N. L.

Dalmia
Institute of Management Studies and Research
(A School of Excellence of N.L. Dalmia Educational Society )

Financial Markets & Institutions

-Prof. Ruchika Agarwal

Overview of Financial Markets

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The Financial System

Funds Deposits/Shares Financial Institutions
Commercial Banks Insurance companies Mutual Funds Provident Funds NBFCs

Funds Loans

Suppliers of Funds Individuals Businesses Governments

Demanders of Funds Individuals Businesses Governments

Financial Markets Funds Securities

Primary Mkts., Secondary Mkts. Money Markets, Capital Markets Bond Markets Forex Markets Derivative Markets Commodities Market FMI

Funds Securities

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Financial Reforms in India

The financial sector reforms initiated from the early 1990s. Few of the examples of reforms are: Removal of financial repression Creation of efficient & profitable financial sector Enable price discovery, particularly, by the market determination of interest rates that then helps in efficient allocation of resources. Provide operational and function autonomy to institutions Prepare the financial system for increasing international competition.
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Classification of Financial Markets

Seasoning of Claim
Primary Market Secondary Market Debt Market Equity Market Money Market Capital Market

Nature of the Claim

Maturity of the claim

Timing of Delivery

Spot/Cash Market Derivative Market

Exchange - Traded Over-the-counter

Organizational Structure

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Seasoning of Claim
It depends on whether the claims represents new issues or outstanding issues. Primary markets The market where issuer sells new claims. Most of the transactions are arranged through financial institutions called investment banks. IBs seeks to guarantee a fixed price for the firm. It buys the whole issue at a fixed price and then resells the issue.
Fund Users (Corp.) u/w with Investment Bank Suppliers of funds (Investors)

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Seasoning of Claim
Initial Public Offer (IPO)
Pre-Issue Activities Prospectus Review Distribution of prospectus

Initialization

Listing

Price fixing

Public issue

Follow on Public Offer (FPO) An already listed & publicly traded company may issue an FPO

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Seasoning of Claim
Secondary Markets: Once the securities are issued in the primary markets, they are then traded i.e. sold in the secondary market. The original issuer of securities is not involved. Secondary markets provide liquidity and an opportunity to diversify. The instruments are stocks, bonds, forex, derivatives, mutual funds etc. The price in the secondary market provides a feedback to corp. as to how well they are performing or effectively utilizing the funds.
Financial Markets
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Securities Brokers
FMI

Other suppliers Of funds

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Classification of Financial Markets

Seasoning of Claim
Primary Market Secondary Market Debt Market Equity Market Money Market Capital Market

Nature of the Claim

Maturity of the claim

Timing of Delivery

Spot/Cash Market Derivative Market

Exchange - Traded Over-the-counter

Organizational Structure

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Nature of the Claim

Debt Market Financial market for fixed claims in terms of interest rates. Interest rates represents the promised return on debt instruments.

In India, the interest rates are substantially market driven.

Key rates in India are: Repo rate (6.25%) Bank Rate (6.00%) Prime lending rate (12.25 12.50%)
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Nature of the Claim

Equity Market Financial market for residual claims Equity instruments do not promise a fixed return but represents an ownership interest. Return here comes from two sources: Dividend Yield & Capital Yield Other ratios used for evaluating the performance of an investment center : ROC, ROE, EVA Some securities have characteristics of both equity & debt. Ex Preference shares
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Classification of Financial Markets

Seasoning of Claim
Primary Market Secondary Market Debt Market Equity Market Money Market Capital Market

Nature of the Claim

Maturity of the claim

Timing of Delivery

Spot/Cash Market Derivative Market

Exchange - Traded Over-the-counter

Organizational Structure

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Maturity of the Claim

Money Market Market for the short-term financial claims i.e. debt securities or other instruments with maturities of one year or less. Examples are T-bills, commercial papers, repurchase agreements, certificate of deposits etc. Money market denotes inter-bank market where the banks borrow and lend among themselves to meet the short term credit and deposit needs of the economy. It is a place where large institutions and government manage their short-term cash needs. An important function of the money market is to provide a focal point for interventions of the RBI to influence the liquidity in the financial system and implement other monetary policy measures. EX CRR (6%), SLR(24%).

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Maturity of the Claim

Capital Markets Market for long-term financial claims. Markets that trade debt (bonds) and equity (stocks) instruments with maturities of more than a year. Major suppliers of securities are corporations & govt. Major suppliers of funds are households. These are generally riskier than money markets and hence, capital market securities must promise to pay a higher rate of return to attract funds.

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Maturity of the Claim

Stock Market This is a market where for the trading of company shares and derivatives is done at a market driven price. The shares are listed on stock exchanges. BSE is the oldest stock exchange in Asia (established in 1875) and the first in the country to be granted permanent recognition under the Securities Contract Regulation Act, 1956. Bond Market Bonds are interest bearing debt certificates. Bonds in India may be issued by the large private organizations and government company. The Bond Market in India with the liberalization has been transformed completely. It plays an important role in fund raising for developmental ventures. Bonds are issued and sold to the public for funds. Important features to look for in the bond market are interest rate or coupon rate and maturity.
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Classification of Financial Markets

Seasoning of Claim
Primary Market Secondary Market Debt Market Equity Market Money Market Capital Market

Nature of the Claim

Maturity of the claim

Timing of Delivery

Spot/Cash Market Derivative Market

Exchange - Traded Over-the-counter

Organizational Structure

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Timing of delivery
Spot/Cash Market The spot market or cash market is a public financial market, in which financial instruments or commodities are traded for immediate delivery. A spot market can be an organized market or over the counter. Spot markets can operate wherever the infrastructure exists to conduct the transaction. The rate which is quoted for immediate settlement is known as spot rate or spot price.

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Timing of delivery
Derivative Market Delivery occurs at a predetermined price & time in future.

Financial Derivative Market A derivative security is a financial security whose payoffs are linked to another, previously issued security. The underlying securities here are stocks, currencies, bonds & other interest rate bearing securities.
It is an agreement b/w two parties to exchange a standard quantity of an asset at a predetermined price on a specified date in future. Derivative contracts can be used for hedging.
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Timing of delivery
Examples are forwards, futures, options, & swaps. Forwards Traded over the counter Liquidity & counterparty risk Futures Standardized forward contracts traded on exchanges. Ex Stock futures, currency futures etc.

Options It is the right but not the obligation to buy & sell. The right to buy & sell comes at a premium.
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Timing of delivery
Swaps Contract whereby parties agree to exchange obligations that each of them have under their respective underlying contracts. Ex Interest rate swaps, Currency swaps Exiting a swap agreement Buy Out the Counterparty Enter an Offsetting Swap Sell the Swap to Someone Else Use a Swaption
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Timing of Delivery
Commodities Derivative Market Commodity derivatives are investment tools that allow investors to profit from certain items without possessing them. Commodity trading is an interesting option for those who wish to diversify from the traditional options like shares, bonds and portfolios. Commodity Exchange is an exchange for buying and selling commodities for future delivery. Three multi commodity exchanges have been set up in the country to facilitate this for the retail investors : Multi Commodity Exchange (MCX) National Commodity and Derivatives Exchange (NCDEX) National Multi-Commodity Exchange (NMCE) The commodities and future market in the country is regulated by Forward Markets commission (FMC).
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Timing of Delivery
Issues in Commodity derivatives The warehousing & Standardization Cash versus physical settlement Regulatory Authority Lack of economy of scale Tax & Legal Bottlenecks Commodity Options

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Classification of Financial Markets

Seasoning of Claim
Primary Market Secondary Market Debt Market Equity Market Money Market Capital Market

Nature of the Claim

Maturity of the claim

Timing of Delivery

Spot/Cash Market Derivative Market

Exchange - Traded Over-the-counter

Organizational Structure

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Organizational Structure
Exchange traded Characterized by a centralized organization with standardized functions. Here, the exchange or the regulatory becomes the counter part to every transaction and delivery of securities/funds is guaranteed. Best price discovery & more liquidity due to large number of clients & participants.

Over the counter (OTC) A decentralized market of securities not listed on exchange and participants trade over the phone or through e-network. Counter party risk exists in OTC market. Most debt instruments are traded OTC with investment banks making markets in specific issues. If someone wants to buy or sell a bond, they call the bank that makes a market in that bond and ask for quotes. Many derivative instruments, including forwards, swaps are also traded OTC.
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Foreign Exchange Markets

The sensitivity of the value of cash flow of foreign investments to changes in the foreign currency price in terms of home currency is known as forex risk. Companies like Infosys, TCS face this risk. A transaction that involves the immediate exchange of currencies at the current (spot) rate is known as Spot transaction. A transaction that involves the exchange of currencies at a specified date in future and at a specified rate is known as forward transaction. The two main functions of the foreign exchange market are to determine the price of the different currencies in terms of one another and to transfer currency risk from more risk-averse participants to those more willing to bear it. A currency crisis can adversely impact the economy of a country. Ex- Asian Crisis of 1997.
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Financial Markets Regulatory Structure

The government has the responsibility for regulating the financial system. The two major regulatory arms of the government are : Reserve Bank of India (RBI) Its a bankers bank. Formulates & implements monetary & credit policies. Supervises credit institutions & promotes development of new institutions. Influences credit allocation. Securities Exchange Board of India (SEBI) Regulates the stock exchanges, market intermediaries & prohibits insider trading. Emphasizes on fair disclosure of information on securities to investors. In the primary markets, the prospectus pertaining to the IPO needs to be filed with the SEBI and the exchange. In the secondary markets, it ensures smooth running of exchanges and prevent excessive price fluctuations. Circuit-breaker is an example.
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Key Financial Intermediaries

Following are the key financial intermediaries in the Indian Financial system : Commercial Banks : Represents the most important financial intermediary in the Indian Financial System. Financial Institutions : Cater to the long-term financing needs of the industrial sector & meet Specialized financing requirements. Insurance Companies Mutual Funds: Mobilizes resources from investors & invest in various types of securities. Non-Banking Financial Companies : These are generally engage in leasing finance, housing finance etc. Non-Banking Financial Services Companies : This group consists of merchant bankers, credit rating agencies and depositors. Financial institutions act like an intermediary between the supplier of funds and users of funds. The intermediaries ensure proper monitoring of usage of funds and evaluate risk associated with the investments. The supplier of funds do have to face the price risk and the liquidity risk. FMI 6/25/2012 27

Key Financial Intermediaries

Services performed by financial intermediaries
Provides a payment system for the exchange of goods & services.

Provides a economies of scale in terms of monitoring costs, transactions costs.

Provide a way for managing price uncertainty and liquidity risk. Hedging, Diversification & Insurance FIs can better bear the risk of mismatching of maturities of their assets and liabilities. FIs such as mutual funds allows small investors to overcome constraints for buying assets imposed by large minimum denomination size. FIs help in superior credit allocation
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