Introduction to Financial Market

Introduction to Financial Introduction to Financial Market Market

Prof. Preeta SinhaProf. Preeta Sinha

Financial SystemFinancial System A financial system means the structure A financial system means the structure

that is available in an economy.that is available in an economy. It mobilizes capital from various surplus It mobilizes capital from various surplus

sectors of the economy and allocate / sectors of the economy and allocate / distribute to various needy sectorsdistribute to various needy sectors

Transformation of saving into investments Transformation of saving into investments and consumption / spending (financial and consumption / spending (financial assets) by the active role played by the assets) by the active role played by the financial system – financial intermediaries financial system – financial intermediaries

The place where these activities take The place where these activities take place could be taken to connote the place could be taken to connote the financial market.financial market.

Financial system comprises a Financial system comprises a mixture of intermediaries, markets mixture of intermediaries, markets and instrument that are related to and instrument that are related to each other.each other.

Capital Formation processCapital Formation process

1.1.Direct transfers Direct transfers of money and securities occur when a of money and securities occur when a business sells its stocks or bonds directly to savers, without going business sells its stocks or bonds directly to savers, without going through any type of financial institution. The business delivers its through any type of financial institution. The business delivers its securities to savers, who in turn give the firm the money it needs.securities to savers, who in turn give the firm the money it needs.

2. Transfers may also go through an 2. Transfers may also go through an Investment banking Investment banking house house such as Merrill Lynch, which such as Merrill Lynch, which underwritesunderwrites the issue. An the issue. An underwriter serves as a middleman and facilitates the issuance of underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the securities. The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to investment bank, which in turn sells these same securities to savers. The businesses’ securities and the savers’ money merely savers. The businesses’ securities and the savers’ money merely “pass through” the investment banking house. However, the “pass through” the investment banking house. However, the investment bank does buy and hold the securities for a period of investment bank does buy and hold the securities for a period of time, so it is taking a risk—it may not be able to resell them to time, so it is taking a risk—it may not be able to resell them to savers for as much as it paid. Because new securities are involved savers for as much as it paid. Because new securities are involved and the corporation receives the proceeds of the sale, this is and the corporation receives the proceeds of the sale, this is called a primary market transaction.called a primary market transaction.

Investment BankInvestment Bank

An investment bankAn investment bank is a financial institution that is a financial institution that assists individuals, corporations and governments assists individuals, corporations and governments in raising capital by underwriting and/or acting as in raising capital by underwriting and/or acting as the client’s agent in the issuance of securities eg: the client’s agent in the issuance of securities eg: IPO/ FPO work is handled by investment banks. An IPO/ FPO work is handled by investment banks. An investment bank also assist companies in mergers investment bank also assist companies in mergers and acquisitions, and provide ancillary services and acquisitions, and provide ancillary services such as market making, trading of derivatives, such as market making, trading of derivatives, fixed income instruments, foreign exchange, fixed income instruments, foreign exchange, commodities, and equity securities.commodities, and equity securities.

Ex: ICRA ,ICICI Securities ,Barclays ,Kotak Investing Ex: ICRA ,ICICI Securities ,Barclays ,Kotak Investing Banks,IFCIBanks,IFCI

3. Transfers can also be made through a 3. Transfers can also be made through a Financial Financial intermediary intermediary such as a bank or mutual fund. Here the such as a bank or mutual fund. Here the intermediary obtains funds from savers in exchange for its intermediary obtains funds from savers in exchange for its own securities. The intermediary uses this money to buy own securities. The intermediary uses this money to buy and hold businesses’ securities. For example, a saver might and hold businesses’ securities. For example, a saver might deposit Rs. in a bank, receiving from it a certificate of deposit Rs. in a bank, receiving from it a certificate of deposit, and then the bank might lend the money to a small deposit, and then the bank might lend the money to a small business as a mortgage loan. Thus, intermediaries literally business as a mortgage loan. Thus, intermediaries literally create new forms of capital—in this case, certificates of create new forms of capital—in this case, certificates of deposit, which are both safer and more liquid than deposit, which are both safer and more liquid than mortgages and thus are better for most savers to hold. The mortgages and thus are better for most savers to hold. The existence of intermediaries greatly increases the efficiency existence of intermediaries greatly increases the efficiency of money and capital markets.of money and capital markets.

QuestionsQuestions

Identify three different ways capital Identify three different ways capital is transferred between savers and is transferred between savers and borrowers borrowers

Why do policy makers promote the Why do policy makers promote the globalization of financial markets?globalization of financial markets?

Components of Financial Components of Financial systemsystem

According to the structural approach, the According to the structural approach, the financial system of an economy consists financial system of an economy consists ofof

three main components:three main components: 1) Financial markets;1) Financial markets; 2) Financial intermediaries (institutions);2) Financial intermediaries (institutions); 3) Financial regulators.3) Financial regulators.

Each of the components plays a specific Each of the components plays a specific role in the economyrole in the economy..

According to the functional approach, According to the functional approach, financial markets facilitate the flow of financial markets facilitate the flow of funds in order to finance investments by funds in order to finance investments by corporations, governments and individuals. corporations, governments and individuals. Financial institutions are the key players in Financial institutions are the key players in the financial markets as they perform the the financial markets as they perform the function of intermediation and thus function of intermediation and thus determine the flow of funds. The financial determine the flow of funds. The financial regulators perform the role of monitoring regulators perform the role of monitoring and regulating the participants in the and regulating the participants in the financial system.financial system.

Structure of Financial SystemStructure of Financial System

Financial MarketFinancial Market


Financial market may be defined as Financial market may be defined as ‘a transmission mechanism between ‘a transmission mechanism between investors (or lenders) and the investors (or lenders) and the borrowers (or users) through which borrowers (or users) through which transfer of funds is facilitated’. transfer of funds is facilitated’.


It consists of individual investors, It consists of individual investors, financial institutions and other financial institutions and other intermediaries who are linked by a intermediaries who are linked by a formal trading rules and formal trading rules and communication network for trading communication network for trading the various financial assets and the various financial assets and credit instrumentscredit instruments


The financial markets act as a link The financial markets act as a link between these two different groups. between these two different groups.

It facilitates this function by acting as It facilitates this function by acting as an intermediary between the an intermediary between the borrowers and lenders of moneyborrowers and lenders of money

Function of Financial MarketFunction of Financial Market

Mobilization of savingsMobilization of savings Price discoveryPrice discovery LiquidityLiquidity Reduction of transaction costReduction of transaction cost


Financial market gives strength to economy by making finance available at the right place.(1) Mobilisation of Savings and their Channelization into more Productive Uses: Financial market gives impetus to the savings of the people. This market takes the uselessly lying finance in the form of cash to places where it is really needed. Many financial instruments are made available for transferring finance from one side to the other side. The investors can invest in any of these instruments according to their wish.


(2) Facilitates Price Discovery: The price of any goods or services is determined by the forces of demand and supply. Like goods and services, the investors also try to discover the price of their securities. The financial market is helpful to the investors in giving them proper price.


(3) Provides Liquidity to Financial Assets:

This is a market where the buyers and the sellers of all the securities are available all the times. This is the reason that it provides liquidity to securities. It means that the investors can invest their money, whenever they desire, in securities through the medium of financial market. They can also convert their investment into money whenever they so desire.


(4) Reduces the Cost of Transactions:

Various types of information are needed while buying and selling securities. Much time and money is spent in obtaining the same. The financial market makes available every type of information without spending any money. In this way, the financial market reduces the cost of transactions.

Types of Financial MarketTypes of Financial Market

Financial markets can be Financial markets can be distinguished by the maturity distinguished by the maturity structure and trading structure of its structure and trading structure of its securitiessecurities

Money & capital marketsMoney & capital markets

1) Money versus capital markets:1) Money versus capital markets:

The flow of short-term funds is The flow of short-term funds is facilitated by money marketsfacilitated by money marketsThe flow of long-term funds is The flow of long-term funds is facilitated by capital marketsfacilitated by capital markets

Characteristics of money market Characteristics of money market InstrumentsInstruments

Short term MaturityShort term Maturity Highly liquidHighly liquid Fluctuation in price is quite smallFluctuation in price is quite small SafeSafe Low returnsLow returns Institutional investorsInstitutional investors Monetary policyMonetary policy Regulated by RBIRegulated by RBI

Money Market InstrumentsMoney Market Instruments Call/NoticeCall/Notice RBI liquidity by adjustment facility (LAF)RBI liquidity by adjustment facility (LAF) Repos and reverse reposRepos and reverse repos Collateralized borrowing & lending obligations Collateralized borrowing & lending obligations

(CBLO)(CBLO) Treasury Bills (T bills)Treasury Bills (T bills) Commercial paper (CP)Commercial paper (CP) Certificate of deposit (CD)Certificate of deposit (CD) PSU bondsPSU bonds Corporate DebenturesCorporate Debentures

Characteristics of Capital Characteristics of Capital MarketMarket

Long term MaturityLong term Maturity Fluctuation in price is highFluctuation in price is high Suppliers are corporates and Suppliers are corporates and

governmentsgovernments Regulated by SEBIRegulated by SEBI

Primary & Secondary marketPrimary & Secondary market

2) Primary versus secondary markets2) Primary versus secondary markets

Primary markets facilitate the Primary markets facilitate the issuance of new securitiesissuance of new securities

e.g., the sale of new corporate e.g., the sale of new corporate stock or new Treasury securitiesstock or new Treasury securitiesSecondary markets facilitate the Secondary markets facilitate the trading of existing securitiestrading of existing securities

e.g., the sale of existing stocke.g., the sale of existing stock

Forex MarketForex Market

3) Forex market3) Forex market

The foreign exchange market is a The foreign exchange market is a market where foreign currencies are market where foreign currencies are bought and sold with the purpose of bought and sold with the purpose of trading.trading.

The forex market is the largest in the The forex market is the largest in the world with over trade worth $ 4 Trillion world with over trade worth $ 4 Trillion on an average day.on an average day.

In India there are three aspects of In India there are three aspects of Forex starting with the RBI which is Forex starting with the RBI which is the overall regulator, the bank to bank the overall regulator, the bank to bank or inter bank trading and bank to or inter bank trading and bank to customer or merchant rate transaction customer or merchant rate transaction trading of foreign exchange. trading of foreign exchange.

The purpose of FOREX is to help The purpose of FOREX is to help international trade and investment.international trade and investment.

A FOREX market helps business A FOREX market helps business convert one currency to another.convert one currency to another.

In a typical foreign exchange In a typical foreign exchange transaction a party purchases a transaction a party purchases a quantity of one currency by paying a quantity of one currency by paying a quantity of another currency.quantity of another currency.

The foreign exchange market started The foreign exchange market started forming during the 1970sforming during the 1970s

The FOREX is unique because of:-The FOREX is unique because of:--Its trading volumes-The extremely -Its trading volumes-The extremely liquidity of the marketliquidity of the market-Its geographical dispersion-Its geographical dispersion-Its long trading hours ,24hours a day-Its long trading hours ,24hours a day-The low margins of profit compared -The low margins of profit compared with other market or fixed income but with other market or fixed income but profits can be high due to very large profits can be high due to very large trading volumes.trading volumes.

Exchange rates fluctuations are Exchange rates fluctuations are usually caused by actual monetary usually caused by actual monetary flows as well as by expectations of flows as well as by expectations of change in monetary flows caused by change in monetary flows caused by changes in GDP growth, Inflation, changes in GDP growth, Inflation, interest rates,budget and trade interest rates,budget and trade deficits or surpluses and other deficits or surpluses and other macro-economic conditions.macro-economic conditions.

Major participantsMajor participants

The participants in the foreign The participants in the foreign exchange market are:-exchange market are:-IndividualsIndividualsFirmsFirmsBanksBanksGovernmentsGovernmentsInternational AgenciesInternational Agencies

There are two tier system in the foreign There are two tier system in the foreign exchange marketexchange market

One involves the transactions between One involves the transactions between the ultimate customer and bank.the ultimate customer and bank.

Other consists of the transaction Other consists of the transaction between the banksbetween the banks

Structure of the FOREXStructure of the FOREX

The foreign exchange market in India The foreign exchange market in India consists of three tier system :consists of three tier system :The first consists of transactions between The first consists of transactions between RBI and the Authorized Dealers(ADs)RBI and the Authorized Dealers(ADs)Second tier is the inter bank market in Second tier is the inter bank market in which the Ads deal with each otherwhich the Ads deal with each otherThird tier consists of transactions between Third tier consists of transactions between Ads and their corporate customerAds and their corporate customer

The daily turnover in the Indian foreign The daily turnover in the Indian foreign exchange market is currently estimated to exchange market is currently estimated to be between USD1.5 -3 billion.be between USD1.5 -3 billion.

The most important center is The most important center is Mumbai.Mumbai.

Other active centers are Delhi, Other active centers are Delhi, Kolkata,Chennai, Cochin and Kolkata,Chennai, Cochin and BangaloreBangalore

Trade currency mechanicsThe main actors in the forex market are the primary market makers who trade on their own account and make a two-way bid offer market.They deal actively and continuously with each other and with their clients, central banks and sometimes with currency brokers.

The ISO has developed three letter codes The ISO has developed three letter codes for all currencies which abbreviate the for all currencies which abbreviate the name of the country as well as currency.name of the country as well as currency.

For Example:-For Example:- USDUSD GBPGBP JPYJPY CADCAD EUREUR

4) Commodity Market4) Commodity Market A market where commodities are traded is A market where commodities are traded is

referred to as “commodity market”. referred to as “commodity market”. commodities are raw or primary productscommodities are raw or primary products Bullion- gold, silver , platinum ,etcBullion- gold, silver , platinum ,etc Non-ferrous metals-copper, zinc, nickel, lead, Non-ferrous metals-copper, zinc, nickel, lead,

aluminum ,tin, etc aluminum ,tin, etc Energy- crude oil, natural gas ,etcEnergy- crude oil, natural gas ,etc Agricultural commodities-soya oil, palm Agricultural commodities-soya oil, palm

oil,coffee,pepper,cashew etcoil,coffee,pepper,cashew etc

Buyers and sellers from different location transact Buyers and sellers from different location transact business in an electronic Market place.business in an electronic Market place.

There are three types of regulated commodity market There are three types of regulated commodity market in India:in India:

i.i. Spot Market-otc marketSpot Market-otc market

ii.ii. Forward marketForward market

iii.iii. Derivatives market (Future & options) Derivatives market (Future & options)

The regulator of Commodity market is Forward The regulator of Commodity market is Forward market Commissionmarket Commission

The national Electronic Exchanges are:The national Electronic Exchanges are:

MCX (Mumbai),NCDEX (Mumbai),NMCE MCX (Mumbai),NCDEX (Mumbai),NMCE (Ahmedabad),ICEX ltd (Gurgaon)(Ahmedabad),ICEX ltd (Gurgaon)

Financial IntermediariesFinancial Intermediaries

Financial intermediary Financial intermediary is a special financial is a special financial entity, which performs the role of efficient entity, which performs the role of efficient allocation of funds, when there are conditions that allocation of funds, when there are conditions that make it difficult for lenders or investors of funds to make it difficult for lenders or investors of funds to deal directly with borrowers of funds in financial deal directly with borrowers of funds in financial markets. markets.

Financial intermediaries include depository Financial intermediaries include depository institutions, insurance companies, regulated institutions, insurance companies, regulated investment companies, investment banks, pension investment companies, investment banks, pension funds.funds.

Financial Intermediaries Financial Intermediaries

Commercial banks Commercial banks Non Banking Financial Companies Non Banking Financial Companies

(NBFC’s)(NBFC’s) Primary dealers (PD’s)Primary dealers (PD’s) Financial institutions (FI’s)Financial institutions (FI’s) Cooperative banksCooperative banks

Equity & debt marketEquity & debt market

Stock exchangesStock exchanges BrokersBrokers Equity & debt raisersEquity & debt raisers Investment bankers (Merchant Investment bankers (Merchant

Bankers)Bankers) Foreign institutional investors (FII)Foreign institutional investors (FII) Depositaries Depositaries Mutual FundsMutual Funds Registrars Registrars

The financial intermediaries are engaged in:The financial intermediaries are engaged in:

obtaining funds from lenders or investorsobtaining funds from lenders or investors

lending or investing the funds that they borrow lending or investing the funds that they borrow to those who need funds.to those who need funds.

Asset transformation Asset transformation provides at least one of provides at least one of three economic functions:.three economic functions:. Risk reduction via diversification.Risk reduction via diversification.Cost reduction for contracting and information Cost reduction for contracting and information processing.processing.

REGULATORSREGULATORS

Financial System

Central Banking Authority

(RBI)

Capital Markets

Regulatory Authority

(SEBI)

Insurance and

Pension Regulators

(IRDA)

Central Banking Authority (RBI)Central Banking Authority (RBI)

Monetary ControlMonetary Control Supervision overSupervision over

Commercial banksCommercial banks NBFCsNBFCs Primary DealersPrimary Dealers Financial institutions Financial institutions Cooperative banksCooperative banks Clearing and settlement systemsClearing and settlement systems

Management of govt. debtManagement of govt. debt Banker to governmentBanker to government Lender of last resort to banksLender of last resort to banks Regulating money markets through monetary Regulating money markets through monetary

instruments (CRR, SLR, Bank Rate, REPO Rate) instruments (CRR, SLR, Bank Rate, REPO Rate)

Capital Markets Regulator Authority Capital Markets Regulator Authority (SEBI)(SEBI) Equity market and debt market supervision and Equity market and debt market supervision and

controlcontrol Supervision overSupervision over

Stock exchangesStock exchanges BrokersBrokers Equity &debt raisersEquity &debt raisers Investment bankers (merchant bankers)Investment bankers (merchant bankers) Foreign institutional investors (FII)Foreign institutional investors (FII) Custodians Custodians DepositoriesDepositories Mutual FundsMutual Funds Listed companiesListed companies Service providers to capital markets like registersService providers to capital markets like registers

Insurance and Pension Regulators Insurance and Pension Regulators (IRDA)(IRDA) Regulatory framework including rules and Regulatory framework including rules and

regulations for running insurance regulations for running insurance business.business.

Supervising all insurance companies both Supervising all insurance companies both in general and life insurance businessin general and life insurance business

Regulating pricing, investments and cost Regulating pricing, investments and cost structure of insurance companies.structure of insurance companies.

Regulating insurance brokers including Regulating insurance brokers including agencies both individuals and banksagencies both individuals and banks

PensionsPensions Framing rules for pension fundsFraming rules for pension funds Regulating all pension funds Regulating all pension funds

Introduction to Financial Market

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