UNIT 1

Submitted ByBimal Yadav Gagan Juneja Geetika Rawat Jyoti Nayyar Krati Saraswat

Mehak Bhargava Ratnanjali Shilpi Jaiswal

INTRODUCTION
A financial system plays a vital role in the economic growth of the country. It intermediates between the flow of funds belonging to those who save a part of their income and those who invest in productive assets. It mobilizes and usefully allocates scarce resources of a country. A financial system is a complex, well-integrated set of sub-systems of financial institutions, markets, instruments and services which facilitates the transfer and allocation of funds efficiently and effectively.

ROLE OF FINANCIAL SYSTEM Indian Financial System

Capital Market Money Market Non-Securities Market Fixed Deposits, Bank Deposits, Provident Fund Mutual Funds Securities Market Primary Market Insurance Equity Market Book Building Private Placement Secondary Market Debt Market Commodity Market Futures & Options Market Financial Statement Analysis

IPOS

The role of the financial system is to promote savings & investments in the economy. It has a vital role to play in the productive process and in the mobilization of savings and their distribution among the various productive activities. Savings are the excess of current expenditure over income. The domestic savings has been categorized into three sectors, household, government & private sectors. The savings from household sector dominates the domestic savings component. The savings will be in the form of currency, bank deposits, non bank deposits, life insurance funds, provident funds, pension funds, shares, debentures, bonds, units & trade debts. All of these currency & deposits are voluntary transactions & precautionary measures. The savings in the household sector are mobilized directly in the form of units, premium, provident fund, and pension fund. These are the contractual forms of savings. Financial actively deals with the production, distribution & consumption of goods and services. The financial system will provide inputs to productive activity. Financial sector provides inputs in the form of cash credit & assets in financial for production activities. The function of a financial system is to establish a bridge between the savers and investors. It helps in mobilization of savings to materialize investment ideas into realities. It helps to increase the output towards the existing production frontier. The growth of the banking habit helps to activate saving and undertake fresh saving. The financial system encourages investment activity by reducing the cost of finance risk. It helps to make investment decisions regarding projects by sponsoring, encouraging, export project appraisal, feasibility studies, monitoring & execution of the projects.

FINANCIAL MARKETS

Financial Markets are the centre or arrangements that provide facilities of buying and selling of financial claims and services. The corporations, financial institutions, individuals and government trade in financial products on these markets either directly or through brokers and dealers on organized exchanges or off-exchanges. The participants on demand and supply sides of these markets are financial institutions, brokers, agents, dealers, borrowers, lenders, savers and others who are inter-linked by the laws, contracts and communication networks.

MONEY MARKET
The Money Market refers to the market for short term debt instrument which has maturity less than one year. The Money Market provides the borrower to borrow the funds for shorter period with lowest cost of funds. At the same time it is also facilitates to the investor a platform to invest his savings which can generate interest thereon. Money Markets do not have an organized trading market place such as the stock exchange for its primary issue and secondary market trades. The participants in the money market are banks, primary dealers, and financial institutions, mutual funds, and non-bank financial companies, manufacturing companies, State Governments, provident funds, non-resident Indians, overseas corporate bodies, foreign institutional investors and trusts. The RBI and Securities and Exchange Board of India (SEBI) regulate the participants and use of instruments in the money market depending upon their respective roles in the financial system. It has two components: Call Money Market Call Money Market is that part of national money market where day to day surplus fund, mostly of banks, is traded in. It is a centre where the borrower and lender of money and near money assets are brought together. Bill Market Bill Market was introduced by RBI in 1952. Under this, RBI made advances to scheduled commercial banks in the form of demand loans against their promissory notes. The main objective of the bill market is to reduce the reliance on cash credit arrangement. Therefore, bill market scheme promotes an active market so that the lending activities of the bank could be shared by other banks.

CHARACTERISTICS OF MONEY MARKET

i. ii. iii. It is a market for short term funds for not exceeding a period of one year. It deals with those assets which can be converted into cash immediately. There is no formal place for money market and transactions generally take place over telephone or fax messages. iv. Transactions are made without the help of brokers. v. The commercial bank plays generally a dominant role in this market. vi. It establishes the link between the RBI and banks.

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The inter-bank markets match the deficits and surplus of banks.

MONEY MARKET INSTRUMENTS

a) Treasury Bill Treasury Bills are short-term instruments issued by the Reserve Bank on behalf of the Government to tide over short term liquidity shortfalls. This instrument is used by the Government to raise short term funds to bridge seasonal or temporary gaps between its receipt and expenditure. They form the most important segment of the money market not only in India but all over the world as well. The treasury bills can be categorized as follows: 14 days treasury bills The 14 day treasury bills has been introduced from 1996-97. These bills are non-transferable. They are issued only in book entry system they would be redeemed at par. Generally the participants in this market are state government, specific bodies & foreign central banks. The discount rate on this bill will be decided at the beginning of the year quarter. 28 days treasury bills These bills were introduced in 1998. The treasury bills in India issued on auction basis. The date of issue of these bills will be announced in advance to the market. The information regarding the notified amount is announced before each auction. The notified amount in respect of treasury bills auction is announced in advance for the whole year separately. A uniform calendar of treasury bills issuance is also announced. 91 days treasury bills The 91 days treasury bills were issued from July 1965. These were issued tap basis at a discount rate. The discount rates vary between 2.5 to 4.6% P.a. from July 1974 the discount rate of 4.6% remained uncharged the return on these bills were very low. However the RBI provides rediscounting facility freely for this bill. 182 days treasury bills The 182 days Treasury bill was introduced in November 1986. The Chakravarthy Committee made recommendations regarding 182 day treasury bills instruments. There was a significant development in this market. These bills were sold through monthly auctions. These bills were issued without any specified amount. These bills are tailored to meet the requirements of the holders of short term liquid funds. These bills were issued at a discount. These instruments were eligible as securities for SLR purposes. These bills have rediscounting facilities.

 364 days treasury bills The 364 treasury bills were introduced by the government in April 1992. These instruments are issued to stabilize the money market. These bills were sold on the basis of auction. The auctions for these instruments will be conducted for every fortnight. There will be no indication when they are putting auction. Therefore the RBI does not provide rediscounting facility to these bills. These instruments have been instrumental in reducing, the net RBI credit to the government. These bills have become very popular in India.
b) Commercial Bills

A bill (draft) drawn against a shipment of products or goods; that is, a draft drawn upon the one to whom the products or goods are consigned. Banks make advances to the customers against commercial bills. In the needs of fund by bankers it can be rediscounted in the money market to get ready money. This rediscount period is 90 days but it can be rediscounted earlier in the secondary market. c) Inter bank call money The inter bank call money market is the core of the formal money market. Banks borrow from the call money market in order to meet sudden demand for funds for payments and to obtain funds to meet any likely shortfalls in their cash reserves to meet the Cash Reserve Ratio stipulation. In India, inter bank call money market is the single most important source for banks for getting overnight and short-term funds. d) Commercial Paper Commercial Paper is a short-term unsecured instrument issued by a company in the form of promissory notes with fixed maturities. The maturity period ranges from 15 days to less than 1 year. Important feature of CP is that through this instrument the firm may raise large amount of funds which is not possible through a single bank. Commercial paper is not usually backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue. A major benefit of commercial paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months (270 days), making it a very costeffective means of financing. The proceeds from this type of financing can only be used on current assets (inventories) and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement. Example: X Ltd issued Commercial Paper worth Rs 10 crores as per the following details: Date of issue: 17th January. 2008

Date of maturity: 17th April, 2008 No of days: 90 days (from 17th Jan 08 to 17th April 08) Rate of interest: 11.25% per annum. Net amount will best received by the company on issue of commercial paper is as follows: 90 days 11.25 Interest for 90 days = x = 2.7740 365 days 100 2.7740 Rs. 10 crores x = Rs. 26, 99,126 or say Rs. 27 lakhs 100 + 2.7740 Net amount will be received by the company is Rs 9.73 crores (ie Rs. 10 crores less Rs. 27 lakhs). e) Certificate of Deposit CDs are negotiable money market instrument issued in Demat form or as a Usance Promissory Notes. CDs issued by banks should not have the maturity less than seven days and not more than one year. Financial Institutions are allowed to issue CDs for a period between 1 year and up to 3 years. CDs are like bank term deposits but unlike traditional time deposits these are freely negotiable and are often referred to as Negotiable Certificates of Deposit. CDs normally give a higher return than Bank term deposit. CDs are rated by approved rating agencies (e.g. CARE, ICRA, CRISIL, and FITCH) which considerably enhance their tradability in the secondary market, depending upon demand. SBI DFHI is active players in secondary market of CDs. CDs are issued in denominations of Rs. 1 Lac and in the multiples of Rs. 1 Lac thereafter. Discount/Coupon rate of CD is determined by the issuing bank/FI. Loans cannot be granted against CDs and Banks/FIs cannot buy back their own CDs before maturity. For Example: X ltd has Rs 20 lacs to invest in Certificate of Deposit of a leading nationalized bank @8% per annum. What money is required to be invested now? Answer: Rate of interest = 8% No of days to maturity = 91 days Interest on Re 1 for 91 days = 0.08 x 91/365 = 0.019945 Maturity value after 91 days on Re 1 = Re. 1.019945 Investment today = Rs 20 lacs / 1.019945 If we want Rs 20 lakhs after 91 days our investment today is Rs 19,60,890/f) Money Market Mutual Funds

In order to create an additional short-term avenue for investment and to bring money market instrument within the reach of individuals and smaller bodies, the Reserve Bank of India set up money market mutual funds in April 1991. Money market mutual funds are one of the safest instruments of investment for the retail low income investor. The assets in a money market fund are invested in safe and stable instruments of investment issued by governments, banks and corporations etc. Generally, money market instruments require huge amount of investments and it is beyond the capacity of an ordinary retail investor to invest such large sums. Money market funds allow retail investors the opportunity of investing in money market instrument and benefit from the price advantage. g) Gilt-edged Securities The Government securities and fixed rate bonds, floating rate bonds, zero coupon bonds, capital index bonds etc., can be grouped under Gilt-edged securities. These are risk less securities. The maturity pattern of Government securities are ranging from 1 year to 10 years. These securities are less liquid than treasury bills and demand for these securities is mainly from banks. h) Repurchase Option The major development in the government securities market is the introduction of a repurchase facility. This instrument of Repurchase Agreement between the RBI and commercial banks started in December 1992. REPO includes the acquisition of funds through sale of agreed securities and is simultaneously committed to repurchase the same at a predetermined price, generally within a period of 14 days to 1 year. REPO is thus a collateral borrowing and represents a liability to the seller at the purchase price, and reflects the conceptual obligations to transfer funds to the banks on the date of maturity of agreement.