Financial Market Money Market & Capital Market by Jatin Verma

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Financial Market Money Market & Capital Market By Jatin Verma

Topics to be Covered

1. Financial Market-Introduction

2. Functions of Financial Market

3. Classification of Financial Market

4. Indian Financial Market

5. Regulators of Indian Financial Markets

6. Factors Affecting Financial Market

7. Bond Market and G-Sec

Financial Market- Introduction

What It is? A market is a place where two parties are involved in transaction of goods and services in exchange of money. The two parties involved are: ● Buyer ● Seller Markets work by placing the two counterparts, buyers and sellers, at one place so they can find each other easily, thus facilitating the deal between them.

Financial markets are where traders buy and sell assets. These include stocks, bonds, derivatives, foreign exchange and commodities. The markets are where businesses go to raise cash to grow. It’s where companies reduce risks and investors make money.

In other words, a financial market is a market in which people and entities can trade financial securities, commodities and other fungible assets at prices that are determined by pure supply and demand principles. Securities include stocks and bonds, and commodities include precious metals or agricultural products.

Producers advertise goods and services to consumers in a financial market in order to generate demand. Also, the term "market" is closely associated with financial assets and securities prices (for example, the stock market or the bond market). A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.

How it works? This may be a physical location (like the NYSE, BSE, LSE, JSE) or an electronic system (like NASDAQ).

Here, people who have a specific good or service they want to sell (the supply) interact with people who wish to buy it (the demand).Therefore,prices in a financial market are determined by changes in supply and demand. If market demand is steady, an increase in market supply results in a decline in market prices and vice versa. If market supply is steady, a rise in demand results in a rise in market prices and vice versa.

Financial markets may be viewed as channels through which flow loanable funds directed from a supplier who has an excess of assets toward a demander who experiences a deficit of funds.

Note: Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.

Why it matters in Economy? ● A financial market facilitates transactions between buyers and sellers, as well as between producers and consumers. ● Financial markets create an open and regulated system for companies to get large amounts of capital.

● Since the markets are public, they provide an open and transparent way to set prices on everything traded. ● They reflect all available knowledge about everything traded. This reduces the cost of getting information, because it's already incorporated into the price. ● The sheer size of the financial markets provide liquidity. ● In other words, sellers can unload assets whenever they need to raise cash. ● The size also reduces the cost of doing business, since companies don't have to go far to find a buyer, or someone willing to sell. ● Without financial markets, borrowers would have difficulty finding lenders themselves. ● Intermediaries such as banks, Investment Banks, and other financial institutions can help in this process. ● More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties.

Functions of Financial Market

Important functions of the financial markets are divided as follows: 1. Intermediary Functions 2. Financial Functions

Intermediary functions: The intermediary functions of financial markets include the following: ● Transfer of resources: Financial markets facilitate the transfer of real economic resources from lenders to ultimate borrowers. ● Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income. ● Productive usage: Financial markets allow for the productive use of the funds borrowed. The enhancing the income and the gross national production. ● Capital formation: Financial markets provide a channel through which new savings flow to aid capital formation of a country. ● Price determination: Financial markets allow for the determination of price of the traded financial assets through the interaction of buyers and sellers. ● Sale mechanism: Financial markets provide a mechanism for selling of a financial asset by an investor so as to offer the benefit of marketability and liquidity of such assets. ● Information: The activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market. So as to reduce the cost of transaction of financial assets.

Financial Functions ● Providing the borrower with funds so as to enable them to carry out their investment plans. ● Providing the lenders with earning assets so as to enable them to earn wealth by deploying the assets in production debentures. ● Providing liquidity in the market so as to facilitate trading of funds. ● Providing liquidity to commercial bank ● Facilitating credit creation ● Promoting savings ● Promoting investment ● Facilitating balanced economic growth ● Improving trading floors

Classification of Financial Market Within the financial sector, the term "financial markets" is often used to refer just to the markets that are used to raise finance: 1. For long term finance, the Capital markets; 2. For short term finance, the Money markets.

There are also different types of financial markets and their characterization depends on the properties of the financial claims being traded and the needs of the different market participants.

Based on the basic function of raising the money:

Based on security types It is recognized several types of markets, which vary based on the type of the instruments traded and their maturity. A common breakdown is the following:

● Capital market 1. The capital market aids raising of capital on a long-term basis, generally over 1 year. 2. It consists of a primary and a secondary market and can be divided into two main subgroups – Bond market and Stock market.

Based on market levels ● Primary market: a. Primary market is a market for new issues or new financial claims. Hence it’s also called new issue market. b. The primary market deals with those securities which are issued to the public for the first time. c. Therefore, primary market is the market where the newly started company issued shares to the public for the first time through IPO (initial public offering).

● Secondary market: a) It’s a market for secondary sale of securities. b) In other words, securities which have already passed through the new issue market are traded in this market. c) Generally, such securities are quoted in the stock exchange and it provides a continuous and regular market for buying and selling of securities. d) Simply put, Secondary market is the market where the second hand securities are sold.

Distinction Between Primary & Secondary market The main points of distinction between the primary market and secondary market are as follows: 1. Function: While the main function of primary market is to raise long-term funds through fresh issue of securities, the main function of secondary market is to provide continuous and ready market for the existing long-term securities. 2. Participants: While the major players in the primary market are financial institutions, mutual funds, underwriters and individual investors, the major players in secondary market are all of these and the stockbrokers who are members of the stock exchange. 3. Listing Requirement: While only those securities can be dealt within the secondary market, which have been approved for the purpose (listed), there is no such requirement in case of primary market.

4. Determination of prices: In case of primary market, the prices are determined by the management with due compliance with SEBI requirement for new issue of securities. But in case of secondary market, the price of the securities is determined by forces of demand and supply of the market and keeps on fluctuating.

Capital market: Financial Institutions • The requirement of project financing made India to go for a number of FIs from time to time, which are generally classified into four categories: • All India Financial Institutions (AIFIs): The all India FIs are IFCI (1948); ICICI (1955); IDBI (1964); SIDBI (1990) & IIBI (1997). All of them were public sector FIs except ICICI, which was a joint sector venture with initial capital coming from the RBI, some foreign banks and FIs. The public sector FIs were funded by the Government of India. • Specialized Financial Institutions (SFIs): Two new FIs were set up by the Central Government in the late 1980s to finance risk and innovation in the area of industrial expansion; this was India’s trial in the area of venture capital funding. 1. IFCI Venture Capital Funds Ltd (IFCI Venture), 2000 2. Tourism Finance Corporation of India Ltd (TFCI), 1989 • Investment Institutions (IIs): Three investment institutions also came up in the public sector, which are yet another kind of FIs, i.e., the LIC (1956), the UTI (1964) and the GIC (1971). • State Level Finance Institutions (SLFIs): In the wake of states involvement in the industrial development, the central government allowed the states to set up their own financial institutions (after the states demanded so). In this process two kinds of FIs came up: 1. State Finance Corporations (SFCs) 2. State Industrial Development Corporations (SIDCs) (fully dedicated state public sector FI )

● Indian Money Market 1. Money market is the short-term financial market of an economy. In this market, money is traded between individuals or groups (i.e., financial institutions, banks, government, companies, etc.), who are either cash-surplus or cash-scarce. 2. The money market enables economic units to manage their liquidity positions through lending and borrowing short-term loans, generally under 1 year. 3. Trading is done on a rate known as discount rate which is determined by the market and guided by the availability of and demand for the cash in the day-to-day trading. 4. The market operates in both ‘organized’ and ‘unorganized’ channels in India.

➢ The organized form of money market in India is just close to three decades old. However, its presence has been there, but restricted to the government only. ➢ It was the Chakravarthy Committee (1985) which, for the first time, underlined the need of an organised money market in the country and the Vahul Committee (1987) laid the blue print for its development.

➢ Today, money market in India is not an integrated unit and has two segments— Unorganized Money Market and Organized Money Market.

● Unorganized Money Market ➢ Before the government started the organized development of the money market in India, its unorganized form had its presence since the ancient times—its remnant is still present in the country. ➢ Their activities are not regulated like the organized money market, but they are recognized by the government. ➢ In recent years, some of them have been included under the regulated organized market (for example, the NBFCs were put under the regulatory control of the RBI in 1997). ➢ The unorganized money market in India may be divided into three differing categories:-

1. Unregulated Non-Bank Financial Intermediaries: Unregulated Non Banking Financial Intermediaries are functioning in the form of chit funds, nidhis (operate in South India, which lend to only their members) and loan companies. 2. Indigenous bankers: They receive deposits and lend money in the capacity of an individual or a private firms. There are, basically, four such bankers in the country functioning as non- homogenous groups:

• Money Lenders: They constitute the most localized form of money market in India and operate in the most exploitative way. They have their two forms: 1. The professional money lenders who lend their own money as a profession to earn income through interest. 2. The non-professional money lenders who might be businessmen and lend their money to earn interest income as a subsidiary business.

Status: • As per a survey carried out by the National Sample Survey Organisation (NSSO) in 2009–10, the total employment in the country was of 46.5 crore comprising around 2.8 crore in the organized and the remaining 43.7 crore workers in the unorganized sector. • Out of these workers in the unorganized sector, there are 24.6 crore workers employed in agricultural sector, about 4.4 crore in construction work and remaining in manufacturing and service.

Organized Money Market • Since the government started developing the organized money market in India (mid-1980s), we have seen the arrival of a total of eight instruments designed to be used by different categories of business and industrial firms. A brief description of these instruments follows: 1. Treasury Bills (TBs): They are used by the Central Government to fulfill its short-term liquidity requirement upto the period of 364 days. There developed five types of the TBs in due course of time: a) 14-day (Intermediate TBs) b) 14-day (Auction-able TBs) c) 91-day TBs d) 182-day TBs e) 364-day TBs f) Out of the above five variants of the TBs, at present only the 91-day TBs, 182-day TBs and the 364-day TBs are issued by the government. The other two variants were discontinued in 2001.

• Certificate of Deposit (CD): Organized in 1989, the CD is used by banks and issued to the depositors for a specified period ranging less than one year—they are negotiable and tradable in the money market. Since 1993 the RBI allowed the financial institutions to operate in it— IFCI, IDBI, IRBI (IIBI since 1997) and the Exim Bank—they can issue CDs for the maturity periods above one year and upto three years. • Commercial Paper (CP): Organized in 1990 it is used by the corporate houses in India (which should be a listed company with a working capital of not less than Rs. 5 crore). The CP issuing companies need to obtain a specified credit rating from an agency approved by the RBI (such as CRISIL, ICRA, etc.) • Commercial Bill (CB): Organized in 1990, a CB is issued by the All India Financial Institutions (AIFIs), Non Banking Finance Companies (NBFCs), Scheduled Commercial Banks, Merchant Banks, Co-operative Banks and the Mutual Funds. It replaced the old Bill Market available since 1952 in the country. • Call Money Market (CMM): This is basically an inter-bank money market where funds are borrowed and lent, generally, for one day that is why this is also known as over-night

borrowing market (also called money at call). Fund can be borrowed/raised for a maximum period upto 14 days (called short notice). • Rate of interest in this market ‘glides’ with the ‘repo rate’ of the time the principle remains very simple—longer the period, higher the interest rate. The scheduled commercial banks, cooperative banks operate in this market as both the borrowers and lenders while LIC, GIC, Mutual Funds, IDBI and NABARD are allowed to operate as only lenders in this market. • Money Market Mutual Fund (MF): Popular as Mutual Funds (MFs) this money market instrument was introduced/organized in 1992 to provide short-term investment opportunity to individuals. Since March 2000, MFs have been brought under the preview of SEBI, besides the RBI. • Repos and Reverse Repos: ‘Repo’ is basically an acronym of the rate of repurchase. Repo allows the banks and other financial institutions to borrow money from the RBI for short- term (by selling government securities to the RBI). In reverse repo, the banks and financial institutions purchase government securities from the RBI (basically here the RBI is borrowing from the banks and the financial institutions). • All government securities are dated and the interest for the repo or reverse repo transactions are announced by the RBI from time to time. Recommendations: • Accepting the recommendations of the Urjit Patel Committee, the RBI in April 2014 (while announcing the first Bi-monthly Credit & Monetary Policy-2014–15) announced to introduce term repo and term reverse repo. This is believed to bring in higher stability and better signaling of interest rates across different loan markets in the economy. • Cash Management Bill (CMB): The Government of India, in consultation with the RBI, decided to issue a new short-term instrument, known as Cash Management Bills, since August 2009 to meet the temporary cash flow mismatches of the government. The Cash Management Bills are non-standard and discounted instruments issued for maturities less than 91 days.

Note: • Treasury Bills serve the same purpose, but as they were put under the WMAs (Ways & Means Advances) provisions by the Government of India in 1997, they did not remain a discretionary route for the government in meeting its short-term requirements of funds. CBM does not come under the similar WMAs provisions.

Mutual Funds • A mutual fund is a fund that is created when a large number of investors put in their money, and is managed by professionally qualified persons with experience in investing in different asset classes—shares, bonds, money market instruments like call money, and other assets such as gold and property.

• For example, a diversified equity fund will invest in a large number of stocks, while a gilt fund will invest in government securities, while a pharma fund will mainly invest in stocks of companies from the pharmaceutical and related industries. • There are three types of schemes offered by MFs:

Mutual Funds • Open-ended Schemes: It is one which is usually available from an MF on an ongoing basis, that is, an investor can buy or sell as and when they intend to at a Net Assets Value (NAV) - based price. • As investors buy and sell units of a particular open-ended scheme, the number of units issued also changes every day and so changes the value of the scheme’s portfolio. So, the NAV also changes on a daily basis. • In India, fund houses can sell any number of units of a particular scheme, but at times fund houses restrict selling additional units of a scheme for some time. • Closed-ended Schemes:A close-ended fund usually issue units to investors only once, when they launch an offer, called new fund offer (NFO) in India. Thereafter, these units are listed on the stock exchanges where they are traded on a daily basis. As these units are listed, any investor can buy and sell these units through the exchange. • They are managed by fund houses for a limited number of years, and at the end of the term either money is returned to the investors or the scheme is made open ended. • Exchange-Traded Funds (ETFs): ETFs are a mix of open-ended and close-ended schemes. ETFs, like close-ended schemes, are listed and traded on a stock exchange on a daily basis, but the price is usually very close to its NAV, or the underlying assets, like gold ETFs.

● Derivatives market 1. It facilitates the trading in financial instruments such as futures contracts and options used to help control financial risk. 2. The instruments derive their value mostly from the value of an underlying asset that can come in many forms – stocks, bonds, commodities, currencies or mortgages. 3. The derivatives market is split into two parts which are of completely different legal nature and means to be traded.

Derivatives (explained) What is a 'Derivative' • A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. • The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. • Certain kinds of derivatives can be used for hedging, or insuring against risk on an asset. Derivatives can also be used for speculation in betting on the future price of an asset or in circumventing exchange rate issues.

1. Exchange-traded derivatives: • These are standardized contracts traded on an organized futures exchange. • They include futures, call options and put options.

• Trading in such uniformed instruments requires from investors a payment of an initial deposit which is settled through a clearing house. • And It aims at removing the risk for any of the two counterparts not to cover their obligations.

2. Over-the-counter derivatives • Those contracts that are privately negotiated and traded directly between the two counterparts, without using the services of an intermediary like an exchange. • Securities such as forwards, swaps, forward rate agreements, credit derivatives, exotic options and other exotic derivatives are almost always traded this way. • These are tailor-made contracts that remain largely unregulated and provide the buyer and the seller with more flexibility in meeting their needs.

● Insurance market 1. It helps in relocating various risks. 2. Insurance is used to transfer the risk of a loss from one entity to another in exchange for a payment. 3. The insurance market is a place where two peers, an insurer and the insured, or the so-called policyholder, meet in order to strike a deal primarily used by the client to hedge against the risk of an uncertain loss.

● Financial Service Market: 1. A market that comprises participants such as commercial banks that provide various financial services like ATM. 2. Credit rating, Housing, Stock broking etc. is known as financial service market.

3. Individuals and firms use financial services markets, to purchase services that enhance the working of debt and equity markets.

● Insurance market

● Equity Markets: • A stock market, equity market or share market is the aggregation of buyers and sellers (a loose network of economic transactions, not a physical facility or discrete entity) of stocks (also called shares), which represent ownership claims on businesses; these may include securities listed on a public stock exchange, as well as stock that is only traded privately, such as shares of private companies which are sold to investors through equity crowd funding platforms. • An example of a secondary equity market for shares is the Bombay stock exchange(BSE), National Stock Exchange (NSE) etc.

● What's the Difference Between the Equity Market and the Stock Market? • Stocks and equity are same, as both represent the ownership in an entity (company) and are traded on the stock exchanges. Equity by definition means ownership of assets after the debt is paid off. Stock generally refers to traded equity. • Stock is the type of equity that represents equity investment. When you buy a stock, you expect returns in the form of dividend. Equity can also mean stocks shares.

● Debt market: 1. The market where funds are borrowed and lent is known as debt market. 2. Arrangements are made in such a way that the borrowers agree to pay the lender the original amount of the loan plus some specified amount of interest.

● Depository markets: • A depository market consists of depository institutions that accept deposit from individuals and firms and uses these funds to participate in the debt market, by giving loans or purchasing other debt instruments such as treasury bills. ● Non-depository market: 1. Non-depository market carry out various functions in financial markets ranging from financial intermediary to selling, insurance etc. 2. The various constituency in non-depositary markets are mutual funds, insurance companies, pension funds, brokerage firms etc.

Others ● Foreign Exchange Market 1. The foreign exchange market is a global decentralized or over-the-counter market for the trading of currencies. This market determines foreign exchange rates for every currency. 2. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. 3. It’s the largest, most liquid market in the world with an average traded value of more than $5 trillion per day.

● Commodity market The commodity market manages the trading in primary products which takes place in about 50 major commodity markets where entirely financial transactions increasingly outstrip physical purchases which are to be delivered. Commodities are commonly classified in two subgroups.

1. Hard commodities are raw materials typically mined, such as gold, oil, rubber, iron ore etc. 2. Soft commodities are typically grown agricultural primary products such as wheat, cotton, coffee, sugar etc.

Indian Financial Market

Regulators of Indian Financial Market The following are five major regulatory bodies in India: (a) Statutory Bodies via Parliamentary enactment 1. Reserve Bank Of India (RBI) 2. Securities Exchange Board of India (SEBI) 3. Insurance Regulatory & Development Authority (IRDA) (b) Part of Ministry of Finance of GoI 1. Forward Market Commission (FMC) 2. Pension Fund Regulatory & Development Authority (PFRDA)

Factors Affecting Financial Market 1. Actions of Investors: Actions of individuals, institutions and mutual funds investors will instantly affect the prices of stocks, bonds, and futures in the securities market. 2. Business Conditions: Business conditions also affect the financial Market. Profits earned volume of sales and even the time of year all will determine how much an investor wants to invest in stock. 3. Government Actions: The government makes all kinds of decisions that affect both how much an individual stock may be worth (new regulations on a business) and what sort of instruments people want to buy. The government‘s interest rates, tax rates, trade policy and budget deficits all have an impact on prices. 4. Economic Indicators: General trends that signal changes in the economy are watched closely by investors to predict what is going to happen next. Such indicators include the Gross National Product (GNP), the inflation rate, the budget deficit and the unemployment rate. These indicators point to changes in the way ordinary people spend their money and how the economy is likely to perform. 5. International Events: Events around the world, such as changed in currency values, trade barriers, wars, natural disasters, and changes in governments will affect the price of securities, which ultimately influence the amount of investment. Hence, markets experience fluctuations and price shifts resulting from changes in supply and demand. These changes result from fluctuations in many other variables including(but not limited to) consumer preferences and perceptions, the availability of materials and other socio-political events (for example, government spending and unemployment).

Bonds What are bonds? • Bonds are instruments issued by a borrower to raise capital from investors or the public at large. Bonds are like loans which mature on a fixed date. In return, the borrower pays interest. Depending on the terms and conditions of the bond, the interest can be paid either at specified intervals or on maturity (deep discount bond).

What are the different types of bonds? • Bonds in India are generally issued by Government bodies. Having a government backing to the bonds provides security to the investor that these bonds will be repaid on maturity. However, other private institutions also issue bonds depending on their need.

These are the different types of bonds available for investment in India: Central Government bonds: • These bonds are issued by the Central Government to raise funds. These bonds are issued by the RBI on behalf of the Government. • The primary purpose of these bonds is to finance fiscal deficit and meet the shortfall of revenue in the Government budget. • These bonds are the safest bonds to invest in, since they are backed by the Government and will be repaid on maturity.

State Government bonds: • These bonds are issued by the State Government to meet their fiscal deficits. These bonds are listed on the stock exchange. These bonds are also backed by the Government, making them low risk investments.

Municipal and Local authority bonds: • A municipal corporation or a local authority may raise finance to meet funding for specific goals such as constructing infrastructure, public water works etc. These bonds are also rated by credit rating agencies and it is best to go by the rating and past records before investing.

Corporate bonds: • These are highly risky bonds since the maturity depends on the track record of the company. Before investing in such bonds, you must do a complete study into the company and its performance. • Public Sector bonds: These bonds are issued by highly rated public sector companies for meeting their growth and expansion needs. These bonds are relatively less risky since PSUs are under the Government. Generally, these bonds are issued by companies where the Central Government is the majority shareholder.

Tax free bonds: • Companies such as the National Highways Association of India (NHAI), Indian Railways Finance Corporation, HUDCO, Rural Electrification Corporation (REC) issue these bonds. The interest earned on these bonds is completely tax free in the hands of the investor. Types of bond markets:

1. Primary market: This is the market where the borrower approaches investors to raise capital. The issue price of the bonds and the coupon rate is fixed at the time of raising capital. 2. Secondary market: Most of the bonds are traded in the stock market. They can be sold depending on when the investor wishes to exit from the bond.

Government Securities • A government security (G-Sec) is a tradeable instrument issued by the central government or state governments. It acknowledges the government’s debt obligations. • Such securities are short term called treasury bills with original maturities of less than one year, or long term called government bonds or dated securities with original maturity of one year or more. • In India, the central government issues both: treasury bills and bonds or dated securities. • While state governments issue only bonds or dated securities, which are called the state development loans. Since they are issued by the government, they carry no risk of default, and hence, are called risk-free gilt-edged instruments.

Types of Government Securities Treasury Bills (T-bills) • These are basically short-term government securities issued by the Government of India and available for three tenors, i.e. 91 days, 182 days and 364 days. • Treasury bills pay no interest. The T-bills are generally issued at a discount and can be redeemed at the face value during the time of the maturity.

• The profit of the investors is the difference between the discounted issue price and the face value. A weekly auction is carried out by the RBI for the purpose of issuing the treasury bills.

Cash Management Bills (CMBs) • CMBs were issued by the Government of India in the year 2010 in consultation with the RBI. It is essentially a short-term instrument, issued for the period of fewer than 91 days. • It is issued to meet the mismatches in the cash flow of the Indian government. They are only issued when required. • Similar to the treasury bills, they are issued at the discounts on the face value through the RBI auction.

Dated Government Securities • These are basically long-term government securities that come up with the fixed or floating interest rate, which is paid on the face value of the securities on the half-yearly basis. The dated government securities are generally issued for the period between 5 years and 30 years. These are issued by the RBI through auction. • Commercial banks and insurance companies invest in these kinds of securities. Fixed rate bonds, floating rate bonds, zero coupon bonds, capital indexed bonds, Separate Trading of Registered Interest and Principal of Securities (STRIPS), etc. are some of the examples of dated government securities.

State Development Loans (SDLs) • These are also one of the kinds of the dated securities, which are issued by the government in order to raise a loan from the market through an auction. • The interest on these kinds of securities is paid on the half-yearly basis and the principal amount is paid on the date of maturity. The rate of interest on the state development loans is determined during the time of an auction.