Financial Markets

Module 1
Introduction of Indian Financial System
The word system implies set of complex and interrelated factors organized in a particular
form. These factors are mostly interdependent but not always mutually exclusive. The
financial system of a country consists of several ingredients. It includes Financial Institutions,
markets, financial instruments, services, transactions, agents, claims and liabilities in the
economy.
Financial system' s canalizes the funds from the surplus units to the deficit units. Deficit units
is the case where current expenditure exceeds their current income.
An efficient financial system not only encourages savings and investments, it also efficiently
allocates resources in different investment, avenues and thus accelerates the rate of economic
development. The financial system of a country plays a crucial role of allocating scare capital
resources to productive uses. Its efficient functioning is of critical importance to the economy.

Meaning of Financial System

Financial system allocates savings efficiently in an economy to ultimate users either for
investment in real assets or for consumption.

Definition of Financial System

According to Prasanna Chandra, “financial system consists of a variety of institutions,
markets and instruments related in a systematic manner and provide the principal means by
which savings are transformed into investments.”

Components of financial system

The financial system refers to the broad network of institutions, markets, instruments, and
regulations that facilitate the flow of funds in an economy. It plays a crucial role in the
functioning of the economy by enabling the allocation of resources, managing risks, and
providing a platform for savings and investments. Here are the key components of a financial
system:
1. Financial Institutions: These are organizations that provide financial services. They
include:
- Banks: Accept deposits and provide loans.
- Insurance Companies: Offer risk management through policies.
- Investment Firms: Help individuals and institutions invest in various assets.
 - Mutual Funds: Pool money from many investors to purchase securities.
2. Financial Markets: These are platforms where financial instruments are traded. They
include:
- Capital Markets: Where long-term securities like stocks and bonds are traded.
- Money Markets: Where short-term debt instruments are traded.
- Foreign Exchange Markets: Where currencies are traded.
3. Financial Instruments: These are contracts that represent a claim to future cash flows. They
include:
- Stocks: Ownership shares in a company.
- Bonds: Debt securities issued by corporations or governments.
- Derivatives: Financial contracts whose value is derived from an underlying asset.
4. Regulatory Framework: This consists of laws and regulations that govern the financial
system to ensure stability, transparency, and fairness. Regulatory bodies oversee financial
institutions and markets to prevent fraud and protect investors.
5. Functions of the Financial System:
- Mobilization of Savings: Encourages individuals to save and invest their money.
- Allocation of Resources: Directs funds to productive uses, fostering economic growth.
- Risk Management: Provides tools for managing financial risks, such as insurance and
hedging.
- Facilitating Payments: Offers mechanisms for transferring funds between parties
efficiently.
The financial system is essential for economic stability and growth, providing the necessary
infrastructure for transactions, investments, and risk management.

Functions of Financial System

Modern economy calls for various ancillary and inter-related functions on account of the
integration of individual economics with the global economy. The emerging concept of global
economy calls for the integration of financial markets globally to take advantage of cross
border diversification and competitive advantage, in respect of products and risk management
practices in the financial sector. Therefore, the functions of a modern financial system,
essentially, includes of following vital areas:
1. Payment system - As efficient financial system should ensure a payment system,
which would enable easy and speedy exchange of goods and services. Commercial
banks and other financial intermediaries are the more major agencies which provide
the payment system.
2. Pooling of funds - The modern business needs large volumes of the finance for
expansion, diversification and undertaking new projects. At the same time, there are
corporate as well as individual entities that have surplus funds. The financial system
should provide a proper link between domestic and corporate savers, and those in
needs of funds, so as to pool the surplus funds and channel them to productive lines.

3. Transfer of resources - An efficient financial system ensures the transfer of economic

resources across time and space. The financial system provides mechanisms to
transfer the surplus resources from the savers to other segments of the markets across
times. It also accelerates the capital formation process by providing appropriate
investment opportunities in corporate and government securities.

4. Risk Management - Multinational business operations have brought in various risk

exposures, along with multi-farious business opportunities. Besides, the domestic side
of the business is also open to various risks. These business risk can be broadly
classified as counter-party risk, credit risk, documentation risk, legal risk, accounting
risk and operating risk. Financial markets across the world provide different types of
hedging instruments to cover such exposures.

5. Price information for decentralized decision-making - Financial markets provide

valuable information to help co-ordinate decentralized decision-making. The
investors, who was spread across the country, may not get all the financial
information. Financial markets, therefore, provide the required information through
various publications, so that all the investors have equal access to such information.

6. Price Discovery process - Buyers and sellers interact with each other in a financial
market like in any other. This interaction enables the counterparties to know at what
price a financial asset can be bought or sold at a mutually agreed price. They decide
the required return, which becomes the benchmark return for the firms that are in
needs of funds. The process enables the firms to estimate the demand for funds and
plan their resource mobilization process accordingly.

7. Liquidity - An efficient financial market should ensure easy liquidity. One of the
important considerations for investment is ability to convert investment into cash in
case of emergencies. Financial markets provide a platform for buyers and sellers to
meet together and buy and sell securities. This process enables an investor to get back
his investment as and when he requires it.

8. Fungibility - Financial market converts cash into securities and back to cash without
any hurdles. Intermediaries operating in the market pool funds from savers and issue
different forms of securities which are offered for investment in the market.
Therefore, the form of the funds is changed and this can be brought back to the
original form as and when required.
Introduction of Financial Markets
Financial markets are platforms or systems where financial instruments, such as stocks,
bonds, currencies, and derivatives, are bought and sold. They facilitate the exchange of funds
between buyers and sellers, allowing businesses to raise capital and investors to earn returns
on their investments. Essentially, financial markets play a crucial role in the economy by
enabling price discovery, providing liquidity, and allowing for risk management.

Meaning of Financial Markets

A financial market is a platform where individuals and institutions trade financial assets such
as stocks, bonds, commodities, and currencies. These markets can be categorized into two
main types: the primary market, where new securities are issued, and the secondary market,
where existing securities are traded.
The primary purpose of financial markets is to allocate capital, provide liquidity, and assist in
price discovery. Participants in financial markets include investors, issuers, and
intermediaries such as brokers and dealers. There are various categories of financial markets,
including the stock market, bond market, foreign exchange market, and commodity market.
A financial market is an ecosystem where financial transactions occur, which is essential for
the functioning of the economy.

Functions of Financial Markets

The main functions of financial markets are:
1. Capital Allocation: Financial markets efficiently allocate capital. Investors place their
money into assets that they believe will yield the highest returns, ensuring the proper use of
resources.
2. Liquidity Provision: These markets provide liquidity, meaning that investors have the
opportunity to easily convert their assets into cash. When needed, investors can sell their
securities to obtain funds.
3. Price Discovery: Financial markets assist in price discovery. Prices of assets are
determined based on supply and demand in the market, helping investors understand the
value of their investments.
4. Risk Management: Financial markets also provide tools for managing risk, such as
derivatives (options, futures). These instruments allow investors to hedge against potential
losses.
5. Information Dissemination: Financial markets share information that helps investors make
informed decisions. Market prices, trends, and economic indicators provide insights into the
health of the market.

In summary, financial markets are crucial for the economy as they perform functions related
to capital allocation, liquidity, price discovery, risk management, and information
dissemination.

Classification of Financial Markets

1. Unorganized Markets - In these markets, there are a number of money lenders,
indigenous bankers, traders etc., who lead money to the public. Indigenous bankers
also collect deposits from the public. There are also private finance companies, chit
funds etc., whose activities are not controlled by the RBI. Recently the RBI has taken
steps to bring private finance companies and chit funds under its strict control by
issuing non-banking financial companies (Reserve Bank) Directions, 1998. the RBI
has already taken some steps to bring the unorganized sector under the organized fold.
They have not been successful. The regulations concerning their financial dealings are
still inadequate and their financial instruments have not been standardized.

2. Organized Markets - In the organized markets, there are standardized rules and
regulations governing their financial dealings. There is also a high degree of
institutionalization and instrumentalization. These markets are subject to strict
supervision and control by the RBI or other regulatory bodies.
These organized markets can be further classified into two. They are:
a. Capital Market – Capital market is a crucial component of the financial system
that facilitates the trading of long-term securities. It serves as a bridge between
those who have surplus funds (investors) and those who require funds for various
purposes (companies and governments). The capital market is essential for
economic development as it provides a platform for raising capital for long-term
investments, which can lead to job creation and infrastructure development.
b. Money Market – The money market refers to the market where borrowers and
lenders exchange short-term funds to solve their liquidity needs. Money market
instruments are generally financial claims that have low default risk, maturities
under one year and high marketability.

Need for Capital Market

 Capital Market plays an extremely important role in promoting and sustaining the
growth of an economy.
 It is an important and efficient conduit to channel and mobilize funds to enterprises,
both private and government.
 It provides and effective source of investment in the economy.
  It plays a critical role in mobilizing savings for investment in protective assets, with
the view to enhancing a country’s long term growth prospects, and thus acts as a
major catalyst in transforming the economy into a more efficient, innovative and
competitive marketplace within the global arena.
 In addition to resource allocation, capital markets also provide a medium for risk
management by allowing the diversification of risk in the economy.
 A well-functioning capital market tends to improve information quality as it plays a
major role in encouraging the adoption of stronger corporate governance principles,
thus supporting a trading environment, which is founded on integrity.
 Capital market has played a crucial role in supporting periods of technological
progress and economic development throughout history.
 Among other things, liquid markets make it possible to obtain financing for capital-
intensive projects with long gestation periods. This certainly held true during the
industrial revolution in the 18th century and continuous to apply even as we move
towards the so-called “New Economy”.
 Capital markets make it possible for companies to give shares to the employees via
ESOPs.
 Capital markets provide a currency for acquisitions via share swaps.
 Capital market provides an excellent route for disinvestments to take place.
 Venture Capital and Private Equity funds investing in unlisted companies get an exit
option when the company gets listed on the capital markets.
 The existence of deep and broad capital market is absolutely crucial in spurring the
growth our country. An essential imperative for India has been to develop its capital
market to provide alternative sources of funding for companies and in doing so,
achieve more effective mobilization of investors’ savings. Capital market also
provides a valuable source of external finance.
For a long time, the Indian market was considered too small to warrant much attention.
However, this view has changed rapidly as vast amounts of both International and Domestic
investment have poured into our markets over the last decade. The Indian market is no longer
viewed as a static universe but as a constantly evolving one providing attractive opportunities
to the investing community.

Importance of Capital Market

Absence of capital market acts as a deterrent factor to capital formation and economic
growth. Resources would remain idle if finance are not funneled through the capital market.
The importance of capital market can be briefly summarized as follows:
 The capital market serves as an important source for the productive use of economy’s
savings. It mobilizes the savings of the people for further investment and thus, avoids
their wastage and unprotective uses.

 It provides incentives to savings and facilitates capital formation offering suitable

rates of interest as the price of capital.
  It provides as avenue for investors, particularly the household sector to invest in
financial assets which are more productive than physical assets.

 It facilitates increase in production and productivity in the economy and thus, enhance
the economics welfare of the society. Thus, it facilitates “the movement of the stream
of command over capital to the point of highest yield” towards those who can apply
them protectively and profitably to enhance the national income in the aggregate.

 The operations of different institutions in the capital market induce economics

growth. They give quantitative and qualitative directions to the flow of funds and
bring about rational allocation of scarce resources.

 A healthy capital market consisting of expert intermediaries promotes stability in

values of securities representing capital funds.

 Moreover, it serves an important source for technological up gradation in the

industrial sector by utilizing the funds invested by the public.
Thus, a capital market serves as an important link between those who save and those who
aspire to invest their savings.

Functions of Capital Market

The major objectives of capital market are:
 To mobilize resources for investments.
 To facilitate buying and selling of securities.
 To facilitate the process of efficient price discovery.
 To facilitate settlement of transactions in accordance with the predetermined time
schedules.

Money Market in India

The Money Market in India is the money market for short-term borrowings and lending with
maturity ranging from overnight to one year in India including financial instruments that are
deemed to be close substitutes of money.
According to Madden and Nadler, “a money market is a mechanism through which short-
term loans are loaned and borrowed and through which a large part of the financial
transactions of a particular country or of the world are cleared”.
Similar to developed economies the Indian money market is diversified and has evolved
through many stages, from the conventional platform of treasury bills and call money to
commercial paper, certificates of deposit, repos, forward rate agreements and most recently
interest rate swaps.
The importance of the money market for the nation does not solely lie on its size; it lies rather
in its liquidity in its capacity for furnishing cash to any part of the country at a few hours’
notice. What a bank balance is to the individual, the money market is to the country’s credit
system.
The money market is the wholesale market. The volume of business is very large and
generally transactions are settled on a daily basis. There are a large number of participants in
the money market commercial banks, mutual funds, investment institutions, financial
institutions and finally the central bank.

Functions of Money Market

 Financing Trade and Industry.

 Link between central banks and actual seeker of credit.

 Encourage profitable investment.

 Self-sufficiency of commercial banks.

 Help central banks to implements monetary policy.

 Capital formations.

 Mobilization of savings.

 Reduces the role of unorganized players.

 Balance regional developments.

 Brings people to be part formal banking system through financial inclusion (Micro
Finance, Small and Payment Banks, Jan Dhan Yojana of PM).

 Helps in economic developments.

 Ensures the effective utilization of natural resources for productive purposes.

 Provides short term credit to meet working capital requirement.

 Assist in foreign trade.

 Reduces the black money by routing the transaction through formal banking system
(Credit Card, wallet mobile etc.)

 Maintains equilibrium between the demand and supply of money.

 Sources of finance to the government

 Limitation Money Market

 Existence of large unorganized players.

 Absence of balance integration between the financial system (all institutions have
their own rules and regulation and there is lack of integration between them).

 Large cash transaction (8% people still held cash in hand).

 Dis-administered rate of interest.

 High competitions.

Primary and secondary market.

Primary market and secondary market are fundamental concepts in finance that refer to
different stages of the trading of securities.

Primary Market: The primary market is where new financial instruments, such as stocks
and bonds, are created and sold for the first time. When a company decides to raise capital, it
can issue new shares through an Initial Public Offering (IPO). In this process, the company
sells its shares directly to investors, and the funds raised go directly to the company for
business expansion, paying off debt, or other financial needs. The primary market is crucial
for companies looking to raise funds and for investors who want to invest in a company at its
initial offering price.
The structure of the primary market consists of several key components that facilitate the
issuance and trading of new securities. Here’s a detailed breakdown:
1.Issuers:
These are the companies or organizations that want to raise capital by issuing new securities.
They can be corporations, government entities, or municipalities.
2.Investment Banks:
These financial institutions play a crucial role in the primary market. They help issuers
determine the right price for the securities, underwrite the issue (which means they buy the
securities and sell them to investors), and assist in marketing the securities to potential
investors.
3.Regulatory Authorities:
Organizations like the Securities and Exchange Board of India (SEBI) in India regulate the
primary market to ensure transparency, fairness, and protection for investors. They oversee
the registration and approval process for new issues.
4.Investors:
These can be institutional investors (like mutual funds, pension funds) or individual investors
who purchase the new securities directly from the issuer during the IPO or new bond
issuance.
5. Offering Documents:
Issuers must provide detailed information about the securities being offered, typically in the
form of a prospectus. This document contains essential data about the company, the purpose
of the funds raised, financial statements, and risks associated with the investment.
6. Subscription Process:
Investors express their interest in the new securities through a subscription process, where
they indicate the number of shares or bonds they wish to buy. If the demand exceeds supply,
the issuer may allocate shares through a lottery or a pro-rata basis.
The primary market is essential for capital formation, allowing companies to access funds for
growth and development while providing investors with opportunities to invest in new
ventures.

Secondary Market: Once securities have been issued in the primary market, they can be
bought and sold in the secondary market. This market allows investors to trade existing
securities among themselves. The secondary market provides liquidity, meaning investors can
easily buy or sell their shares without affecting the price substantially. Stock exchanges, such
as the Bombay Stock Exchange (BSE) or the National Stock Exchange (NSE), are examples
of secondary markets where these transactions occur. Prices in the secondary market are
determined by supply and demand dynamics, and investors can gain or lose money based on
market conditions.
The structure of the secondary market consists of several key components that facilitate the
trading of existing securities. Here’s a detailed explanation:
1.Exchanges:
Stock exchanges, such as the Bombay Stock Exchange (BSE) and the National Stock
Exchange (NSE), play a crucial role in the secondary market. Investors trade securities with
each other through these exchanges.
2.Brokers:
Brokers are individuals or firms that assist investors in buying and selling securities. They
have access to the exchanges and execute orders on behalf of investors.
3.Market Makers:
Market makers are brokers or dealers who actively buy and sell specific securities. They help
maintain liquidity in the market, allowing investors to buy and sell securities more easily.
4.Investors:
The secondary market comprises various types of investors, including institutional investors
(like mutual funds and pension funds) and individual investors (retail investors). They are
ready to buy and sell existing securities.
5. Regulatory Authorities:
Regulatory bodies, such as the Securities and Exchange Board of India (SEBI), oversee the
secondary market. They create rules and regulations to ensure fair trading practices,
transparency, and investor protection.
6. Trading Platforms:
Today, online trading platforms, such as Zerodha and Upstox, enable investors to trade
securities easily. These platforms allow investors to buy and sell securities directly through
their accounts.
The primary purpose of the secondary market is to provide liquidity, allowing investors to
easily buy and sell their investments. The prices of securities in this market are determined by
the forces of demand and supply.

In summary, the primary market is where new securities are created and sold to investors for
the first time, while the secondary market is where those securities are traded among
investors after their initial issuance. Both markets play a vital role in the functioning of the
financial system.

INTRODUCTION - FINANCIAL INSTRUMENTS

A document (such as a cheque, draft, bond, share, bill of exchange, futures or options
contract) that has a monetary value or represents a legally enforceable (binding) agreement
between two or more parties regarding a right to payment of money. Which includes various
financing instruments namely viz., debt instrument, equity instrument, instrument etc.
Various types of instruments are there for an investor to invest such as:

Financial Instruments
1.Equities
Equity is a type of security that represents the ownership in a company. Equities are traded
(bought and sold) in stock markets. Alternatively, they can be purchased via the Initial Public
Offering (IPO) route, i.e. directly from the company. Investing in equities is a good long-term
investment option as the returns on equities over a long-time horizon are generally higher
than most other investment avenues. However, along with the possibility of greater returns
comes greater risk.
2.Mutual Funds
A mutual fund allows a group of people to pool their money together and have it
professionally managed, in keeping with a predetermined investment objective. This
investment avenue is popular because of its cost-efficiency, risk-diversification, professional
management and sound regulation. You can invest as little as 1,000 per month in a mutual
fund. There are various general and thematic mutual funds which helps to choose from the
risk and return possibilities vary accordingly.

3.Bonds
A bond is fixed income instruments which are issued for the purpose of raising capital. Both
private entities, such as companies, financial institutions, and the central or state government
and other government institutions use this instrument as a means of garnering funds. Bonds
issued by the Government carry the lowest level of risk but could deliver fair returns.

4.Deposits
Investing in bank or post-office deposit is a very common way of securing surplus funds.
These instruments are at the low end of the risk-return spectrum.

5.Cash Equivalents
These are relatively safe and highly liquid investment options Treasury bills and money
market funds are cash equivalents.

Non-Financial Instruments
1.Real Estate
With the ever-increasing cost of land, real estate has come up as a profitable investment
proposition.

2.Gold
The 'yellow metal' is a preferred investment option, particularly when markets are volatile.
Today, beyond physical gold, a number of products which derive their value from the price of
gold are available for investment. These include gold futures and gold I funds. exchange
traded funds.

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