FINANCIAL MARKETS AND INSTITUTIONS

Mrs. SRIDEVI .P

Chapter 1
INTRODUCTION TO FINANCIAL MARKETS

Financial System

FINANCIAL MARKETS
Financial Finance

Markets:

is a prerequisite for modern business and financial institutions play a vital role in economic system. It's through financial markets the financial system of an economy works. The main functions of financial markets are:
1.

To facilitate creation and allocation of credit and liquidity; 2. To serve as intermediaries for mobilization of savings;

Primary Market
The

primary markets are where investors can get first crack at a new security issuance. E.g. IPO

Secondary market
Once

financial instruments such as stocks are issued in primary market they are then traded --- that is rethought and resold ___in the secondary market E.g. NSE SENSEX

Benefits to Investors and corporate

Primary

Market Investors : opportunity to invest Corporate : Raise money

Secondry

market : Investors : opportunity to trade securities at market values Corporate : current value of its instrument

MONEY MARKET - OTC

Markets that trade in debt securities or instruments with maturities with one or less than one year. Money market instruments : Issued by Gov and corporate
Commercial

papers. Certificate of deposit. Inter-bank participation certificates. Repo instrument Banker's Acceptance Money Market mutual fund Treasury bills

Capital market
Markets

that trade equity (STOCKS) Debt(Bonds) instuments with maturities of more than one year Types of financial instruments that are traded in the capital markets are: equity instruments (Stock Market) credit market instruments, (Corporate securites) foreign exchange instruments, hybrid instruments (debt-type instruments with exposure to
the equities market.)

derivative instruments.

The stock exchange

The stock exchange market is a highly organized market for the purchase and sale of second-hand quoted or listed securities. quoting or listing of a particular security implies incorporating the security in the register of the stock exchange so that it can be bought and sold there.

Hybrid securities
An

investment product that combines the attributes of an equity security with a debt security. Generally, hybrid instruments are designed as debt-type instruments with exposure to the equities market. Examples of hybrid instruments are convertible bonds, preferred stocks, equity default swaps and structured notes linked to an equity index. Also called hybrid securities.

Derivative instruments
Derivative

instruments (or simply derivatives) are a category of financial instruments that includes options, futures, forwards and swaps. While there is general agreement among financial practitioners as to which instruments are considered derivatives and which are not, coming up with a general definition that conforms precisely to that understanding is difficult.

STRUCTURE OF THE CAPITAL MARKET

Capital market is divided into 2 constituents : The financial institutions provide long-term and medium term loan facilities. The securities market Gilt-edged securities The corporate securities market

Securities market
SM

is an economic institute within which takes place the sale and purchase transactions of securities between subjects of the economy, on the basis of demand and supply. Also we can say that securities market is a system of interconnection between all participants (professional and nonprofessional) that provides effective conditions: to buy and sell securities,

Securities market
to

attract new capital by means of issuance new security (securitization of debt), to transfer real asset into financial asset, to invest money for short or long term periods with the aim of deriving profit. commercial function (to derive profit from operation on this market)

Securities market
price

determination (demand and supply balancing, the continuous process of prices movements guarantees to state correct price for each security so the market corrects mispriced securities) informative function (market provides all participants with market information about participants and traded instruments) regulation function (securities market creates the rules of trade, contention regulation, priorities determination)

Gilt-edged securities
Gilt-edged

securities are bonds issued by certain national governments. The term is of British origin, and originally referred to the debt securities issued by the Bank of England, which had a gilt (or gilded) edge. Hence, they are known as gilt-edged securities, or gilts for short. Today the term is used in the United Kingdom as well as some Commonwealth nations, such as South Africa and India. 2]

Gilt-edged securities
The

term "gilt account" is also a term used by the Reserve Bank of India to refer to a constituent account maintained by a custodian bank for maintenance and servicing of dematerialized government securities owned by a retail customer.[

Corporate security
Corporate

security identifies and effectively mitigates or manages, at an early stage, any developments that may threaten the resilience and continued survival of a corporation. It is a corporate function that oversees and manages the close coordination of all functions within the company that are concerned with security, continuity and safety.

ROLE OF CAPITAL MARKET IN INDIAS INDUSTRIAL GROWTH

Financing

Five Year Plans Mobilization of savings and acceleration of capital formation. Promotion of industrial growth. Raising long-term capital. Ready and continuous market. Proper channelization of funds. Provision of a variety of services.

FINANCIAL INSTITUTIONS
The

Indian financial system can broadly classified into the following groups Organized sector Unorganized sector.

Organized and Unorganized

Organized Institutions banking system, co-operative bank system,(Small group of people) development banking system,(IDBI,ICICI) money markets, mutual funds, financial companies/institutions. Unorganized Institutions Moneylenders Indigenous bankers(chettys,sahukars,Marwaris) lending pawnbrokers(personal property pledge or collateral) landlords, traders, etc.

1$ = ____ Rupees

Foreign exchange markets

The

market in which participants are able to buy, sell, exchange and speculate on currencies. Foreign exchange markets are made up of banks, commercial companies, central banks, investment management firms, hedge funds, and retail forex brokers and investors.
Global Spot

events effects profitability of companies

Foreign exchange transaction Forward foreign exchange transaction

The

forex market is considered to be the largest financial market in the world.

FM Regulation
SEBI - The Securities and Exchange Board of India (frequently abbreviated SEBI) is the regulator for the securities market in India
SEBI

registration-Legal document called Prospectus Provides full and accurate Information Reduce Excessive price fluctuation-Circuit breakers

Chapter 2
MONEY MARKET

Money Market
What is Money Market Need for money market Features of Money Market Objective of Money Market Importance of Money Market Instrument of Money Market

WHAT IS MONEY MARKET?

As per RBI definitions A market for short terms financial assets that are close substitute for money, facilitates the exchange of money in primary and secondary market. The money market is a mechanism that deals with the lending and borrowing of short term funds (less than one year). A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded.

FEATURES OF MONEY MARKET

Transaction have to be conducted without the help of brokers. It is not a single homogeneous market, it comprises of several submarket like call money market, acceptance & bill market. The component of Money Market are commercial banks, acceptance houses NBFC (Non-banking financial companies) In Money Market transaction can not take place formal like stock exchange, only through oral communication, relevant document and written communication transaction can be done.

'Acceptance Market'
The

acceptance market is useful to exporters, who are immediately paid for exports; For importers, who do not need to pay until possession of goods occurs; for the financial institutions, that are able to profit from the acceptances; and for investors who trade acceptances in the secondary market. Acceptances are sold in the secondary market at a discount from face value (similar to the Treasury Bill market), at published acceptance rates.

Call Money Markets

The call money market is an integral part of the Indian Money Market, where the day-to-day surplus funds (mostly of banks) are traded. The loans are of short-term duration varying from 1 to 14 days. The money that is lent for

Call Money Market Participants

1.Those

who can both borrow as well as lend in the market - RBI (through LAF - Liquidity adjustment facility) Banks, PDs (Primary dealers)
2.Those

who can only lend Financial institutions-LIC, UTI, GIC, IDBI, NABARD, ICICI and mutual funds etc.
Reserve

Bank of India has framed a time schedule to phase out the second category out of Call Money Market and

CALL RATES
Rate

of intrest paid on call loans is known as call rate Highly variable There are 2 call rates in india 1.Inter bank call rate 2.The lending rate of DFHI CBLO-Collateralized Borrowing and Lending Obligation(FM instrument by RBI) CCIL-Clearing Corporation of India (Owns CBLO)

OBJECTIVE OF MONEY MARKET

To provide a reasonable access to users of short-term funds to meet their requirement quickly, adequately at reasonable cost. To provide a parking place to employ short term surplus funds.

IMPORTANCE OF MONEY MARKET

Development of trade & industry. Development of capital market. Smooth functioning of commercial banks. Effective central bank control. Formulation of suitable monetary policy. Non inflationary source of finance to government.

INSTRUMENT OF MONEY MARKET?

A variety of instrument are available in a developed money market. In India till 1986, only a few instrument were available. They were Treasury bills Money at call and short notice in the call loan market. Commercial bills, promissory notes in the bill market.

NEW INSTRUMENT Commercial papers T-Bills Certificate of deposit. Inter-bank participation certificates. Banker's Acceptance Repurchase agreement Money Market mutual fund

COMMERCIAL PAPER (CP)

CP

is a short term unsecured loan issued by a corporation typically financing day to day operation. CP is very safe investment because the financial situation of a company can easily be predicted over a few months. Only company with high credit rating issues CPs.

TREASURY BILLS (T-BILLS)

(T-bills)

are the most marketable money market security. They are issued with threemonth, six-month and one-year maturities. Tbills are purchased for a price that is less than their par(face) value; when they mature, the government pays the holder the full par value. T-Bills are so popular among money market instruments because of affordability to the individual investors.

CERTIFICATE OF DEPOSIT (CD)

A

CD is a time deposit with a bank. Like most time deposit, funds can not withdrawn before maturity without paying a penalty. CDs have specific maturity date, interest rate and it can be issued in any denomination. The main advantage of CD is their safety. Anyone can earn more than a saving account interest.

REPURCHASE AGREEMENT (REPOS)

Repo

is a form of overnight borrowing and is used by those who deal in government securities. They are usually very short term repurchases agreement, from overnight to 30 days of more. The short term maturity and government backing usually mean that Repos provide lenders with extremely low risk. Repos are safe collateral for loans.

BANKER'S ACCEPTANCE
A bankers acceptance (BA) is a short-term credit investment created by a non-financial firm. BAs are guaranteed by a bank to make payment. Acceptances are traded at discounts from face value in the secondary market. BA acts as a negotiable time draft for financing imports, exports or other transactions in goods. This is especially useful when the credit worthiness of a foreign trade partner is unknown.

Mutaul Fund
An

investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.

July 2013 Continuation..of Chapter 2 Money market

22

Discount yield
Yields

for discount instruments traded in the money market are generally quoted on a bank discount basis, which amply illustrates this tradeoff. The bank discount yield (or simply discount yield)

Discount Yield for T-Bill

Treasury bill

Bond-equivalent yields.
In

the money market, discount instruments are generally quoted with discount yields, which are not directly comparable with yields calculated for other types of instruments. To facilitate comparisons, discount yields may be converted to bond-equivalent yields.

CHAPTER 3 DETERMINANTS OF INTEREST RATES

Determinants of Interest rates

Real

Risk-free Rate: Refers to the interest rate on a risk-free security where there is inflationary concerns.
Inflation

Premium: The premium added to an interest rate to cover the cost of any inflationary concerns that may affect purchasing power.

Determinants of Interest rates

Default

Risk Premium: Refers to the premium added to an interest rate relative to the likelihood that the financial obligation will not be fulfilled.
Maturity

Risk Premium: An opportunity cost arises over the lifetime of loaned funds, thus a maturity risk premium is added to compensate for opportunity costs. The company loaning the funds must cover itself from Inflation, Defaults, and opportunity costs.

Nominal rate of interest

In

finance and economics, nominal interest rate or nominal rate of interest refers to two distinct things:
The

rate of interest before adjustment for inflation (in contrast with the real interest rate); or,
For

interest rates "as stated" without adjustment for the full effect of compounding (also referred to as the nominal annual rate)

Real interest rate

The real interest rate is the nominal rate of interest minus inflation.
In

the case of a loan, it is this real interest that the lender receives as income. If the lender is receiving 8 percent from a loan and inflation is 8 percent, then the real rate of interest is zero.
because nominal interest and inflation are equal. A lender would have no net benefit from such a loan because inflation fully diminishes the value of the loan's profit.

Real interest rate

The

relationship between real and nominal interest rates can be described in the equation: (1+r)(1+i)=(1+R) where r is the real interest rate, i is the inflation rate, and R is the nominal interest rate.
A

common approximation for the real interest rate is:

real interest rate = nominal interest rate expected inflation

Term structure of interest rate

Theory of Term structure of interest rate

expectation Liquidity Market

theory

premium theory

segmentation theory

Monetary policy- Role of Central Bank

The

central bank has a number of policy instruments that can effect the major objectives of monetary policy: -Stability of prices -Stability of exchange rate Central banks can focus on
Quantitative monetary policy: central banks regulate monetary base Qualitative monetary policy: central banks regulate market interest rate and provide monetary base which respond to money demand

Monetary Policy Instruments

The main monetary policy instruments available to central bank open market operation- OMO bank reserve requirement, interest-rate policy, re-lending and re-discount (including using the term repurchase market), and credit policy (often coordinated with trade policy).

MONEY SUPPLY AND DEMAND

Determines Monetary

interest rate

policy

Govt manipulates supply of money to effect interest rate

Measures of money supply

The

Reserve Bank of India defines the monetary aggregates as:

Reserve

Money (M0): Currency in circulation + Bankers deposits with the RBI + Other deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBIs claims on banks + RBIs net foreign assets + Governments currency liabilities to the public RBIs net non-monetary liabilities.
M1:

Currency with the public + Deposit money of the public (Demand deposits with the banking system + Other deposits with the RBI).

Measures of money supply

M2: M3:

M1 + Savings deposits with Post office savings banks

M2+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Governments currency liabilities to the public Net non-monetary liabilities of the banking sector (Other than Time Deposits).
M4:

M3 + All deposits with post office savings banks (excluding National Savings Certificates).

What is all this M1,M2,M3,M4?

It

shows the money supply in the market. money = more liquidity = easy to get loans = inflation

More Less As

money = less liquidity = hard to get loans = problem

we saw earlier, RBI controls the money supply by changing its CRR, Repo etc rates. (thus controls inflation) thats called Monetary Policy
But

for that, RBI needs to measure how much money is there in the market (=liquidity) ? they know it via these M1-M4.

Side note Govt. controls economy via changing Tax rates- thats called Fiscal Policy

Measures of money supply

Who

calculates M1-M4? RBI since 1970-71 What are the other names of this? 1. Money Stock measure 2. Measures of monetary Aggregates

Influence of interest on economics

Mortgages/lending

Home

sales
and investments startup expansion

Savings

Business Business