism where, during the period for which the book for
the offer is open, the bids are collected from investors at various prices, which are within the
price band specified by the issuer. The process is directed towards both the institutional as
well as the retail investors. The issue price is determined after the bid closure based on the
demand generated in the process.

Secondary Market
The secondary market, also called the aftermarket and follow on public offering, is
the financial market in which previously issued financial instruments such
as stock, bonds, options, and futures are bought and sold.
Stock exchange
Stock exchange is the place where the stocks, shares and the securities are bought and
sold. A stock exchange is a corporation of mutual organizations which provide the facilities
for stock brokers to trade company stocks and other securities. SE also provide facilities for
the issue and redemption of securities, as well as other financial instruments and capital
events including the payment of income and dividends
Salient features of stock exchange are:
o It is a place where securities are purchased and sold.
o A stock exchange is an association of persons whether incorporated or
not.
o The trading in a stock exchange is strictly regulated.
o Both genuineinvestors and speculators buy and sell shares
o 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 ofsecurities.
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.
✓ Ensures diversification of investment and risks by providing liquidity of
investment.
✓ Imparts negotiability to securities which in turn helps investors to raise loans by
pledging their holdings as collateral security Assures safety and fair dealing.
✓ Gives at all times knowledge of the true value of their investment through stock
exchange quotations.
✓ Minimises risks of investment in industry by facilitating quick disposal of
securities, at all times.
✓ 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.
✓ Enhances the credit standing of the company as the listing of its securities gives an
impression of being a sound concern.
✓ Widens the market for the listed securities.
✓ Reduces the danger of group opposition to management by enhancing
marketability to the company’s securities which in turn diversifies ownership.
✓ Minimises the risk of the new issue remaining unsold by enhancing the response to
public issue of shares.
 ✓ Minimises price fluctuations of securities that are listed and thus enhances the
confidence of one and all dealing with it.
✓ Enables the company to command better bargaining power during amalgamation or
merger.
✓ Enables the company to enjoy several tax advantages.
▪ Benefits to the Community.
✓ Stimulates investment in industry, public savings and ensures a steady flow of
capital into productive enterprises.
✓ Helps the government in raising necessary finance from public for this purpose.
✓ Assists in the best utilization of capital and in minimizing the waste of scarce capital
resources.
✓ Smoothens the process of capital formation.
✓ Reflects business conditions.

Trading mechanism
Once you have your Demat account and trading account is ready, you are all set
to trade in the stock market. Companies list their shares in the Primary Market through an
Initial Public Offering Or IPO. After the IPO the stocks of the company are listed on an
exchange and are available for trading in the secondary market.
Stocks of companies are traded in order to make profits or cut down losses. This
trading of stocks is carried out through a stockbroker or brokerage firm. These brokers act as
an intermediary body between you and the stock exchange
Whenever you want to buy and trade a stock, you place the order with your broker at
a fixed price. The broker passes on the order to the stock exchange. The exchange then
searches for availability of buyer or seller to execute the order at the instructed price. If the
order is completed the exchange communicated with the broker that the order has been
executed.
The stock exchanges keep record of all the details of buyers and sellers trading on the
exchange through the brokers to avoid any chance of default. The stocks are then transferred
from the Demat account of the seller to the Demat account of the buyer electronically. The
settlement process earlier used to take weeks, but the electronic settlement and introduction
of Demat has made it possible to carry out all settlements in T+2 days.

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.
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.
3. NSDL
NSDL, one of the largest Depositories in the World, established in August 1996 has
established a state-of-the-art infrastructure that handles most of the securities held and settled
in dematerialized form in the Indian capital market. Although India had a vibrant capital
market which is more than a century old, the paper-based settlement of trades caused
substantial problems like bad delivery and delayed transfer of title, etc. The enactment of
Depositories Act in August 1996 paved the way for establishment of NSDL.

Using innovative and flexible technology systems, NSDL works to support the
investors and brokers in the capital market of the country. NSDL aims at ensuring the safety
and soundness of Indian marketplaces by developing settlement solutions that increase
efficiency, minimize risk and reduce costs. At NSDL, we play a central role in developing
products and services that will continue to nurture the growing needs of the financial services
industry. In the depository system, securities are held in depository accounts, which is more
or less similar to holding funds in bank accounts. Transfer of ownership of securities is done
through simple account transfers. This method does away with all the risks and hassles
normally associated with paperwork. Consequently, the cost of transacting in a depository
environment is considerably lower as compared to transacting in certificates.

NSDL provides bouquet of services to investors, stock brokers, custodians, issuer

companies etc. through its nation wide network of Depository Partners.
4. CDSL
Central Depository Services Limited (“CDSL”) was found in 1999 to fulfil one
goal: Convenient, Dependable and secured depository services. Over two decades later,
everything we have done – the values we have built on, dematerialisation of various asset
classes, e-services – have all been in support of that singular goal, at an affordable cost.

We are a Market Infrastructure Institution (MII) and a crucial part of the Capital market
structure, providing services to all Market participants - Exchanges, Clearing Corporations,
Depository Participants (DPs), Issuers and Investors.

A Depository is a facilitator for holding of securities in the dematerialised form and an

enabler for securities transactions.
5. STCIL and STCI
The State Trading Corporation of India Ltd. (STC) is a premier International
trading company of the Government of India, and, was engaged primarily in exports,
and imports operations.
It was set up in 1956 primarily with a view to undertake trade with East European
Countries and to supplement the efforts of private trade and industry in developing
exports from the country. The Corporation is registered as an autonomous company
under the Companies Act, 1956 and functions under the administrative control of the
Ministry of Commerce & Industry, Govt. of India.
The Corporation has played a key role in the Indian economy. In the pre-liberalisation
era, it acted as an arm of the Government of India not only to regulate foreign trade
but also for intervention in the domestic market. The Corporation handled canalized
exports and imports of large number of items varying from chemicals and drugs to
bulk commodities such as edible oils, cement, sugar, newsprint, wheat, urea, etc.
thereby ensuring timely availability and equitable distribution of mass consumption
items as well as essential raw materials for the industry. Canalisation also helped the
nation to benefit from economies of scale and keeping a close watch on the scarce
foreign exchange.
It undertook price support operations to ensure remunerative prices to growers for
their crops such as raw jute, shellac, tobacco, rubber and vanilla as and when called
upon by the Government to do so.
As part of its export development effort, STC in the past extended technical,
marketing and financial assistance to exporters by arranging import of machinery and
raw material for export production, setting up design centres, providing testing
laboratories, taking products of small manufacturers to overseas markets by
organising their consortia, participation in exhibitions and trade fairs, etc.
Recently, STC has stopped undertaking any new business activity and is currently
continuing as a non-operative company for the time being.

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
✓ To save the rights and interests of investors particularly individual investors and to
guide and educate them.
✓ To prevent trading malpractices like rigging the price, insider trading, misleading
statements in prospectus, etc.
✓ To regulate stock exchanges and the securities market to promote their orderly
functioning.
✓ To registering and regulating the working of stock brokers, sub-brokers etc
✓ To promote the development of Securities Market;
✓ To Promoting and regulating self-regulatory organizations.
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 take- over 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.
 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:
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.
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.
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).

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.
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].
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.

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.
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 SWAPS
 Origin of the derivatives market in India
Derivatives market in India has a history dating back in 1875. The Bombay Cotton Trading
Association started future trading in this year. History suggests that by 1900 India became one of the
world’s largest futures trading industry.

However after independence, in 1952, the government of India officially put a ban on cash settlement
and options trading. This ban on commodities future trading was uplift in the year 2000. The creation
of National Electronics Commodity Exchange made it possible.

In 1993, the National stocks Exchange, an electronics based trading exchange came into existence.
The Bombay stock exchange was already fully functional for over 100 years then.

Over the BSE, forward trading was there in the form of Badla trading, but formally derivatives trading
kicked started in its present form after 2001 only. The NSE started trading in CNX Nifty index futures
on June 12, 2000, based on CNX Nifty 50 index

Let us understand the various types of derivatives instruments with the help of examples.
The main instruments for derivatives trading in India are future contracts, options contracts,
swaps and etc. These instruments are originally meant for hedging purpose. However, their
use for speculation can’t be ruled out.

Basics of options trading in the Indian derivatives market

Consider the same example. Let us now suppose that the seller Gold Inc. believes that the spot price
may rise above INR 32000 per 10 gram during the forward contract agreement with you. So to limit
loss, Gold Inc. purchases a call option for Rs. 105 at the exercise price of INR 32000 per 10 gram
with the three months expiration date.

The exercise price is technically known as a strike price. Similarly, the price of the call option is
technically known as the option price or the premium.

Actually, the call option gives the seller the right to buy the gold at the strike price on the expiration
date. However, there is no obligation to buy on the expiration date. He may or may not exercise his
right on the expiration date.

For instance, if the spot price decline below INR 31800 our Gold Inc will choose not to exercise the
option. In this way, his loss would be limited to the premium of INR 105 per 10 gram.

In an alternative situation, when you expect the price to fall below the spot price in the future, you
have the option to purchase put options. Buying a put option provides you the advantage to sell at the
strike price on the expiration date. Here also you have no obligation to exercise your right.
What are Swaps?
Swaps are derivatives instruments. The swaps contract involve an exchange of cash flows over time.
Swaps are typically done between two parties. One party makes a payment to the other. This depends
on whether a price is above or below a reference price. This reference price is the basis of the swap
contract and is there is mention regarding it in the contract.

What is “Badla” trading?

The “Badla” trading is a mechanism of trade settlement in India. “Badla” is a Hindi term for carryover
transactions. This kind of trading facilitates trade shares on the margin on the Bombay Stock
Exchange.

Further, it also allows to carry forward the positions to the next settlement cycle. There was no fixed
expiration date, contract terms for such carryover transactions. Also, no standard margin requirement
was there. Moreover, earlier such transactions were carryforward indefinitely. But this was later fixed
for a maximum period of 90 days.

The SEBI put a complete ban on Badla trading in 2001 with the introduction of futures trading.