Dr.

Neelam Tandon

a. b. c.

Financial System is a complex system comprising of sub-systems of: financing institutions, markets, instruments, and services which facilitates the transfer and allocation of funds, efficiently and effectively.

The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. While performing their activities these units will be placed in a surplus/deficit/balanced budgetary situations.

There are areas or people with surplus funds and there are those with a deficit. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit.

The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other.

Financial market is a market where financial instruments are exchanged or traded and helps in determining the prices of the assets that are traded in and is also called the price discovery process.

Organizations that facilitate the trade in financial products. For e.g. Stock exchanges (BSE, NSE, MCX) facilitate the trade in stocks, bonds and warrants.

Coming together of buyer and sellers at a common platform to trade financial products is termed as financial markets, i.e. stocks and shares are traded between buyers and sellers in a number of ways including: the use of stock exchanges; directly between buyers and sellers etc.

Financial markets may be classified on the basis of Types of claims debt and equity markets Maturity money market and capital market Trade spot market and delivery market Deals in financial claims primary market and secondary market

Indian Financial Market consists of the following markets: Capital Market/ Securities Market Primary capital market, Secondary capital market Money Market Debt Market

Primary Market : Deals with new securities Provides additional capital to issuer companies Secondary Market: Is the market for existing securities, which are already listed No additional capital is generated. It Provides liquidity to existing stock.

Bombay Stock Exchange Limited Oldest in Asia Presence in 417 cities and towns in India Trading in equity, debt instrument and derivatives National Stock Exchange New York Stock Exchange (NYSE) NASDAQ London Stock Exchange Functions of Stock Exchanges Liquidity and marketability of securities Fair price determination Source of long-tern funds Helps in capital formation Reflects general state of economy

A stock market index is the reflection of the market as a whole. It is a representative of the entire stock market. Movements in the index represent the average returns obtained by the investors. Stock market index is sensitive to the news of: Company specific Country specific Thus the movement in the stock index is also the reflection of the expectation of the future performance of the companies listed on the exchange

Settlement is the process whereby the trader who has made purchases of scrip makes payment and the seller selling the scrip delivers the securities. This settlement process is carried out by Clearing Houses for the stock exchanges. The Clearing House acts like an intermediary in every transaction and acts as a seller to all buyers and buyer to all sellers.

Money market is a market for debt securities that pay off in the short term usually less than one year, for example the market for 90-days treasury bills. This market encompasses the trading and issuance of short term non equity debt instruments including treasury bills, commercial papers, bankers acceptance, certificates of deposits, etc.

It is a short term (usually less than one year, typically three months) maturity promissory note issued by a national government as a primary instrument for regulating money supply and raising funds via open market operations. Issued through RBI , T-bills commonly pay no explicit interest but are sold at a discount their yield being the difference between the purchase price and the par-value (also called redemption value).

This yield is closely watched by financial markets and affects the yield on municipal and corporate bonds and bank interest rates. Although their yield is lower than on other securities with similar maturities, T-bills are very popular with institutional investors because, being backed by the government's full faith and credit, they come closest to a risk free investment.

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CP, as a privately placed instrument, was introduced in India in 1990 with a view to enable highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors.

Certificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialised form against funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India (RBI), as amended from time to time.

It is a short-term debt instrument issued by a firm that is guaranteed by a commercial bank. These instruments are similar to T-Bills and are frequently used in money market funds. They are traded at a discount from face value on the secondary market, which can be an advantage because the banker's acceptance does not need to be held until maturity. Banker's acceptances are regularly used financial instruments in international trade.

Capital Market: Capital market is a market for long-term debt and equity shares. In this market, the capital funds comprising of both equity and debt are issued and traded. This also includes private placement sources of debt and equity as well as organized markets like stock exchanges. Capital market includes financial instruments with more than one year maturity

The sale of securities to a relatively small number of select investors as a way of raising capital. Investors involved in private placements are usually large banks, mutual funds, insurance companies and pension funds. Private placement is the opposite of a public issue, in which securities are made available for sale on the open market.

A well functioning stock market may help the development process in an economy through the following channels: 1. Growth of savings, 2. Efficient allocation of investment resources, 3. Better utilization of the existing resources.

In market economy like India, financial market institutions provide the avenue by which long-term savings are mobilized and channelled into investments. Confidence of the investors in the market is imperative for the growth and development of the market.

For any stock market, the market Indices is the barometer of its performance and reflects the prevailing sentiments of the entire economy. Stock index is created to provide investors with the information regarding the average share price in the stock market. The ups and downs in the index represent the movement of the equity market.

These indices need to represent the return obtained by typical portfolios in the country. Generally, the stock price of any company is vulnerable to three types of news: Company specific Industry specific Economy specific

The most important use of an equity market index is as a benchmark for a portfolio of stocks. All diversified portfolios, belonging either to retail investors or mutual funds, use the common stock index as a yardstick for their returns.

Indices are useful in modern financial application of derivatives. Capital Market Instruments some of the capital market instruments are: Equity Preference shares Debenture/ Bonds ADRs/ GDRs Derivatives

A contractual arrangement in which the issuer agrees to pay interest and repay the borrowed amount after a specified period of time is a debt instrument. Certain features common to all debt instruments are:

Maturity the number of years over which the issuer agrees to meet the contractual obligations is the term to maturity. Debt instruments are classified on the basis of the time remaining to maturity Par value the face value or principal value of the debt instrument is called the par value.

Coupon rate agreed rate of interest that is paid periodically to the investor and is calculated as a percentage of the face value. Some of the debt instruments may not have an explicit coupon rate, for instance zero coupon bonds. These bonds are issued on discount and redeemed at par. Thus the difference between the investors investment and return is the interest earned. Coupon rates may be fixed for the term or may be variable.

Share money forms a part of the capital of the company. The share holders are part proprietors of the company, whereas debentures are mere debt, and debenture holders are just creditors. Share holders get dividend only out of profits and in case of insufficient or no profits they get nothing and debenture holders being creditors get guaranteed interest, as agreed, whether the company makes profit or not.

Debentures are quite often secured, that is, a security interest is created on some assets to back up debentures. There is no question of any security in case of shares. Share holders have a right to attend and vote at the meetings of the share holders whereas debenture holders have no such rights.

Preference shares Preference shares are different from ordinary equity shares. Preference share holders have the following preferential rights (i) The right to get a fixed rate of dividend before the payment of dividend to the equity holders. (ii) The right to get back their capital before the equity holders in case of winding up of the company.

Provisions about investments by nonresidents, non resident Indians, overseas bodies corporates and other foreign investors are made by the RBI in pursuance of FEMA provisions.

Foreign investment is freely permitted in almost all sectors in India. Under Foreign Direct Investments (FDI) Scheme, investments can be made by non-residents in the shares / convertible debentures of an Indian Company under two routes; Automatic Route; and Government Route.

A derivative picks a risk or volatility in a financial asset, transaction, market rate, or contingency, and creates a product the value of which will change as per changes in the underlying risk or volatility. The idea is that someone may either try to safeguard against such risk (hedging), or someone may take the risk, or may engage in a trade on the derivative, based on the view that they want to execute.

The risk that a derivative intends to trade is called underlying. A derivative is a financial instrument, whose value depends on the values of basic underlying variable. In the sense, derivatives is a financial instrument that offers return based on the return of some other underlying asset, i.e the return is derived from another instrument.

Commodity derivatives in India were established by the Cotton Trade Association in 1875, since then the market has suffered from liquidity problems and several regulatory dogmas. However in the recent times the commodity trade has grown significantly and today there are 25 derivatives exchanges in India which include four national commodity exchanges; National Commodity and Derivatives Exchange (NCDEX), National Multi-Commodity Exchange of India (NCME), National Board of Trade (NBOT) and Multi Commodity Exchange (MCX)

To serve the purpose of transfer of funds from surplus to deficit sector, Financial intermediaries came into existence. Financial intermediation in the organized sector is conducted by a wide range of institutions functioning under the overall surveillance of the Reserve Bank of India.

Having designed the instrument, the issuer should then ensure that these financial assets reach the ultimate investor in order to garner the requisite amount. When the borrower of funds approaches the financial market to raise funds, mere issue of securities will not suffice. Adequate information of the issue, issuer and the security should be passed on to take place. There should be a proper channel within the financial system to ensure such transfer.

In the initial stages, the role of the intermediary was mostly related to ensure transfer of funds from the lender to the borrower. This service was offered by banks, FIs, brokers, and dealers. However, as the financial system widened along with the developments taking place in the financial markets, the scope of its operations also widened.

Some of the important intermediaries operating in the financial markets include; investment bankers, underwriters, stock exchanges, registrars, depositories, custodians, portfolio managers, mutual funds, financial consultants, primary dealers, satellite dealers, self regulatory organizations, etc.

Though the markets are different, there may be a few intermediaries offering their services in more than one market e.g. underwriter. However, the services offered by them vary from one market to another.

The Financial Institutions in India mainly comprises of the Central Bank which is better known as the Reserve Bank of India, the commercial banks, the credit rating agencies, the securities and exchange board of India, insurance companies and the specialized financial institutions in India.

The Reserve Bank of India was established in the year 1935 with a view to organize the financial frame work and facilitate fiscal stability in India. The bank acts as the regulatory authority with regard to the functioning of the various commercial bank and the other financial institutions in India. The bank formulates different rates and policies for the overall improvement of the banking sector. It issue currency notes and offers aids to the central and institutions governments.

The commercial banks in India are categorized into foreign banks, private banks and the public sector banks. The commercial banks indulge in varied activities such as acceptance of deposits, acting as trustees, offering loans for the different purposes and are even allowed to collect taxes on behalf of the institutions and central government.

The credit rating agencies in India were mainly formed to assess the condition of the financial sector and to find out avenues for more improvement. The credit rating agencies offer various services as: Operation Up gradation Training to Employees Scrutinize New Projects and find out the weak sections in it Rate different sectors The two most important credit rating agencies in India are: CRISIL ICRA

The securities and exchange board of India, also referred to as SEBI was founded in the year 1992 in order to protect the interests of the investors and to facilitate the functioning of the market intermediaries. They supervise market conditions, register institutions and indulge in risk management.

The insurance companies offer protection against losses. They deal in life insurance, marine insurance, vehicle insurance and so on. The insurance companies collect the little saving of the investors and then reinvest those savings in the market. The insurance companies are collaborating with different foreign insurance companies after the liberalization process. This step has been incorporated to expand the Indian Insurance market and make it competitive.

The specialized financial institutions in India are government undertakings that were set up to provide assistance to the different sectors and thereby cause overall development of the Indian economy. The significant institutions falling under this category includes: Board for Industrial & Financial Reconstruction Export-Import Bank Of India Small Industries Development Bank of India National Housing Bank

Financial Dualism - Is co-existence of formal and informal financial sectors. Formal institution is institutionalized; organized and regulated system caters to the need of modern economy. It comes under the preview of Ministry of Finance, the Reserve bank of India, and Securities and exchange board of India. Informal Institution - Is non-institutionalized; unorganized and non-regulated system caters to the need of traditional and rural economy. Examples are friends, and relatives, groups of persons operating as funds or association under their own rules and use name as fixed fund, association, Partnership consisting of local brokers, chit fund companies, investment, and finance companies.

Financial institutions: 1. Banking Institutions are creators and purveyors of credit. 2. Non-banking institutions purveyors of credit. Example: (Development financial institutions DFI), non-banking financial companies (NBFCs), Housing finance companies (HFCs). 3. Term finance institutions : IDBI(industrial development bank of India), ICICI(industrial credit and investment corporation of India) ,IFCI(industrial financial corporation of India), SIDBI(small industrial development bank of India), IIBI(industrial investment bank of India).

4. Specialized finance institutions: Export Import Bank of India (EXIM) , Tourism finance corporation of India (TFCI), ICICI venture, the Infrastructure Development Finance Company(IDFC), National Bank for Agriculture and Rural Development (NABARD), National Housing Bank (NHB). 5. Investment Institutions in the business of mutual funds, UTI, public sector and private sector mutual funds and insurance activity of Life Insurance Corporation (LIC), (GIC) General Insurance Corporation and its subsidiaries are classified as financial institutions. 6. State level financial institutions: State financial corporation (SFCs), and State Industrial development corporation (SIDCs) which are owned and managed by the state governments.

Financial assets/instruments- Financial assets comprises of

loans, deposits, bonds, equities, etc. It Enable channelizing funds from surplus units to deficit units. There are instruments for savers such as deposits, equities, mutual fund units, etc. Also there are instruments for borrowers such as loans, overdrafts, etc. Just Like corporate, governments too raise funds through issuing of bonds, Treasury bills, etc. The Instruments like Public Provident Fund (PPF), KissanVikas Patra (KVP), etc. are available to savers who wish to lend money to the government

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Financial Markets facilitates the process of raising funds. Financial Markets are : Money Market- for short-term funds (less than a year) Organized (Banks) Unorganized (money lenders, chit funds, etc.) Capital Market- for long-term funds (maturity period one year or more than that) Primary Market deals with new issues Secondary market deals in trading in outstanding or existing securities. Over the counter (OTC) the government securities market is an OTC market. Spot trades are negotiated and traded for immediate delivery. Exchange traded market trading takes place over a trading cycle in stock exchanges. Derivatives (derived from underlying assets) market is exchange traded.

Money market instruments are those which have maturity period of less than one year. Some of the important money market instruments are: 1.Call Money 2. Treasury Bill 3. Commercial Paper 4. Certificate of Deposit 5. Trade Bill

Organized money market comprises RBI, banks (commercial and co-operative) . Organized Money Market is meant for short term securities, which include: Call money market Is an integral part of the Indian money market where dayto-day surplus funds (of banks) are traded? It is mainly used by the banks to meet their temporary requirement of cash. The loans are of short-term duration (1 to 14 days). Money lent for one day is called call money; if it exceeds 1 day but is less than 15 days it is called notice money. Money lent for more than 15 days is term money.

The borrowing is exclusively limited to banks, which are temporarily short of funds. Call loans are generally made on a clean basis- i.e. no collateral is required. The rate of interest paid on call money is known as call rate. The main function of the call money market is to redistribute the pool of day-to-day surplus funds of banks among other banks in temporary deficit of funds . The call market helps banks economize their cash and yet improve their liquidity. It is a highly competitive and sensitive market. It acts as a good indicator of the liquidity position

The Banks can borrow in the money market to: 1. To fill the gaps or temporary mismatch of funds. 2. To meet the CRR and SLR mandatory requirements as stipulated by the central bank. 3. To meet sudden demand for funds arising out of large outflows (like advance tax payments) 4. Call money market serves the role of equilibrating the short-term liquidity position of the banks

Bill Market - Treasury bill market- Also called the T-Bill market

These bills are short-term liabilities (91-day, 182-day and 364-day) of the Government of India It is an IOU of the government, a promise to pay the stated amount after expiry of the stated period from the date of issue They are issued at discount to the face value and at the end of maturity the face value is paid The rate of discount and the corresponding issue price are determined at each auction RBI auctions 91-day T-Bills on a weekly basis, 182-day T-Bills and 364day T-Bills on a fortnightly basis on behalf of the central government

Treasury bills are highly liquid instruments , that means, at any time the holder of treasury bills can transfer of or get it discounted from RBI. These bills are normally issued at a price less than their face value , so the difference between the issue price and the face value of the treasury bill represents the interest on investment. Banks , financial institutions and corporations normally play major role in the Treasury Market.

It is a popular instrument for financing working capital requirements of companies. The CP is an unsecured instrument issued in the form of promissory note. This instrument was introduced in 1990 to enable the corporate borrowers to raise short term funds. It can be raised from period ranging from 15 days to one year.

CDs are short term instruments issued by Commercial Banks and Special Financial Institution(SFIs). CDs are transferable from one party to another. The maturity period of CDs ranges from 91 days to one year. These can be issued to individuals, cooperatives and companies.

Normally the traders buy goods from the wholesaler or manufacturers on credit. The sellers get payment after the end of the credit period. But if any seller does not want to wait or is in immediate need of money he /she can draw a bill of exchange in favour of the buyer. When buyer accepts the bill it becomes negotiable instrument and is termed as bill of exchange or trade bill.

Trade bill can now be discounted with a bank before its maturity. On maturity the bank gets the payment from the buyer of goods. When trade bills are accepted by commercial banks it is known as Commercial Bills. So trade bill is an instrument, which enables the drawer of the bill to get funds for short period to meet the working capital needs.

Intermediary Stock Exchange

Market Capital Market

Role Secondary Market to securities Corporate advisory services, Issue of securities Subscribe to unsubscribed portion of securities Issue securities to the

Investment Bankers

Capital Market, Credit Market Capital Market, Money Market

Underwriters

Registrars, Depositories, Custodians

Capital Market

investors on behalf of the company and handle share transfer activity

Primary Dealers Satellite Dealers Forex Dealers

Money Market

Market making in government securities Ensure exchange ink currencies

Forex Market