Financial system

Institutional arrangement through which

surplus resources are mobilized from surplus units and passed on to deficit spenders Constituents financial assets, financial markets and financial institutions Functions of financial system
Inducement to save Mobilization of savings Allocation of funds Serving production, investment and trade

Structure of financial markets

What is money market

Market for short-term funds RBI definition: Market for short terms financial

assets which are close substitutes for money this market facilitates exchange of money in primary and secondary market Segment of financialmarket in which financial instruments are highly liquid and have very short maturities Organized money market comprises RBI, Discount and Finance House of India (DFHI), commercial banks, co-operative banks, NBFIs like LIC, quasigovt. bodies and large companies (who operate through banks) Unorganized market comprises local bankers and moneylenders

Composition of money market

Call money market Interbank market Redistributing day-to-day surplus funds from surplus banks to deficit banks Operates through brokers Competitive, sensitive and volatile market Best indicator of short term liquidity position Treasury bill market Short-term liability of the government 91 and 364 day bills Ad hoc and regular treasury bills auctioning Linked to monetization of government debt Purchase price less than face value at maturity face value is paid Marketable, affordable and risk free bills

Contd.
Commercial bill of exchange market Instrument for short term finance to trade and industry Trade bill and finance bill Discount rate Bills rediscounting scheme announced by RBI since 1970 to develop this market Weak performance in India Unorganized segment Hundis commercial bills in this segment Local bankers and moneylenders No coordination amongst themselves Usurious interest rates No control over their working

New instruments
Commercial paper (CP) Certificate of deposit (CD) Repurchase (Repo) agreement Banker's Acceptance Money Market mutual fund

Commercial paper (CP)

Short

term unsecured loan issued by a corporation typically for financing day to day operations like accounts receivable, inventories and short term liabilities Issued at discount rates Not back by any kind of collateral, hence companies with good credit ratings find buyers for CPs Safe investment because the financial situation of a company is known and can be predicted over a few months

Certificate of deposit (CD)

CDs issued by commercial banks and other

financial institutions like IDBI, IFCI, etc. and issued to individuals, companies, associations, etc. Like most time deposits, funds can not withdrawn before maturity without paying a penalty CDs have specific maturity date, interest rate (discounted at the time of purchase) and issued in large denomination The main advantage of CD is their safety and greater interest rate compared to T-bills and term deposits

Repurchase agreement (Repo)

Short term borrowing instrument for those

dealing in government securities Dealers sell govt. securities to investors on an overnight basis and repurchase them the next day For the party selling the securities, it is repo agreement and for those buying and promising to sell later, it is reverse repo agreement The short term maturity and government backing usually mean that repos provide lenders with extremely low risk

Banker's Acceptance
Bankers acceptance (BA) is a short-term

credit instrument created by a non-financial firm BAs are guaranteed by a bank to make payment Typically done to finance transactions when one party is unwilling to offer goods and services on credit Acceptances are traded at discounts from face value in the secondary market BA acts as a negotiable instrument for financing imports, exports or other transactions in goods This is especially useful when the credit

Money market mutual funds

Mutual funds investing only in money markets They park their funds in T-bills, CDs and CPs Goal of preserving principal amount at

modest dividend Preferred by investors who want to part large cash reserves for a short term Risk of inflation exceeding the funds returns, thus eroding the purchasing power of investors money

Shortcomings of Money Market

Purchasing power of money suffers in case of

inflation Dichotomized and loosely integrated Irrational interest rate structure Highly volatile market Seasonal stringency of loanable funds Lack of funds Inadequate banking facilities

What is capital market

Market for long term funds Participants in capital market
Government Corporate sector Underwriters and stockbrokers General public

Trading Instruments used Bonds / Shares Derivatives

Structure

Primary market
Instruments issued for first time Arrangement for raising of new capital for

enterprises Used by government and corporates for IPOs Ways of floating new issues
Issue of prospectus to the public Private placement Rights issue to existing shareholders

Successful floatation requires

Origination careful investigation of viability and prospects of new projects technical and financial evaluation Underwriting guaranteeing purchase of stipulated amounts of a new issue at fixed price

Secondary market
Trading of already issued securities Provides easy liquidity to existing securities

Stock - capital raised by corporations through issue and distribution of shares Share - signifies ownership in the company

Stock Exchange organization for orderly buying

and selling of listed (approved) existing securities

Securities approved on the basis of size of the issue, holding pattern, transparency in producing timely and annual accounts , etc. Prices settled by open bidding and offers on the floor

OTC deals in securities not listed on the stock

exchange

Securities of small companies with limited market

Gilt-edged market
Market for government securities or securities

guaranteed by the government Gilt-edged means of the best quality No risk of default Government bond market for primary and secondary govt. securities RBI as the sole dealer in govt. securities Demand side dominated by financial institutions captive market for govt. securities

Capital market reforms

SEBI set up in 1992 by an act of parliament Capital Issues Control Act 1947 and office of

Controller of Capital Issues abolished in 1992 no prior permission required to access capital market Indian companies permitted to raise capital through international capital markets Companies in primary market required to disclose all facts and risk factors associated with their projects All restrictions on interest rates on debentures and public sector bonds removed Foreign pension funds allowed to invest in India FIIs allowed to invest in govt. securities subject to certain limits

Derivatives
Products whose value is entirely derived from

other assets like securities, commodities, bullion, etc. Types

Forwards settlement done at scheduled future

date at todays pre-determined rate Futures special forward contracts Options calls and puts calls give buyer the right but not the obligation to buy certain quantity of an asset at a given price on or before given future date puts give buyer the right but not the obligation to sell certain quantity at a given price on or before given future date

Contd.
LEAPS long term equity anticipation securities

options with 3 yr maturity Baskets options on portfolios of underlying assets Swaps - private agreements between two parties to exchange cash flows in the future according to prearranged formula
Interest rate swaps: swapping only interest related cash flows between parties in the same currency Currency swaps: swapping both principal and interest between parties, with the cash flows in one direction being in a different currency than those in the opposite direction

Commodity derivatives