Meaning of Financial System

Finance involves the inflow and outflow of funds from the individual/institute who has
in excess to the individual/institute who is the need of the same. The financial system
refers to the various institute in the form of banks, insurance companies, and stock
exchanges, which permits the exchange of funds. Financial systems generally exist
on firm, regional, and global levels.
It plays a significant role in the economic growth of a country by mobilizing surplus
funds and utilizing them effectively for productive purposes.
It encourages both savings and investment, helps in capital formation, and allocation
of risk, and facilitates the expansion of financial markets.
Role of Indian Financial System
The Indian financial system plays a crucial role in the country's economic
development and stability. Here are some key roles it performs:
1. Mobilization of Savings
The financial system helps to collect savings from individuals, households, and
businesses and utilise them into productive investments. There are variety of
financial products like savings accounts, fixed deposits, mutual funds, and insurance
policies to encourage savings.
2. Provision of Credit
The financial system helps in the allocation of credit facilities in form of different
types of loans, including personal loans, business loans, mortgages, and educational
loans to the various sectors of the economy, including agriculture, industry, and
services, facilitating growth and development.
3. Facilitation of Investments
The financial system involves platforms such as stock exchanges (BSE, NSE) for
businesses to raise capital by issuing shares and bonds. Also, services are offered
to guide investors in making informed decisions through financial advisors, brokers,
and investment banks.
4. Risk Management
The financial system offers various insurance products to protect individuals and
businesses against health issues, accidents, property damage, and interruptions.
This is done by providing financial instruments like futures, options, and derivatives
to hedge against financial risks.
5. Payment and Settlement System
The financial system facilitates smooth and efficient payment and settlement of
transactions through various payment systems like UPI, NEFT, RTGS, and mobile
banking and also helps to manage the distribution and circulation of currency
through banks and ATMs.
6. Economic Stability
A financial institution such as The Reserve Bank of India (RBI) implements monetary
policy to control inflation, regulate the money supply, and maintain economic
stability. It also regulates and supervises financial institutions to ensure their stability,
solvency, and adherence to laws and regulations.
7. Financial Inclusion
There are different inclusive growth programs such as bringing the unbanked
population into the formal financial system through initiatives like Jan Dhan Yojana,
promoting financial literacy, and expanding banking services to rural areas. Similarly,
there is also a provision of financial services to low-income individuals or groups who
lack access to traditional banking services.
8. Development of Financial Markets
Capital Market Development helps to enhance the efficiency and depth of capital
markets, facilitating better price discovery, liquidity, and investment opportunities.
Few of the opportunities such as developing a robust money market have helped in
short-term borrowing and lending, providing liquidity to financial institutions.
9. Support for Government Policies
The financial system helps in raising funds for government expenditure through the
issuance of government bonds and securities. It also supports government economic
reforms by aligning financial policies and regulations with national economic goals.

10. Innovation and Technological Advancement

The financial system promotes digital banking, fintech innovations, and the use of
technology in financial services to enhance accessibility, efficiency, and
convenience. There is continuous innovation new financial products and services to
meet the evolving needs of consumers and businesses.
Overall, the Indian financial system is pivotal in fostering economic growth, ensuring
financial stability, promoting financial inclusion, and supporting the overall
development of the nation.

Components of Financial System

The financial system consists of components such as financial institutions, financial
markets, financial services, financial instruments and financial regulators.
Financial Institutions
The Financial Institutions act as a bridge between the investor and the borrower. It
acts as an intermediary between savers and borrowers mobilizes savings, and
channels them into productive investments, fostering economic growth and financial
stability. Financial institutions perform a few roles: banking services, insurance
services, capital formation, investment advice, and brokerage services.
It is the primary force that keeps the finance industry dynamic. The financial
institutions are the ones that facilitate in conducting transactions related to loans,
deposits, investment opportunity, buying and selling or making and receiving
payments related to any kind of business.
One such example of a Financial Institution is a Bank. People who have surplus
amounts of money make savings in their accounts, and people who are in need of
money take loans. The bank acts as an intermediate between the two.
Banks are classified into commercial and cooperative. The commercial Banks
are as follows
Commercial
Public Sector Banks:

These Banks are controlled by the federal or state governments, with a combined
ownership of more than 51 percent by the government. SBI, Punjab National Bank,
Bank of India, etc. are a few examples. The Nationalized Banks (private banks
taken over by the government) which were nationalized in 1969 and 1980s are also
public sector banks as the government owns more than 51% of these banks.

Private Sector Banks:

These are those Indian Banks that are owned by private individuals for example
ICICI bank, HDFC Bank, Axis Bank etc.
Regional Rural Banks (RRBs):

The Regional Rural Banks Act of 1976 established RRBs in 1975 to develop the
rural economy by providing credit and other facilities, particularly to small farmers,
agricultural labourers, artisans, and small entrepreneurs, to develop agriculture,
trade, commerce, industry, and other productive activities in rural areas.
The national government, the concerned state government, and the sponsor bank
generally own [Link] of RRBs (each RRB is sponsored by a particular bank).
There is a condition on RRBs to distribute 75% of their funding to priority industries.

Foreign Banks
Foreign banks are those banking companies that open a branch in a different nation
than the headquarters. They have their registered office in one country. These
foreign banks open branches in other countries. It is to provide better services and
convenience to multinational customers. It facilitates international trade. E.g. Citi
Bank
Co-operative Bank
Cooperative banks are owned and operated by their customers to provide banking
services to members. They operate on a cooperative basis, catering to the financial
needs of the members.
It is a small-sized, financial entity, where its members are the owners and customers
of the Bank.

Non-Banking Financial Institutions (NBFC)

The non-banking financial institutions are the organizations that facilitate bank-
related financial services but do not have banking licenses. These are companies
that provide financial services such as lending, insurance, and investment banking
but that are not regulated as banks.
They do not take deposits from customers however, they raise money by selling
securities or borrowing money.
They are not subject to the same lending restrictions as banks. This means that they
can lend money to anyone they choose, without having to follow the government’s
guidelines.

The criteria to be followed for setting up of NBFC are

 The company must be registered as a public or private company
 Must have at least Rs 10 crores are minimum NOF
 One-third of all directors must have finance-related work experience
 Fulfilment of regulations and norms under Capital compliances and FEMA laws.
 The company must have a detailed business plan for five years.
 The CIBIL records of the Company should be clean.
The types of NBFC

Asset Finance Company

It is a financial institution that facilitates the service of financing the various assets for
individuals and the businesses which include machinery, heavy industrial equipment,
production and farming equipment and large power generators.

The income arising from there from should not less be than the 60% of its total
assets.
e.g. UTI AMC, ICICI AMC, BIRLA SUN LIFE AMC are few examples of asset
management company.

Investment Company

It is a financial institution whose principal business is the acquisition of securities. In

a simple term, these companies take money from the public which invested in
various securities and financial products.

e.g. Bajaj Alliance General Insurance Company, IDFC, HDFC mutual fund are
examples of some Investment company.

Infrastructure Finance Company

It is a Non- Banking Finance Company –

a. That deploys three- fourth of its total assets in infrastructure loans

b. That has a minimum Net Owned Fund of 300crores

c. That has minimum ‘A’ credit rating or equivalent

d. CRAR of 15%

e.g. GMR infrastructure ltd, Hindustan Construction Company.

Infrastructure Debt Fund

IDFs raise resources through bonds for long-term infrastructure projects. The bonds
are issued in multiple currencies to ensure that have they had a five –year maturity
for investors.

Loan Company

Loan Company as its name states is a financial institution which offers loan for
various purposes other than of the AMC which also includes the Housing Finance
Firms.

e.g. LIC finance ltd, PNB Housing Finance Firm, HDFC

 Financial Markets
Financial Market refers to the place where securities trading takes place in the form
for different securities such as stock (shares), bond (debentures), foreign exchange,
money market (short term securities) and derivatives.
This is place which provides finance for companies to help them in investing and
grow. It assists in deciding the securities price by interaction with the investors and
depending on the demand and supply in the market.
It also gives liquidity to the assets. It plays a critical role in the modern economy by
facilitating the flow of funds and financial instruments globally, helping to fuel
economic growth and development.
The participants in financial markets include individual investors, institutional
investors like banks, mutual funds, pension funds, hedge funds, and corporations.
The Financial Market is classified into two categories.

Money Market
 Money Market involves securities which are highly liquid and short-term financial
assets with a maturity of up to 1 year are traded. Thus, the money market caters
to the short-term borrowing needs of working capital.
 Major institutions of the Money Market are – Commercial Banks, RRBs, Markets,
etc.
 Major instruments of the Money Market are – Call Money, Treasury Bills,
Commercial Paper, Certificates of Deposit (CD), etc.
Capital Market
 Capital Market refers to that part of the Financial Market which provides a market
for borrowing and lending of medium and long-term funds, above 1 year. The
capital market is concerned with long-term funding and investment. This involves
the equity market and the debt market.

Primary Market:

This is also known as the new issue market, is where securities are created and sold
for the first time. It is the market for new long-term capital. Companies raise capital
by issuing shares and bonds through initial public offerings (IPOs), follow-on public
offerings (FPOs), private placements and right issues

The participants are

 Issuing Companies: Corporations, government entities, and other organizations
that need to raise capital.

 Underwriters: Investment banks and financial institutions that help in pricing,

marketing, and selling securities.

 Investors: Institutional investors, retail investors, high-net-worth individuals, and

venture capitalists.

Secondary Market:

Where existing securities are traded. It provides liquidity to the financial instruments
issued in the primary market. The major stock exchanges in India are the Bombay
Stock Exchange (BSE) and the National Stock Exchange (NSE).

The participants are

 Retail Investors: Individual investors buying and selling securities for personal
investment.
 Institutional Investors: Mutual funds, pension funds, insurance companies, and
hedge funds engaging in large-scale trading.
 Brokers and Dealers: Intermediaries who facilitate trading between buyers and
sellers.
 Market Makers: Firms or individuals that provide liquidity by being willing to buy
and sell securities at quoted prices.

Both the primary and secondary markets are integral to the overall functioning of the
financial system, each serving complementary roles in supporting economic activity
and investment.

Financial Instruments
Financial Instrument refers to any asset which holds capital i.e. money invested
and which can be liquated (sold) due to increase in its value or even during the need
of funds. These are traded and used to raise capital in financial markets. Some of
the financial instruments involves less risk and are secured in nature but have low
rate of returns such as bank deposits whereas some involve high risk and high
rate of returns.
The different types of financial instruments in the form of traditional one such as
bank deposit, shares, bonds, mutual funds, derivatives – futures and options,
exchange traded funds (ETF) and money market instruments such as treasury bills,
certificate of deposit and commercial paper.
There have been modern instruments in the form of crypto currencies and Real
Estate Investment Trusts (REITs).
Financial instruments are vital components of the financial system, offering diverse
options for investment, risk management, capital raising, and liquidity provision. They
are used for investment, trading, hedging, and raising capital. It is a contract that
gives rise to a financial asset of one entity and a financial liability or equity instrument
of another entity.
The various financial instruments are

Equity instrument – shares (equity and preference)

Investing in stocks:

Investing in the stock market or equities can be a great way to grow wealth over
time. It takes careful analysis to be able to determine the best stocks to invest in, as
well as when to enter and exit the market.
Market volatility can have an effect on the capital growth of investments, and the
returns on these investments depend on the types of investors in India and their risk
tolerance. Fortunately, many stocks have been shown to deliver returns that
outperform inflation over the long run.

Debt instruments – loans, credits, debenture, bonds.

They are a form of debt investment that has become popular in India. Bond investors provide
money to the issuer of the instrument, and in exchange, the bond issuer pays interest to the
investor at a pre-defined coupon rate until the bond matures. Upon maturity, the investor
gets their original investment back. Although most bonds in India come with a fixed coupon
rate, other types of bonds such as floating rate bonds and zero-coupon bonds are
increasingly gaining favour.

To invest in bonds in India, one can either do so directly or through Debt Mutual Funds.
Investors should be aware that the bond issuer is obligated to return the principal amount to
them at the time of maturity.

Money Market Instrument – Treasury Bills, Commercial paper, Certificate of

Deposit

Certificate of Deposit:

Investing in a Certificate of Deposit (CD) is a money market instrument regulated by

the Reserve Bank of India (RBI) and issued by the Federal Deposit Insurance
Corporation (FDIC).
The minimum amount that can be invested in a CD is Rs.1 lakh and its multiples.
Commercial banks typically issue CDs with a maturity period ranging from 7 days to
1 year, while financial institutions offer CDs with a maturity period from 1 year to 3
years.

Hybrid Instrument – Mutual Funds

Mutual Funds (MFs):

Investing in Mutual Fund (MF) can involve stocks, bonds, or a combination of the
two. Depending on your financial goals and risk appetite, different types of investors
in India can choose between equity funds, debt funds, and balanced funds.
Additionally, you can also use Systematic Investment Plan (SIP) to invest smaller
amounts periodically. Before investing, review your risk preferences and be aware of
the taxation system. Moreover, you may opt for tax-saving mutual funds such as the
ELSS (Equity Linked Savings Scheme) to help maximise your returns.

Derivative instruments – Forward, Futures, Options, Swaps

Derivative instruments derive their value from the underlying asset such as
resources, currency, bonds, stocks, indices, etc. The performance of derivatives
instruments is dependent on the performance of the underlying assets. The following
are the most common types of derivative instruments –
Forward: A forward contract is a customized agreement. It is between two parties
that involve the exchange of an underlying asset at a specific exchange during a
specific time period.
Future: This is a derivative contract that involves the exchange of derivatives on a
future date at a predetermined exchange rate.
Options: An option is a derivative contract between two parties. Here, the buyer gets
the right to purchase or sell the underlying asset at a predetermined price for a
specific time period. However, there is no obligation to exercise the right.
Interest Rate Swap: This is a derivative contract between two parties. It involves the
exchange of interest rates where one party agrees to pay the other party’s interest
rate on their loans in different currencies.
Foreign Exchange Instruments
Insurance Instruments

ULIPs (Unit Linked Insurance Plans):

ULIP is a form of investment in India that comes with tax benefits. This instrument
combines investment and insurance, with part of the premium going towards
providing a life cover and the other part being invested in market-linked instruments
or funds. Additionally, deductions are allowed according to the Income Tax Act,
1961, with premiums paid being deductible and maturity benefits and long-term
capital gains being tax-free.

It is important to note the charges associated with investing in ULIPs, such as

premium allocation charges, administrative charges, fund management charges,
mortality charges, etc.

To get the optimum benefit from ULIPs, one should opt for an insurer provider who
levies a minimum charge and provides flexibility in terms of premium payments and
customizable plans with different fund options.

Additionally, ULIPs offer the ability to switch funds depending on market movements
and changing risk appetite. Policyholders can also opt for a fixed proportion to be
maintained in equity and debt throughout the policy term.

Saving Schemes – Public Provident Funds ( PPF), Kisan Vikas Patra, National
Saving Certificate(NSC), Bank Fixed Deposit, Recurring Deposit.

Public Provident Fund (PPF):

Public Provident Fund (PPF) is viewed as one of the safest forms of investment in
India, since it is backed by the government. Opening an account with any bank or
post office is the first step to investing in PPF and can be done with a minimal
amount of Rs.100 in some banks (can vary for different banks). Yearly deposits
range from a minimum of Rs.500 to a maximum of Rs.1.5 lakh, and these
investments are locked in for 15 years, as well as qualifying for tax deductions under
section 80C of the Income Tax Act, 1961.
To get the most out of PPF, it is advisable to invest before the 5th of every month,
taking advantage of online transfers for convenience and efficiency.

National Savings Certificate (NSC):

National Savings Certificate (NSC) is a government-backed fixed-income investment

scheme offered by India Post. This scheme attracts conservative investors making
medium to small-scale investments for five years. The interest rates for NSC are pre-
determined and reviewed/revised by the Ministry of Finances under the Government
of India on a quarterly basis.

Fixed Deposits (FD):

When you choose to invest in a Fixed Deposit offered by banks or non-banking

financial organisations (NBFCs), you can put aside a lump sum of cash for a pre-
determined period of time and gain interest at the agreed rate. This type of
investment is quite popular in India as it offers a secure way to grow your funds.
Upon completion of the tenure, your deposit gets you interest at the rate that was
set.

Investing in real estate:

To invest in real estate, one can buy residential or commercial properties and benefit
from capital appreciation or regular rental income. An alternative is to invest in units
of Real Estate Investment Trusts (REITs). REITs in India typically invest in
commercial properties, and investors gain returns based on the income from rentals.

REITs in India

REITs or real estate investment trust can be described as a company that owns and
operates real estates to generate income. Real estate investment trust
companies are corporations that manage the portfolios of high-value real estate
properties and mortgages. For instance, they lease properties and collect rent
thereon. The rent thus collected is later distributed among shareholders as income
and dividends.

Typically, REITs offer investors an opportunity to possess high-priced real estate and
enable them to earn dividend income to boost their capital eventually. This way,
investors can utilise the opportunity to appreciate their capital and generate income
at the same time.

Both big and small investors can park their funds into this investment option and
reap benefits accordingly. Small investors may attempt to pool their resources along
with other investors and invest the same into large commercial real estate projects.
Properties included in REITs comprise data centres, infrastructure, healthcare units,
apartment complexes, etc.

The income for the REIT comes in the form of rental income from real estate
investments as well as capital gains on the sale of such properties. The profit is
derived after adjusting for various costs associated with the management of this real
estate portfolio as well as the fees for various professionals, including the
management company and the trustees. As of July 30, 2021, the minimum
investment amount for Real Estate Investment Trusts (REITs) in India is between
₹10,000 and ₹15,000. The minimum lot size for REITs is also one unit. REITs are
listed on stock exchanges and trade like equity shares. They can be purchased in
two ways

 Initial Public Offering (IPO): Subscribe to the issue during the IPO.
 Secondary market: Buy units from the stock exchange after the IPO.

The benefits of investing in REITs are

1. Low-ticket size: The investor can invest small amounts of money into the REITs.

2. Liquidity: As the units of REITs are listed on stock exchanges, there is

reasonable liquidity (an exit option) for the existing investors. New investors can also
invest at any point in time by buying these units on the secondary market without
having to wait for a new launch.

3. Divisibility: A benefit related to liquidity and small ticket sizes is divisibility. In the
case of physical real estate, when an investor wants liquidity, the entire property
must be sold, as it cannot be divided into parts and sold off. REIT units can be sold
on the exchange to the extent of the liquidity requirement.
4. Diversification: A typical real estate investment is done in a single property, or a
couple of properties at most, in the majority of cases. This exposes the investor to
the risk of a concentrated portfolio. REIT is a diversified portfolio across various
different properties located across the country.
5. Transparency: The investor can easily know where the money is invested as well
as what the fair value of the investment would be as the NAV is declared regularly.
6. Regulations: REITs are regulated by SEBI.

Financial Regulators
Financial Regulator is a government agency or organization which controls and
regulates financial markets, institutions, and participants within a particular
jurisdiction.
Financial regulators play a crucial role in maintaining the stability, integrity, and
efficiency of the financial system, as well as protecting investors and consumers.
There are also other activities done in the form of compliance enforcement,
development of various policy and regulation of the financial markets.
Some of the financial regulator in India are
Securities and Exchange Board of India (SEBI): Regulates stock exchanges,
brokers, depositories, mutual funds, portfolio managers, and other entities operating
in the securities market.

Reserve Bank of India (RBI): Is the Central bank of India and the primary regulatory
authority for the banking sector.

Insurance Regulatory and Development Authority of India (IRDAI): Is

responsible for regulating and supervising the insurance industry in India.

National Housing Bank (NHB): Regulates and supervises housing finance

companies (HFCs) and provides refinance facilities to promote housing finance.
Pension Fund Regulatory and Development Authority (PFRDA): Regulates and
supervises pension funds, pension fund managers, and other entities involved in the
pension industry.
They also collaborate with other government agencies to address systemic risks and
promote the development of the financial sector.
 Challenges of Indian Financial System
The Indian Financial System has seen a phenomenal rise due to the implementation
of technology into financial processes, regulations, and reforms. However, there are
several challenges that it encounters that can affect sustainable economic growth
and financial stability. A few of the challenges of the Indian Financial System are as
follows
1. Regulatory and Compliance Challenges
There are complex regulatory frameworks involving multiple regulators such as the
Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI),
and the Insurance Regulatory and Development Authority of India (IRDAI). This
creates a lot of doubts and concerns in the minds of the investors because of the
various regulation issues. Many times there are frequent changes in regulations and
compliance requirements can be burdensome for financial institutions. At the same
time, ensuring uniform regulations across various financial segments to prevent
regulatory arbitrage.

2. Technological Challenges

One of the major issues of the rise of technology is the concern of

cybersecurity such as protecting against the increasing threat of cyber-attacks and
ensuring different cybersecurity measures. There is also a need to make
continuous investments in upgrading technology and integrating new digital solutions
with legacy systems.

3. Market Volatility and Economic Fluctuations

There are different risks associated with global economic conditions, including trade
wars, geopolitical tensions, and economic slowdowns at the same time domestic
economic fluctuations due to domestic economic challenges such as inflation, fiscal
deficits, and economic slowdown.

4. Structural Issues

There are various structural issues in public sector banks, including governance
reforms, operational efficiency, and reducing government interference. There is also
a need to balance for consolidation in the banking sector to create stronger entities
with the need to maintain competition and diversity.

5. Corporate Governance

There is a need to improve corporate governance standards across financial

institutions to ensure transparency, accountability, and ethical practices. There is
also a need to strengthen the effectiveness of boards of directors in overseeing
management and strategic decision-making.
6. Innovation and Competition

Encouraging innovation while balancing the need for regulation to prevent systemic
risks and maintaining healthy competition in the financial sector to avoid monopolistic
practices and ensure better services for consumers.

Trading Process of Shares in the Stock Exchange

1. Selection of Broker

One can buy and sell securities only through the brokers registered under SEBI
and who are members of the stock exchange. A broker can be a partnership firm,
an individual, or a corporate body. Hence, the first step of the trading procedure is
the selection of a broker who will buy/sell securities on the behalf of a speculator or
investor. Before placing an order to the registered broker, the investor has to
provide some information, including PAN Number, Date of Birth and Address,
Educational Qualification and Occupation, Residential Status (Indian/NRI), Bank
Account Details, Depository A/c details, Name of any other brokers with whom they
have registered, and Client code number in the client registration form. After getting
information regarding all the said things, the broker opens a trading account in the
name of the investor.

2. Opening Demat Account with Depository

An account that must be opened with the Depository Participant (including stock
brokers or banks) by an Indian citizen for trading in the listed securities in electronic
form is known as Demat (Dematerialised) Account or Beneficial Owner (BO)
Account.
The second step of the trading procedure is the opening of a Demat Account. The
Depository holds the securities in electronic form. A Depository is an organisation
or institution, which holds securities like bonds, shares, debentures, etc. At present
there are two Depositories; namely, NSDL (National Securities Depository
Ltd.) and CDSL (Central Depository Securities Ltd.). The Depository and the
investor do not have direct contact with each other and interact with each other
through Depository Participants only. The Depository Participant will have to
maintain the securities account balances of the investor and intimate investor from
time to time about the status of their holdings.

3. Placing the Order

The next step after the opening of a Demat Account is the placing of an order by
the investor. The investor can place the order to the broker either personally or
through email, phone, etc. The investor must make sure that the order placed
clearly specifies the range or price at which the securities can be sold or
bought. For example, an order placed by Kashish is, “Buy 200 equity shares of
Nestle for no more than ₹200 per share.”
4. Match the Share and Best Price

The broker after receiving an order from the investor will have to then go online and
connect to the main stock exchange to match the share and best price available.

5. Executing Order

When the shares can be bought or sold at the price mentioned by the investor, it
will be communicated to the broker terminal, and then the order will be executed
electronically. Once the order has been executed, the broker will issue a trade
confirmation slip to the investors.

6. Issue of Contract Note

Once the trade has been executed within 24 hours, the broker will issue a contract
note. A contract note consists of the details of the number of shares bought or sold,
the date, time of the deal, price of securities, and brokerage charges. A contract
note is an essential legal document. It helps in settling disputes claims between the
investors and the brokers. A contract note also consists of a printed unique order
code number assigned to each transaction by the Stock Exchange.

7. Delivery of Share and making Payment

In the next step, the investor has to deliver the shares sold or has to pay cash for
the shares bought. The investor has to do so immediately after receiving the
contract note or before the day when the broker shall make delivery of shares to
the exchange or make payment. This is known as Pay in Day.

8. Settlement Cycle
The payment of securities in cash or delivery of securities is done on Pay in Day,
which is before T+2 Day. It is because the settlement cycle is T+2 days on w.e.f
April 2003 rolling settlement basis. For example, if the transaction took place on
Tuesday, then the payment must be done before Thursday, i.e., T+2 days
(Transaction plus two more days).

9. Delivery of Shares or Making Payment

On the T+2 Day, the Stock Exchange will then deliver the share or make payment
to the other broker. This is known as Pay out Day. Once the shares have been
delivered of payment has been made, the broker has to make payment to the
investor within 24 hours of the pay out day, as he/she has already received
payment from the exchange.

10. Delivery of Shares in Demat Form

The last step of the trading procedure is making delivery or shares in Demat form
by the broker directly to the Demat Account of the investor. The investor is
obligated to give details of his Demat Account and instruct his Depository
Participant (DP) for taking delivery of securities directly in his beneficial owner
account.

Initial Public Offer (IPO)

An IPO is the process by which a private company offers its shares to the public for
the first time. A company raises capital from investors by going public, which can be
used for various purposes such as expanding operations, paying off debt, or funding
research and development. When a company lists its shares on a stock exchange, it
becomes a publicly traded entity, allowing investors to buy and sell its shares in the
open market.

For a company to be eligible for an IPO listing in India, it must meet certain criteria
set by the Securities and Exchange Board of India (SEBI). These include:
1. Net Tangible Assets: The company should have at least INR 3 crore net
tangible assets in the preceding three years.
2. Profitability: The company should have generated a profit in at least three
out of the preceding five years.
3. Net Worth: The company’s net worth should have been at least INR 1 crore
in the preceding three years.
4. Size of the Issue: The issue should not exceed five times the pre-issue net
worth.

IPO Process in India

The IPO process in India involves several steps and regulatory requirements. Here’s
a detailed overview:
1. Appointment of Intermediaries
The company appoints intermediaries such as investment bankers, underwriters,
legal advisors, and auditors to assist with the IPO process. These intermediaries
help prepare the necessary documents and ensure compliance with regulatory
requirements.

2. Due Diligence and Documentation

The intermediaries conduct a thorough due diligence process, which includes
reviewing the company’s financials, business operations, and legal aspects. The
company prepares the draft red herring prospectus (DRHP), which contains detailed
information about the company, its financials, and the IPO.
3. SEBI Approval
The DRHP is submitted to SEBI for approval. SEBI reviews the document to ensure
all regulatory requirements are met, and the information provided is accurate and
complete. Upon approval, the DRHP becomes the red herring prospectus (RHP).

4. Marketing and Roadshows

The company and its intermediaries conduct marketing campaigns and roadshows to
promote the IPO to potential investors. This helps generate interest and understand
the demand for the shares.

5. Pricing and Bidding

For book-building IPOs, the company sets a price band, and investors place their
bids within this range. The final price is determined based on the demand and the
bids received. For fixed-price IPOs, the price is pre-determined.

6. Allotment of Shares
Once the bidding process is complete, shares are allotted to investors based on the
demand and the subscription level. If the IPO is oversubscribed, shares are allotted
on a pro-rata basis.

7. Listing on the Stock Exchange

After the allotment, the shares are listed on the stock exchange, and trading begins.
The company’s shares can now be bought and sold in the open market.

Types of IPO
There are two primary types of IPOs: Fixed Price Offerings and Book Building
Offerings.

Fixed Price Offerings

In a fixed price offering, the company sets a fixed price at which its shares will be
offered to the public. This price is determined before the IPO opens for subscription.
Investors must pay the full share price when applying for the IPO.

Book Building Offerings

The company offers a price range within which investors can bid for the shares in a
book-building offering. The final price is determined based on the bids received
during the subscription period. Investors can choose a price within the specified
range, and the shares are allotted based on the demand and bids.
In this the process followed is of Cut Off price in the following manner
The cut-off price is essentially the highest price at which the IPO can be fully
subscribed.

Parameters
Total Demand - The sum of shares bid for at each price level within the price
band.
Available Shares - The total number of shares the company is offering in the
IPO.
Cut-Off Price - The highest price at which the total demand equals or just
exceeds the number of available shares.

In an Initial Public Offering (IPO), the "cut-off price" is the final price at which shares
are allotted to investors. This price is determined after the book-building process,
which involves collecting bids from investors within a specified price range (price
band). The cut-off price is typically the highest price at which the total shares on offer
can be sold, and it ensures that all investors who bid at or above this price receive
shares at the same final price.

Key Points About the Cut-Off Price:

1. Book-Building Process: During the book-building phase, investors place

bids for shares at different prices within the provided price band. The
company and its underwriters then analyze these bids to determine the cut-off
price.
2. Retail Investors: Retail investors can opt to apply at the cut-off price,
indicating their willingness to pay the final determined price without specifying
a particular bid price. This simplifies the process for retail investors and
ensures they are allotted shares at the final price.
3. Final Allotment Price: The cut-off price is the final price at which shares are
allotted to all investors who bid at or above this price. It ensures uniformity in
the share price for all successful bidders.

Example of Cut-Off Price in an Indian IPO:

Zomato IPO (2021):

 Issue Details: Zomato, a food delivery and restaurant discovery platform,

went public in July 2021.
 Price Band: The price band for the Zomato IPO was set between ₹72 and
₹76 per share.
  Cut-Off Price: During the book-building process, the final cut-off price was
determined to be ₹76 per share, which was the upper end of the price band.
 Investor Bidding: Retail investors who applied at the cut-off price were
allotted shares at ₹76 each. Institutional investors also received shares at this
final determined price.

The calculation of the cut-off price in an IPO is a result of the book-building process.
Here is a step-by-step explanation of how the cut-off price is determined:

1. Price Band Determination:

The company and its underwriters set a price band for the IPO, indicating the
minimum and maximum price at which the shares can be bid. For example, the price
band could be set between ₹72 and ₹76 per share.

2. Collection of Bids:

Investors submit their bids within the price band during the book-building period.
Each bid includes the number of shares the investor wants to buy and the price they
are willing to pay. Retail investors can also choose to bid at the cut-off price without
specifying a price.

3. Demand Analysis:

The company and underwriters analyze the bids to determine the total demand at
different price levels. They create a demand chart, also known as a demand curve,
showing the cumulative number of shares bid at or above each price point within the
band.

4. Determining the Cut-Off Price:

The cut-off price is determined by identifying the price at which the total number of
shares offered in the IPO can be sold. This involves the following steps:

 Cumulative Demand Calculation: Calculate the cumulative demand at each

price point within the price band.
 Total Shares Offered: Identify the total number of shares available for the
IPO.
 Matching Demand with Supply: Find the highest price at which the total
cumulative demand is equal to or greater than the total shares offered. This
price becomes the cut-off price.

The cut-off price ensures that shares are allocated to investors in a fair manner
based on demand. Investors who bid at or above the cut-off price receive shares,
and retail investors who opted for the cut-off price are assured of getting shares at
this final price.

Here's an example to illustrate how the cut-off price is determined in an IPO:

Company: ABC Ltd. Total Shares Offered: 1,000,000 shares Price Band: ₹100 to
₹110 per share

Step-by-Step Process:
1. Collection of Bids:

Investors submit their bids during the book-building period. The bids received are as
follows:

Price (₹) Number of Shares Bid Cumulative Shares Bid

100 200,000 200,000

101 150,000 350,000

102 100,000 450,000

103 100,000 550,000

104 50,000 600,000

105 50,000 650,000

106 200,000 850,000

107 100,000 950,000

108 100,000 1,050,000

109 200,000 1,250,000

110 300,000 1,550,000

Arrange them in the descending order of price

Price (₹) Number of Shares Bid Cumulative Shares Bid
110 3,00,000 3,00,000
109 200,000 5,00,000
108 100,000 6,00,000
107 100,000 7,00,000
106 200000 900000
105 50000 950000
104 50000 1000000
103 100000 1100000
102 100000 1200000
101 150000 1350000
100 200000 1550000
 2. Determining the Cut-Off Price:

 Total Shares Offered: 1,000,000 shares

 Matching Demand with Supply: Find the highest price at which the
cumulative demand is equal to or greater than the total shares offered.

From the table, we can see that at ₹104, the cumulative demand is 1,050,000
shares, which exceeds the total shares offered (1,000,000). Hence, the cut-off price
is determined to be ₹104 per share.

Green Shoe Option

A greenshoe option, also known as an over-allotment option, is a provision in an
initial public offering (IPO) underwriting agreement that allows underwriters to sell
more shares than originally planned.
This option can help companies address increased demand and stabilize share
prices during the 30-day stabilization period after listing.
It can also help underwriters manage risk by buying back shares and stabilizing
prices if demand is high, without risking their own capital.

The greenshoe option gets its name from the Green Shoe Manufacturing Company,
which was the first company to agree to sell extra shares when it went public in
1960.

A greenshoe option allows the group of investment banks that underwrite an initial
public offering (IPO) to buy and offer for sale 15% more shares at the same offering
price than the issuing company originally planned to sell.
The clause is activated if demand for shares is more enthusiastic than anticipated
and the stock is trading in the secondary market above the offering price.
Eg

XYZ Corporation

XYZ Corporation plans to issue 10 million shares at Rs. 20 per share, but includes
a greenshoe option in its underwriting agreement with Investment Bank ABC. This
option allows the bank to sell an additional 15% of shares, or 1.5 million shares, at
the same price. This means the maximum number of shares that can be issued is
11.5 million.

 Alibaba
In 2014, Alibaba exercised its greenshoe option during its IPO to buy an extra 48
million shares from the company. This move helped stabilize the stock price during
volatile market conditions.

The green shoe option is a vital tool in the world of IPOs, offering a balancing act
between the interests of companies, underwriters, and investors. Its ability to
maintain price stability, meet high demand, and in still investor confidence makes it
an integral part of the IPO process.

The role of different entities in the Stock Trading

Depository
Depository also known as Depository participants (DP) play a critical role in the
stock market as they serve as the bridge between traders and the market itself.
These individuals provide a platform for traders to access the stock market and
make their investments. They are authorized by the NSDL and CDSL based on the
Depositories Act of 1996.
The National Securities Depository Limited (NSDL)
NSDL was established in 1996 and is headquartered in Mumbai. It is the largest
depository in India, holding securities for over 2 million investors. NSDL provides a
range of services related to the dematerialization of securities, including the opening
and maintenance of Demat accounts, the settlement of trades, and the issuance and
transfer of securities. It also offers a range of value-added services, such as e-voting
and e-proxy services, to its clients.

Central Depository Services (India) Limited (CDSL)

CDSL was established in 1999 and is also headquartered in Mumbai. It is the
second-largest depository in India, holding securities for over 1 million investors. Like
NSDL, CDSL provides a range of services related to the dematerialization of
securities, including the opening and maintenance of Demat accounts, the
settlement of trades, and the issuance and transfer of securities. It also offers a
range of value-added services, such as online access to account statements and the
ability to place requests for physical certificates online.

Few of the activities done by them are

Holding securities electronically
Depositories hold securities like stocks, bonds, and mutual funds in electronic form,
which reduces the risk of theft or loss.
Facilitating transactions
Depositories help to efficiently transfer and settle securities transactions. For
example, when an investor wants to sell their stocks, they instruct their depository
participant (DP) to initiate the sale. The DP then communicates with the depository
to transfer the stocks to the buyer's account.
Managing corporate actions
Depositories manage corporate actions like dividend payments, stock splits, and
bonus issues. They ensure that any benefits from these actions are reflected in the
investor's account.
Providing account statements
DPs provide regular account statements to investors that include details of all
holdings and transactions.
Acting as a connection
Depositories act as a connection between the public companies that issue financial
securities and the investors or shareholders.

Stockbroker
A stockbroker's role in the stock market is to act as an intermediary between
investors and the stock exchange, and to help investors make informed decisions. A
broker is officiated after their registration with a recognised stock exchange such as
the Bombay Stock Exchange or by working for a brokerage firm. Such brokers levy a
charge in the form of commission, fee, or mark-up. This charge widely varies from
broker to broker. Some dealers charge a flat fee, whereas some levy a percentage of
the securities value traded. The activities done by stockbroker are

 Executing trades: Stockbrokers take orders from clients and execute them on the
stock exchange.
 Providing advice: Stockbrokers provide investment advice, research, and market
insights to help clients make informed decisions.
 Managing portfolios: Stockbrokers manage their clients' wealth portfolios.
 Keeping up with regulations: Stockbrokers stay up to date with the latest financial
and tax legislation.
 Monitoring the market: Stockbrokers monitor stock market performance.
 Conducting research: Stockbrokers conduct market research and analysis.
 Earning a commission: Stockbrokers earn a fee, known as a commission, for
their services
 Value at Risk ( VaR)
Value at Risk, or VaR, is a tool that helps investors, companies, and fund managers
figure out how much money they might lose if the market is in not the favour.

VaR can be applied to a single asset, a portfolio of assets, or even an entire

business operation. The choice depends on what you want to assess.

When calculating the Value at Risk of an investment, we ask ourselves: "What is the
maximum amount I could lose on my investment, given a certain level of confidence,
over a specific period?"

In simple terms Value at Risk measures largest loss likely (in future) to be suffered
on a portfolio position over a holding period with a given probability (confidence
level). VAR is a measure of market risk, and is equal to one standard deviation of the
distribution of possible returns on a portfolio of positions.

It is widely used in finance for setting risk limits, capital allocation, and regulatory
reporting, but it should be complemented with other risk measures for a
comprehensive risk assessment. VaR is used by clearing corporations to understand
the margin they must collect, while fund managers use VaR to analyse and manage
their total level of risk exposure. Investors can also use the VaR data while making
an investment decision.

Value at Risk Measures:

1. The Amount of Potential Losses

2. The chance of that loss

3. The Time Frame of the Loss

Key Components of VaR:

1. Time Horizon: The period over which the risk is assessed (e.g., 1 day, 10
days).
2. Confidence Level: The probability that the actual loss will not exceed the
VaR (e.g., 95%, 99%).
3. Loss Amount: The estimated maximum loss in value at the specified
confidence level and time horizon.

Calculation Methods:

1. Historical Simulation: Uses historical market data to simulate potential

losses.
 2. Variance-Covariance (Parametric) Method: Assumes normal distribution of
returns and calculates VaR using the mean and standard deviation.

Methods of VaR calculation

Historical Method

This method is like looking at the past to predict the future. Let's say you have Rs
1,000 invested in a stock. You want to know how much you could lose in the next
day (your time horizon) with 95% confidence (your confidence level).

As per the historical method, you will look at the past 100 days, and the worst loss
was Rs 50 on one of those days. So, your VaR for one day at a 95% confidence
level would be Rs 50.

Based on historical data, you are 95% sure you won't lose more you won't lose more
than Rs 50 in one day.

Variance – Covariance Method

In the variance-covariance method, the volatility of the stock plays an important role.

So, in this method, there is a use of mathematics and statistics to make future
predictions. There is a need for two data: the average (mean) return of an
investment and the stock's volatility (standard deviation). For example, suppose a
stock typically goes up by 5% on average and has a volatility of 10%. In that case,
you can use these numbers to estimate how much you might lose over a certain
period if your investment amount is Rs 1,000.

Formula for calculating VaR = [Average Return - (Z-score * Volatility)] * Investment

Amount

Note that the Z-score is a term that corresponds to your chosen level of confidence.
For a 95% confidence level, the Z-score is approximately 1.96.

Average Return = 5%

Z-score for 95% confidence = 1.96

Volatility = 10%
Investment = Rs 1,000

The VaR in the given case −146. This means you might expect to lose around Rs
146 with a 95% confidence level if your investment is 10% volatile over the specified
time frame.

But, if the volatility becomes 30%, the loss you might expect increases from Rs 146
to Rs 537. The higher the volatility of the asset, the higher the losses

For example, the VaR of Reliance Industries on NSE is 8.83%, while for SBI, it is
9.64%. This shows that SBI’s stock is more volatile than Reliance on a specific day.

n the equity segment, every transaction involves a certain level of financial security
known as margins. This is collected upfront by the clearing corporation from brokers
for the trades they execute. This money ensures that you have the means to cover
potential losses from your trade.

Margin requirements typically include VaR (Value at Risk) and ELM (Extreme Loss
Margin).

• ELM, or Extreme Loss Margin, is an additional margin complementing VaR. It

is designed to provide coverage for potential losses that might exceed what is
initially predicted by the VaR models. ELM represents a fixed supplementary
margin that is imposed alongside VaR. Both of these margins are calculated
based on the value of the trade and are expressed as a percentage of that
trade's total value. It is usually 3.5% for any stock and 2% for ETFs that
track broad based market indices and do not include ETFs which track
sectoral indices.

Here is an example: Suppose an investor decides to acquire stocks with a total value
of Rs 1 lakh, and the designated VaR and ELM margin for this particular stock is set
at 12.50%. In this scenario, a sum of Rs 12,500 is temporarily held as a margin to
secure the trade. This ensures sufficient funds are in place to cover potential losses
and maintain the financial system's stability.

The Extreme Loss Margin for any stock is higher of: 5%, or 1.5 times the standard
deviation of daily logarithmic returns of the stock price in the last six months. This
computation is done at the end of each month by taking the price data on a rolling
basis for the past six months and the resulting value is applicable for the next month.

Calculation of VaR
• Step 1: Take volatility for T minus 1 day (‘T-1’) i.e the day before transaction
day (‘T’) [this will be given]

• Step 2: Calculate volatility for T day using following formula:

o Square root of [0.94*(T-1 volatility)*(T-1 volatility) + 0.06*(LN return for
T)*(LN return for T)]

[LN returns means returns computed using natural log. LN returns will be given]
VaR is computed using exponentially weighted moving average (EWMA)
methodology where 94% weight is given to volatility on ‘T- 1’ day and 6% weight is
given to ‘T’ day returns.

• Step 3: Identify category of company based on regularity of trading and

liquidity

o Group I = shares that are regularly traded (that is, on more than 80% of
the trading days in the previous six months) and have high liquidity
(impact cost less than 1%)

o Group II = shares that are regularly traded (more than 80% of the trading
days in the previous six months) but less liquid than Group I (impact cost
more than 1%).

o Group III = All other shares are classified under Group III

• Step 4: Calculate VaR margin rate as under:

o Group I = VaR margin rate would be higher of:

• 6 times volatility of T day ; or
• 9%

o Group II = VaR margin rate would be higher of below:

• 6 times volatility of T day ; or
• 21.5%

o Group III VaR margin rate:

• 50% if traded at least once per week on any stock exchange;
• 75% otherwise

Group III the securities shall be monitored on a weekly basis, and the VaR margin
rates shall be increased to 75% if the security has not traded for a week. In case the
VaR margin rate is 75% and the security trades during the day, the VaR margin rate
shall be revised to 50% from start of next trading day.
 Total Amount of Investment Rs.10,00,000
T-1 Sep 3rd,2024
T Sep 4th, 2024
Closing price on 3rd September (T-1) 360

Closing price on 4th September (T) 330

T-1 day Volatility 0.0314

T day LN return 0.08701

Volatility as on T day ?

Amount of VaR Margin ?

Extreme Loss margin (ELM) 3.5%

Steps
1
Given T-1 volatility = 0.0314
2
Calculating volatility for T day using following formula:
Square root of [0.94*(T-1 volatility)*(T-1 volatility) + 0.06*(LN return for T)*(LN
return for T)]
Given LN returns for T day = 0.08701
Square root of [0.94*(0.0314)*(0.0314) + 0.06*(0.08701)*(0.08701)] = 0.037 or
3.7%

3
Identify the category of company based on regularity of trading and liquidity
4
Calculation of VaR
Group I VaR margin rate would be higher of:
• 6 times volatility of T day = 6 x 3.7 = 22.2% OR
• 9%
Therefore, VaR Margin = 22.2% of Rs.10,00,000 = Rs.2,22,000
Group II VaR margin rate is higher of
• 6 times volatility of T day = 6 x 3.7% =22.20% ; or
• 21.5%
Therefore, VaR Margin = 22.2% of Rs.10,00,000 = Rs.2,22,000
Group III = VaR margin rate = 50% if traded at least once per week
Therefore, VaR margin = 50% x Rs.10,00,000 = Rs.500,000 (if traded once per
week)
Otherwise, VaR margin = 75% x Rs.10,00,000 = Rs.750,000 (if NOT traded once
per week)

Therefore, Extreme loss margin = 3.5% x 10,00,000 = Rs. 35,000

Total margin = VaR margin + Extreme loss margin = 3.5% + 22.2% =25.7% =
Rs.2,57,000