Module I

Financial Markets
Prof. Rahul Mailcontractor,
KLS’s Institute of Management Education and
Research,
Hindwadi, Belgaum
 Financial System
• “Financial system", implies a set of complex and closely connected or
interlined institutions, agents, practices, markets, transactions, claims, and
liabilities in the economy”.
• A financial system is a complex , well integrated set of sub systems of
financial institutions, markets, instruments & services which facilitates
the transfer and allocation of funds efficiently & effectively
• It is the system that allows the transfer of money between savers (and
investors) and borrowers.
• It is the set of Financial Intermediaries, Financial Markets and Financial
Assets.
• It helps in the formation of capital.
• It meets the short term and long term capital needs of households,
corporate houses, Govt. and foreigners.
• It’s responsibility is to mobilize the savings in the form of money and
invest them in the productive manner.
Flow Of Funds In The Financial System
 Functions of the Financial system
• To link the savers & investors.
• To inspire the operators to monitor the performance of their
investment.
• To achieve optimum allocation of risk
• To make available price - related information.
• To help promote the process of financial deepening and
broadening
 Organization / Structure of financial system

Financial
system

Financial Financial Financial

Intermediaries Markets Assets
 Financial Intermediaries
• Financial intermediaries are firms that collect the funds from lenders
and channel those funds to borrowers (Mishkin)
• Financial intermediaries are firms whose primary business is to
provide customers with financial products and services that can not be
obtained more efficiently by transacting directly in securities markets
(Z.Bodie &Merton)
• There are roughly three classes of financial intermediaries:
1. Depository institutions accept deposits from savers and transform
them into loans (Commercial banks, savings and loan associations,
mutual savings banks and credit unions)
2. Contractual savings institutions acquire funds at periodic
intervals on a contractual basis (insurance and pension funds)
3. Investment intermediaries serve different forms of finance. They
include finance companies, mutual funds and money market
mutual funds.
 Function of Financial Intermediaries
• Lower transaction costs
• Economies of scale
• Liquidity services
• Since transaction costs are reduced, financial intermediaries are able to
provide customers with additional liquidity services, such as checking
accounts which can be used as methods of payment or deposits which can
be liquidated any time while still bearing some interest.
• Reduce Risk
• Risk Sharing (Asset Transformation)
• Diversification
• Through the process of asset transformation not only maturities, but also the
risk of an asset can change: A financial intermediary uses funds it acquires
(e.g. through deposits) and often turns them into a more risky asset (e.g. a
larger loan).
• The risk then is spread out between various borrowers and the financial
intermediary itself.
• The process of risk sharing is further augmented through diversification of
assets (portfolio-choice), which involves spreading out funds over a
portfolio of assets with different types of risk.
 Function of Financial Intermediaries
• Reduce Asymmetric Information
• Asymmetric Information in financial markets - one party often does not
know enough about the other party to make accurate decisions.
• Adverse Selection (before the transaction)—more likely to select risky
borrower
• Moral Hazard (after the transaction)—less likely borrower will repay
loan
• Financial intermediaries are important in the production of information.
They help reduce informational asymmetries about some unobservable
quality of the borrower for example through screening, monitoring or
rating of borrowers, Net worth and collateral.
• Finally, some financial intermediaries specialize on services such as
management of payments for their customers or insurance contracts
against loss of supplied funds.
• Through all of these channels financial intermediaries increase market
efficiency from an economic point of view.
 Commercial Banks

Savings and Loans

Associations (S&L)
Depository
Institutions Credit Unions

Specialized Banks

Financial Contractual
Insurance Companies
Intermediaries savings
Institutions
Pension Funds

Finance Companies
Investment
intermediaries
Mutual Funds
(Investment Funds)
 Depository institutions
• Depository institutions accept deposits from surplus units and provide
credit to deficit units
• Depository institutions are popular because:
1. Deposits are liquid
2. They customize loans
3. They accept the risk of loans
4. They have expertise in evaluating creditworthiness
5. They diversify their loans
The Depository institutions are
• Commercial Banks
• Savings institutions
• Credit unions
• Specialized Banks
 Commercial banks
• A commercial bank is a financial institution which performs the functions of accepting
deposits from the general public and giving loans for investment with the aim of
earning profit.
• The two most distinctive features of a commercial bank are borrowing and lending, i.e.,
acceptance of deposits and lending of money to projects to earn Interest (profit)
• Primary Functions
1. It accepts deposits- Current account deposits, Fixed deposits, and Savings account
deposits
2. It gives Loans and Advances- Cash credit, Demand Loan, Short term Loans
• Secondary Functions
1. Discounting bills of exchange
2. Overdraft facility
3. Agency functions- Transfer of funds, Collection of funds, Payments of various item,
Purchase and sale of shares and securities,
4. Performing general utility services
(i) Traveller’s cheques .
(ii) Locker facility.
(iii) Underwriting securities issued by government, public or private bodies.
(iv) Purchase and sale of foreign exchange (currency).
 Significance of Commercial banks:
(i) They promote savings and accelerate the rate of capital formation.
(ii) They are source of finance and credit for trade and industry.
(iii) They promote balanced regional development by opening branches
in backward areas.
(iv) Bank credit enables entrepreneurs to innovate and invest which
accelerates the process of economic development.
(v) They help in promoting large-scale production and growth of priority
sectors such as agriculture, small-scale industry, retail trade and export.
(vi) They create credit in the sense that they are able to give more loans
and advances than the cash position of the depositor’s permits.
(vii)They help commerce and industry to expand their field of operation.
(viii) Thus, they make optimum utilization of resources possible.
 Savings institutions
• Savings institutions, sometimes called thrift institutions, are
banks that serve a local community.
• They take the deposits of local residents and lend the money
back in the form of consumer loans, mortgages, and small
business loans.
• Include savings and loan associations (S&Ls) and savings
banks
• They are mostly owned by depositors (mutual)
• Concentrate on residential mortgage loans
 Credit Unions
• Banks and credit unions work similarly but Credit unions are unique
because they’re member-owned.
• When you deposit money in a credit union account, you become an
owner-member of the credit union. You’re both a customer and an
owner.
• The credit union uses the money that you and other members deposit
to make loans to other credit union members, much like a bank.
• Since a credit union’s main goal is to serve their members, they take
the money that would have been profit and instead use it to help
credit union members.
• Credit unions often do this by offering better rates on savings
products and lower interest rates on loan products. Credit unions may
also offer lower fees, too
 Specialized Banks
• The specialized banks are defined as those banks that are banking
operations that serve a specific type of economic activity, such as
industrial activity or agricultural or real estate, in accordance with the
resolutions of their establishment, which does not have to accept
demand deposits of the main aspects of its activities.
• These banks are specialized in financing specific economic sectors
such as agricultural, industrial, real estate, mortgage, rural
development etc
• It is the institutions that does not rely on financial resources on
deposits of individuals, as in the case of commercial banks, but
depends on the capital and issue the bonds.
• Export Import Bank of India (EXIM)
• Small Industries Development Bank of India (SIDBI)
• National Bank for Agricultural and Rural Development (NABARD)
• Industrial Development Bank of India (IDBI)
• Industrial finance Corporation of India (IFCI)
 Insurance companies
• Provide insurance policies to individuals and firms for death, illness,
and damage to property
• Charge premiums
• Invest in stocks or bonds issued by corporations
• They invest the savings of their policy holders in exchange promise them
a specified sum at a later stage or upon the happening of a certain event.
• Provide the combination of savings and protection
• Through the contractual payment of premium creates the desire in people
to save.
 Pension funds
• Pension funds are investment pools that pay for workers'
retirements. Funds are paid for by either employees,
employers, or both. Corporations and all levels of
government provide pensions.
• Offered by most corporations and government agencies
• They manage funds until they are withdrawn from the
retirement account
• Invest in stocks or bonds issued by corporations or in bonds
issued by the government
 Types of Financial intermediaries

Financial
Intermediaries

Insurance
Banks NBFCs Mutual Funds Organizations
 Types of Financial intermediaries
1. Commercial banks
• Collect savings primarily in the form of deposits and traditionally
finance working capital requirement of corporates
• With the emerging needs of economic and financial system banks have
entered in to:
Term lending business particularly in the infrastructure sector,
Capital market directly and indirectly,
Retail finance such as housing finance, consumer finance……
Enlarged geographical and functional coverage
 2. Non-banking finance companies (NBFC)
• A Non-Banking Financial Company (NBFC) is a company registered
under the Companies Act, 1956 engaged in the business of loans and
advances, acquisition of shares/stocks/ bonds/debentures/securities
issued by Government or local authority or other marketable
securities . They provide services likes, leasing, hire-purchase,
insurance business, etc.
• Provide variety of fund/asset-based and non-fund based/advisory
services.
• Their funds are raised in the form of public deposits ranging between
1 to 7 years maturity.
 Non-banking finance companies (NBFC)
• Depending upon the nature and type of service provided, they are
categorised into:
Asset finance companies
Housing finance companies
Venture capital funds
Merchant banking organisations
Credit rating agencies
Factoring and forfaiting organisations
Housing finance companies
Stock brokering firms
Depositories
 3. Mutual funds
• A mutual fund is a company that pools money from many investors
and invests in well diversified portfolio of sound investment.
• issues securities (units) to the investors (unit holders) in accordance
with the quantum of money invested by them.
• profit shared by the investors in proportion to their investments.
• set up in the form of trust and has a sponsor, trustee, asset
management company and custodian
• advantages in terms of convenience, lower risk, expert management
and reduced transaction cost.
Mutual Fund Operation
Flow Chart
 4. Insurance organizations
• They invest the savings of their policy holders in exchange
promise them a specified sum at a later stage or upon the
happening of a certain event.
• Provide the combination of savings and protection
• Through the contractual payment of premium creates the desire
in people to save
 Financial Markets
• It is a place where funds from surplus units are transferred to deficit
units.
• It is a market for creation and exchange of financial assets
• They are not the source of finance but link between savers and
investors.
• Corporations, financial institutions, individuals and governments
trade in financial products on this market either directly or indirectly.
• Financial markets perform the essential function of channeling funds
from economic players that have saved surplus funds to those that
have a shortage of funds.
• At any point in time in an economy, there are individuals or
organizations with excess amounts of funds, and others with a lack of
funds they need for example to consume or to invest.
• Exchange between these two groups of agents is settled in financial
markets
• The first group is commonly referred to as lenders, the second group
is commonly referred to as the borrowers of funds.
 Functions of Financial markets
• Borrowing and Lending
• Financial markets channel funds from households, firms,
governments and foreigners that have saved surplus funds to
those who encounter a shortage of funds (for purposes of
consumption and investment)
• Price Determination
• Financial markets determine the prices of financial assets.
The secondary market herein plays an important role in
determining the prices for newly issued assets
• Coordination and Provision of Information
• The exchange of funds is characterized by a high amount of
incomplete and asymmetric information. Financial markets
collect and provide much information to facilitate this
exchange.
 Functions of Financial markets
• Risk Sharing
• Trade in financial markets is partly motivated by the transfer of
risk from borrowers to lenders who use the obtained funds to
invest
• Liquidity
• The existence of financial markets enables the owners of assets
to buy and resell these assets. Generally this leads to an increase
in the liquidity of these financial instruments
• Efficiency
• The facilitation of financial transactions through financial
markets lead to a decrease in informational cost and transaction
costs, which from an economic point of view leads to an
increase in efficiency.
 Structure of Financial Markets
• Financial markets can be categorized as follows:
1. Debt vs Equity markets
2. Primary vs Secondary markets
3. Exchange vs Over the Counter (OTC)
4. Money vs Capital Markets
 Debt Market or Bond Market
• Financial markets are split into debt and equity markets.
• Debt Securities are the most commonly traded securities. In these
arrangements, the issuer of the Securities (borrower) earns some
initial amount of money (such as the price of a bond) and the holder
(lender) subsequently receives a fixed amount of payments over a
specified period of time, known as the maturity of a debt securities.
• Debt Securities can be issued on short term (maturity < 1 yr.), long
term (maturity >10 yrs.) and intermediate terms (1 yr. < maturity < 10
yrs.).
• The holder of a debt Securities does not have ownership of the
borrower’s enterprise.
• Common debt Securities are bonds and Debentures
 Equity Market or Stock Market
• Equity shares are somewhat different from bonds. The most common
equity shares is (common) stock. First and foremost, an equity
instruments makes its buyer (lender) an owner of the borrower’s
enterprise.
• Formally this entitles the holder of an equity instrument to earn a
share of the borrower’s enterprise’s income, but only some firms
actually pay (more or less) periodic payments to their equity holders
known as dividends. Often these titles, thus, are held primarily to be
sold and resold.
• Equity shares do not expire and their maturity is, thus, infinite.
Hence they are considered long term securities
 Primary/new issue market
• A market for new issues i.e. a market for fresh capital.
• Primary markets are markets in which financial instruments
are newly issued by borrowers.
• It provides the channel for sale of new securities, not
previously available.
• It gives an opportunity to issuers of securities; government as
well as corporates to raise capital
• It helps businesses raise capital to meet their requirements of
investment and/or discharge some obligation.
• It performs triple-service function: origination, underwriting
and distribution.
 Secondary market
• Secondary market refers to a market where securities are traded
after being initially offered to the public in the primary market
and/or listed on the Stock Exchange.
• The secondary market enables participants who hold securities to
adjust their holdings in response to changes in their assessment
of risk and return. They also sell securities for cash to meet their
liquidity needs.
• Majority of the trading is done in the secondary market.
• Secondary market comprises of equity markets and the debt
markets.
• Secondary markets are markets in which financial instruments
already in existence are traded among lenders.
• Secondary markets can be organized as exchanges, in which
titles are traded in a central location, such as a stock exchange, or
alternatively as over-the-counter markets in which titles are sold
in several locations.
 OTC (Over the Counter) vs Exchange
• OTC (over the counter) market and exchange are the terms that are used in
the secondary market where issued securities and financial instruments are
traded. OTC is the market that is operated through a dealer and is largely
disorganized whereas exchange refers to an organized and established trade
system where stocks are traded with defined rules and regulations.
• Exchange is the intricate network where there is constant surveillance on
the action of the participant so that there is no obligation of rules by the
participants whereas OTC is a decentralized market that happens through a
dealer therefore there are no rigid rules and obligations.
• The difference between OTC and Exchange is over the counter refers to a
process of how securities are traded for companies without following any
formal obligations whereas Exchange is the marketplace for the trading of
commodities, derivatives with a centralized method to ensure fair and
efficient trading.
• The OTC trading happens through the involvement of the mediator know
as the dealer whereas exchange is a formal network where trading follows
varied rules and norms.
 Difference between OTC and Exchange
Parameters of Comparison OTC
Definition OTC or over the counter is the
method of trading for the
companies that are not listed
formally.
Exchange
Exchange is the method of trading
commodities and derivatives for the
well-established companies in an
organized manner.

Operated by Securities that are traded over the The exchange is the centralized
counter are traded through the system of trading with a well-
dealer. organized network of people to ensure
fair trading.

Formality status OTC is the decentralized and Exchange is an absolute formal setting
informal setting for trading which of trading done by well-established
is usually used by small companies to keep constant
companies and businessmen. supervision on the action.

Work hours It can be operated at any time This works according to the exchange
because it is done through the timings and not the entire day because
dealer. it is the intricate network.

Defined Location For trading through OTC one can Exchange is the formal setting that has
make use of phones and laptops a physical location to be operated
and can connect from anyplace. from.
 Money Markets Vs Capital Market
• The money market and the capital market are not single institutions but two
broad components of the global financial system. Together, the money market
and the capital market comprise a large portion of what is known as the
financial market
• Money Market
• The money market is the trade in short-term debt. It is a constant flow of cash
between governments, corporations, banks, and financial institutions,
borrowing and lending for a term as short as overnight and no longer than a
year.
• It is market for short term debt instruments.
• A highly liquid market.
• E.g. Call money market, certificates of deposits, commercial paper and treasury
bills
• Capital Market
• It is a market for long-term securities like equity or debt
• The capital market encompasses the trade in both stocks and bonds. These are
long-term assets bought by financial institutions, professional brokers, and
individual investors.
Difference between Money Markets & Capital Market
Parameters Money Markets
Definition The money market is a good place for
individuals, banks, other companies, and
governments to park cash for a short period of
time, usually one year or less. It exists so that
businesses and governments that need cash to
operate can get it quickly at a reasonable cost,
and so that businesses that have more cash
than they need can put it to use
Market Nature Money markets are informal in nature.
Instruments Commercial Papers, Treasury Certificate of
involved Deposit, Bills, Trade Credit, etc.
Investor Types Commercial banks, non-financial institutions,
central bank, chit funds etc
Market Money markets are highly liquid.
Liquidity
Capital Market
The capital market is where stocks and
bonds are traded. Its movements from
hour to hour are constantly monitored
and analyzed for clues to the health of
the economy at large, the status of
every industry in it, and the consensus
for the short-term future..
Capital markets are formal in nature.
Bonds, Debentures, Shares, Asset
Securitization, Retained Earnings,
Euro Issues, etc
Stockbrokers, insurance companies,
Commercial banks, underwriters etc
Capital markets are comparatively less
liquid
Difference between Money Markets & Capital Market
Parameters Money Markets Capital Market

Risk Involved Money markets have low risk. Capital markets are riskier in
comparison to money markets.
Maturity of Instruments mature within a year. Instruments take longer time to attain
Instruments maturity

Purpose served To achieve short term credit requirements of To achieve long term credit
the trade requirements of the trade

Functions Increasing liquidity of funds in the economy Stabilizing economy by Increase in

served savings

Return on ROI is usually low in money market ROI is comparatively high in capital
investment market
achieved
COMPONENTS OF FINANCIAL
MARKET
Financial
Market

Capital/
Money Securities
Market Market

Primary
Market

Secondary/
Stock Market
 Money markets

• A market for dealing in monetary assets of short term nature, less than
one year.
• enables raising up of short term funds for meeting temporary shortage
of fund and obligations and temporary deployment of excess fund.
• Major participant are: RBI and Commercial Banks
• Major objectives:
equilibrium mechanism for evening out short term surpluses and
deficits
focal point for influencing liquidity in economy
access to users of short term funds at reasonable cost
COMPONENTS OF MONEY MARKET

Money
Market

Call T-bills Bills CP CD Repo

Market Market Market Market Market Market
 Capital market
• A market for long term funds
• focus on financing of fixed investments
• Main participants are mutual funds, insurance organizations,
foreign institutional investors, corporate and individuals.
• two segments: Primary market and secondary market
 Primary/new issue market
• A market for new issues i.e. a market for fresh capital.
• It provides the channel for sale of new securities, not previously
available.
• It provides opportunity to issuers of securities; government as well as
corporates to raise resources to meet their requirements of investment
and/or discharge some obligation.
• It does not have any organizational setup
• It performs triple-service function: origination, underwriting and
distribution.
 Secondary market/ stock market
• It is a market for old/existing securities.
• It is a place where buyers and sellers of securities can enter into transactions
to purchase and sell shares, bonds, debentures etc.
• It enables corporates, entrepreneurs to raise resources for their companies and
business ventures through public issues.
• It has physical existence.
• It’s vital functions are:
nexus between savings and investments
liquidity to investors
continuous price formation
 Financial Instruments
Financial instruments : the commodities that are traded in financial market are financial
assets/securities or instruments

Financial
Instruments

Primary Securities Indirect Securities Derivatives

 PRIMARY SECURITIES
Securities issued by the non-financial economic units
• Equity Shares: An equity share are the ownership securities.
They bear the risk and enjoy the rewards of ownership.
• Preference Shares: Holders enjoy preferential right as to:
(a) payment of dividend at a fixed rate during the life time of
the Company; and (b) the return of capital on winding up of
the Company
• Debentures: An creditorship security. Holders are entitled to
predetermined interest and claim on the assets of the
company.
• Innovative Debt instruments: A variety of debt innovative
instruments emerges with the growth of financial system to
make them more attractive.
Participative Debentures: participate in the excess profits
of the company after the payment of dividend.
Convertible debentures with options:
Third party convertible debentures: entitle the holder to
subscribe to the equity of another firm at a preferential price.
Convertible debenture redeemable at premium: issued at
face value with option to sell at premium.
Debt equity swap: offers to swap debentures for equity.
Zero coupon convertible notes : convertible in to shares and
all the accrued /unpaid interest is forgone.
Warrants: entitles the holder to purchase specified number of
shares at a stated price before a stated date. Issued with shares or
debentures.
Secured premium notes with detachable warrants:
 redeemable after lock-in period
 warrants entitle the holder to receive shares after the SPN is
fully paid
 no interest during lock-in period
 option to sell back SPN to company at par after lock-in.
 no interest/ premium on redemption if option exercised
 right to receive principal+interest in instalments, in case of
redemption after expiry of the term
 detachable required to be converted in to shares within specified
period.
Non -Convertible debenture with detachable equity
warrants: option to buy a specified no. of share at a specified
price and time.
Zero interest Fully Convertible debentures: carries no
interest and convertible in to shares after lock-in period.
Secured zero interest partly convertible debentures with
detachable and separately tradable warrants:
 Having two parts
 Part A convertible at a fixed amount on the date of allotment
 Part B redeemable at par after specified period from date of
allotment.
 Carries warrants of equity shares at a price to be determined by
company
Fully convertible debentures with interest(optional):
 No interest for short period
 After that option to apply for equities at premium without
paying for premium.
 Interest is made from first conversion date to the second/final
conversion date
 INDIRECT SECURITIES/ FINANCIAL
ASSETS:
• Issued by financial intermediaries.
• such as units of mutual funds, policies of insurance
companies, deposits of banks, etc.
• Better suited to small investors
• Benefits of pooling of funds by intermediaries
• Convenience, lower risk and expert management.
 DERIVATIVES
Derivative is a product whose value is derived from the value of one
or more basic variables called base, in a contractual manner
The underlying asset can be equity/FOREX or any other assets.
The Securities Contracts (Regulation) Act, 1956 (SCIA) defined
derivative to include-
1. A security derived from a debt instrument, share, loan whether
secured or unsecured, risk instrument or contract for differences or
any other form of security.
2. A contract which derives its value from the prices, or index of prices,
of underlying securities.
 DERIVATIVES

Derivatives

Forward Indirect
Securities Options
Contract
 Forward contract
• is a customized contract between two entities, where settlement
takes place on a specific date in the future at today's pre-agreed
price.
• At the end offsetting is done by paying the difference in the
price.
 Future Contract
• is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price.
• They are special types of forward contracts which are
standardized exchange-traded contracts.
 Options
• Contracts that give the buyer the right to buy or sell securities at a
predetermined price within/at the end of a specified period.
• Two types - calls and puts.
• Calls give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a given
future date.
• Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given
date.
 Role And Need Of Financial Markets
• The Financial Markets enforces securities, financial reporting, and
company law as they apply to financial services and markets.
• They also regulate securities exchanges, financial advisers and
brokers, trustees, issuers including issuers of Kiwi Saver and
superannuation schemes, and auditors of issuers.
• Efficient financial markets are critical to achieving economic and
social goals. They ensure investment finance reaches productive
firms - helping them to grow, and create employment and wealth.
• Efficient financial markets also offer investors the opportunity to
create diversified portfolios that can achieve their personal financial
goals, including a comfortable retirement. FM's role is not to direct
investors' capital or remove risk from investing.
• No regulator can prevent all loss, however, financial markets
promote investment markets that are fair, efficient and transparent.
 Financial Engineering
• Financial engineering is the use of mathematical techniques to solve
financial problems.
• Financial engineering uses tools and knowledge from the fields of
computer science, statistics, economics and applied mathematics to
address current financial issues as well as to devise new and innovative
financial products.
• Financial engineering is sometimes referred to as quantitative analysis
and is used by regular commercial banks, investment banks, insurance
agencies and hedge funds.
• These businesses apply the methods of financial engineering to such
problems as new product development, derivative securities valuation,
portfolio structuring, risk management, and scenario simulation.
• Quantitative analysis has brought innovation, efficiency and rigor to
financial markets and to the investment process.
• As the pace of financial innovation accelerates, the need for highly
qualified people with specific training in financial engineering continues
to grow in all market environments