Financial market

Introduction

·       A financial market is a marketplace which facilitates buyers and sellers to participate in the trading of financial assets such as bonds, currencies, equities, derivatives and other financial instruments. It provides a mechanism between the investors/lenders and the borrowers/users for the transfer of funds.

·       In the financial markets, the individual investors, Financial Institutions and other financial intermediaries are linked by trading rules and communication networks for the trading of various financial instruments and financial assets. The characteristics of financial markets include transparent pricing, trading regulations on costs and fees, and determination of prices of securities by the market forces.

Main function of Financial Market

·       It provides facilities for interaction between the investors and the borrowers.

·       It provides pricing information resulting from the interaction between buyers and sellers in the market when they trade the financial assets.

·       It provides security to dealings in financial assets.

·       Financial markets provide liquidity to various financial assets and financial instruments.

·       It ensures low cost of transactions and information.

Classification of financial markets

Ø  Financial markets are categorized as organized market and unorganized market.

Unorganized market

·       Unorganized market is those which are not governed and controlled by the central bank, and it mainly consists of money lenders, indigenous bankers etc. who provide credit facilities to the public.

Organized market

·       The financial markets which work according to the laws, rules, and regulations made by the government and supervised by the central bank of the country (RBI) or any other regulatory body are known as organized financial markets.

Organized financial markets are further classified as -

·       Money market which mainly deals with short term credit transactions.

·       Capital market which deals with the medium term and long-term credit and financial transactions.

Money Market

Introduction

·       The money market is the trade in short-term debt. It is a constant flow of cash between governments, corporations, banks, and financial institutions, borrowing and lending for a term as short as overnight and no longer than a year.

·       It exists so that businesses and governments that need cash to operate can get it quickly at a reasonable cost, and so that businesses that have more cash than they need can put it to use.

·       Money market instruments are basically debt instruments and include Treasury bills, Commercial Papers, Certificate of Deposits etc.

 

Functions of money market

·       Money markets ensure an equilibrium between the demand and supply of money and short-term funds through financial transactions.

·       It promotes economic growth by ensuring availability of funds to different sectors of the economy such as Industry, agriculture service sector etc.

·       Money market makes available sufficient finance to the trade and industry and provides a platform for discounting bills of exchange for them.

·       Money market provides a mechanism for Reserve Bank of India (RBI) to implement monetary policy.

·       It helps the government to meet its deficits through non-inflationary financial sources. Government issues treasury bills to raise short term loans.

·       It provides facilities for allocation of short-term funds through money market instruments and interbank transactions.

The important money market instruments are - 

Treasury bill

·       Treasury bills are the government securities issued by RBI on behalf of the central government to meet its fiscal deficits.

·       Treasury Bills were first issued in India in 1917. At present, the active T-Bills are 91-days T-Bills, 182-day T-Bills and 364-days T-Bills. The maturity period of these securities varies from 14 days to 364 days.

·       T-bills have an advantage over the other bills such as zero risk weightage associated with them. 

·       Treasury bills are further classified into two types viz. ordinary/regular treasury bills and ad hoc treasury bills.

Commercial bills

·       They are also called Trade Bills or Bills of Exchange. Commercial bills are drawn by one business firm to another in lieu of credit transactions. It is a written acknowledgment of the debt by the maker directing to pay a specified sum of money to a particular person.

·       They are short-term instruments generally issued for 90 days. These are freely marketable. Banks provide working capital finance to firms by purchasing the commercial bills at a discount; this is called ‘discounting of bills

·       These are negotiable and self liquidating financial instruments used to finance the sales of Corporate firms, in which the seller is the drawer while the buyer is the drawee.

Cash management bills (CMBs)

·       Cash Management Bills (CMBs) are short term bills issued by central government to meet its immediate cash needs. The bills are issued by the RBI on behalf of the government. Hence the CMBs are short-term money market instruments that help the government to meet its temporary cash flow mismatches. 

·       CMBs are issued first on May 12, 2010. The purpose of the mechanism is to enable the government to get short term money.

Certificates of Deposits (CDs)

·       Certificate of Deposit or CD is a fixed-income financial instrument governed under the Reserve Bank and India (RBI) issued in a dematerialized form. The amount at payout is assured from the beginning.

·       A CD can be issued by any All-India Financial Institution or Scheduled Commercial Bank. They are issued at a discount provided on face value. Like a fixed deposit (FD), a CD’s purpose is to denote in writing that you have deposited money in a bank for a fixed period and that bank will pay you interest on it based on the amount and duration of your deposit.

·       These are issued to the individuals, corporations and companies etc by scheduled commercial banks, excluding local area banks and regional rural banks.

·       The minimum amount issued through the certificate of deposit is rupees 1 lakh by a single user, and larger amounts are in the multiples of rupees 1 lakh.

·       For banks, the minimum maturity period of the certificate of deposit should not be less than 7 days and maximum maturity period should not be more than 1 year. For Financial Institutions, the minimum maturity period should not be less than 1 year and the maximum maturity period should not be more than 3 years.

Commercial papers (CPs)

·       The CP was introduced in 1990 on the recommendation of the Vaghul Committee.

·       A commercial paper is an unsecured promissory note issued by a corporate with a net worth of at least Rs 5 crore to the banks for short term loans.

·       These are issued at discount on face value for a period of 14 days to 12 months. These are issued in multiples of Rs 1 lakh subject to a minimum of Rs 25 lakh.

Call money

·       Call money deals with day to day cash requirement of banks. Banks which are faced with cash shortage borrow from other commercial banks for a period of 1-14 days. When banks borrow for one day it is known as call-money. Any money borrowed for more than 1 day but maximum of 14 days is known as notice money.

·       The rate at which these transactions take place is known as the call rate. Thus, banks resort to call money to fill temporary mismatches in funds and maintain short-term liquidity. It is the central point by which RBI is able to influence interest rates.

 

Disadvantages of Money Market:

·       Absence of Integration: The money market is basically divided into the Organized and Unorganized Sectors. The organized sector comprises the legal financial institutions backed by the RBI. The unorganized statement of it includes various institutions such as indigenous bankers, village money lenders, traders. There is lack of proper incorporation between these two segments.

·       Multiple rate of interest: In the money market, particularly the banks, there are variable rates of interests. These rates vary for lending, borrowing, government activities, etc. Many rates of interests create confusion among the investors.

·       Inadequate Funds or Resources: The economy with its seasonal structure suffer from frequent shortage of financial recourse. Lower income, lower savings, and lack of banking habits among people are some of the reasons for it.

·       Shortage of Investment Instruments: In the money market, various investment instruments such as Treasury Bills, Commercial Bills, Certificate of Deposits, Commercial Papers, etc. are used. But taking into account the size of the population and market these instruments are insufficient.

·       Shortage of Commercial Bill: It is observed that in money market, as many banks keep large funds for liquidity purpose, the use of the commercial bills is very limited. Correspondingly since a large number of transactions are preferred in the cash form, the scope for commercial bills are limited.

·       Lack of Systematized Banking System: There is huge network of commercial banks, still the banking system suffers from major flaws such as the NPA, huge losses, and poor efficiency. The absence of the organized banking system is major problem for money market.

·       Less number of Dealers: There are less dealers in the short-term assets who can act as mediators between the government and the banking system. The less number of dealers leads to the slow contact between the end lender and end borrowers.

Importance of the money market

·       The money market is a market for short term transactions. Hence it is responsible for the liquidity in the market. Following are the reasons why the money market is essential:

·       It maintains a balance between the supply of and demand for the monetary transactions done in the market within a period of 6 months to one year.

·       It enables funds for businesses to grow and hence is responsible for the growth and development of the economy.

·       It aids in the implementation of monetary policies.

·       It helps develop trade and industry in the country. Through various money market instruments, it finances working capital requirements. It helps develop the trade in and out of the country.

·       The short term interest rates influence long term interest rates. The money market mobilises the resources to the capital markets by way of interest rate control.

·       It helps in the functioning of the banks. It sets the cash reserve ratio and statutory liquid ratio for the banks. It also engages their surplus funds towards short term assets to maintain money supply in the market.

·       The current money market conditions are the result of previous monetary policies. Hence it acts as a guide for devising new policies regarding short term money supply.

·       Instruments like T-bills, help the government raise short term funds. Otherwise, to fund projects, the government will have to print more currency or take loans leading to inflation in the economy. Hence the money market is also responsible for controlling inflation.

 

Capital market

Introduction

·       Capital market provides and institutional arrangement for borrowing and lending of medium and long term funds.

·       The capital market provides a platform for marketing and trading of different securities. It includes all the long term borrowings from scheduled commercial banks, Financial Institutions, borrowings from foreign markets and capital raised by issuing various securities including shares, debentures, bond etc.

Classification of capital market

·       Capital market is classified into primary market and secondary market.

Primary market

·       The primary market is the part of the capital market that deals with the issuance and sale of securities to investors directly by the issuer. An investor buys securities that were never traded before. Primary markets create long term instruments through which corporate entities raise funds from the capital market.

·       The primary market deals with shares, debentures and other securities sold for the first time for raising long term capital. The corporate firms and companies follow the well defined rules during the auctioning of shares and debentures for the first time which is known as the initial public offer.

·       The funds raised by firms is generally used for improving their business and for the establishment of new business units etc. The merchant bankers, Financial Institutions, mutual funds and individual investors etc are the main players in the primary market.

·       The primary market does not indicate any specific marketplace but it refers to the activity of bringing in new issues of shares and debentures.

Benefits of primary market

·       Primary markets are considered as safer for investment as there are lower chances of manipulation of prices.

·       There is no requirement to time the market and all the investors get the shares at the same price.

·       The primary market is considered secure as primary research data is collected by the organisation which deploys the research.

·       The company which issues the initial public offer receives funds and issues new security certificates to its investors.

Secondary market

·       Secondary market deals with the buying and selling of existing securities. Trading of securities in the secondary market are done through the stock market or stock exchanges.

·       This stock exchange plays an important role in mobilizing medium and long term funds and provides liquidity to shares and debentures.

·       The secondary market is an organised market which deals with the regular trading of shares and debentures with high degree of security and transparency.

·       Secondary market creates liquidity in the existing securities and boosts new investments.

Benefits of the secondary market:

·       Secondary market provides investors the platform to recover their initial investment to a certain extent when they need funds.

·       Secondary market provides the opportunity for investors to get large interest by investing for a longer period of time.

Regulation of capital market - 

·       The four main legislations that govern the capital market are - 

1.     The SEBI Act, 1992 which establishes the SEBI with four-fold objectives of protection of the interests of investors in securities, development of the securities market, regulation of the securities market and matter connected therewith and incidental thereto.

2.     The Companies Act, 1956 which deals with issue, allotment and transfer of transfer of securities, disclosures to be made in public issues, underwriting, rights and bonus issues and payment of interest and dividends.

3.     The Securities Contracts Regulation Act, 1956 which provides for regulations of securities trading and the management of stock exchanges.

4.     The Depositories Act, 1996 which provides for establishment of depositories for electronic maintenance and transfer of ownership of demat securities.

 

Functions of capital market

·       To mobilize idle savings from the economy and ensure their utilisation and proper Investments.

·       The capital market provides incentives to savers in the form of interest or dividend and transfers funds to investors. Thus it leads to capital formation.

·       Capital market increases the overall production and productivity of the economy and expedites the economic growth and development.

·       Capital market ensures proper allocation of financial resources and helps in regulation over these resources so that funds can be directed in a qualitative manner.

·       Capital market ensures continuous availability of funds for long term investments. It is a liquid market in which the buyers and sellers can easily trade in financial securities.

Structure of the capital market

·       Capital market can be categorized into Financial Institutions and security market.

Financial Institutions-

·       The main role of Financial Institutions is to make available long term and medium term credit facilities. Financial Institutions are called classified as development Financial Institutions and financial intermediaries.

Ø  Development Financial Institutions are those which provide long term loan and credit facilities to industry, trade and Agriculture. It Includes IFCI, IDBI, LIC, ICICI, GIC etc.

Ø  Financial intermediaries: It includes mutual funds, Merchant Bank etc which ensures mobilisation of savings and their supply in the capital market.

Securities market

·       It is a part of the wider financial market were selling and buying of securities take place on demand supply basis. It can further be classified into government securities market and the corporate or industrial securities market.

Ø  Government securities market - Gilt edged market: government securities do not have the risk of default and hence they are known as gilt edged (or of the best quality). The government securities are risk free and both principal and interest are guaranteed. RBI has the responsibility to issue new government securities as it manages the public debt operations of both the union and the state governments. These securities are considered as most liquid debt instruments, and the market for these securities is large.

Ø  Industrial securities market deals with the trading of securities issued by corporate firms viz. Shares, bonds, and debentures. It consists of primary market dealing with new issues and secondary markets dealing with old securities through stock exchanges.

Examples of capital markets are given below.

·       Stock Market: A stock market, equity market or share market is the aggregation of buyers and sellers of stocks, which represent ownership claims on businesses

·       Bond Market: The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities

·       Currency and Foreign Exchange Markets: 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.

 

Major differences between money market and capital market

·       Money market deals with short term marketable securities whereas capital market deals with medium term and long term securities.

·       The securities in the money market have lower risk and are considered as a safer investment, whereas capital market securities comparatively have higher risks.

·       The liquidity of financial instruments is higher in the money market whereas liquidity is comparatively less in the capital market.

·       The central bank, scheduled commercial banks, non banking Financial Institutions etc mainly deal with the financial instruments of the money market. Whereas stock exchange, commercial bank, non banking institutions operate in the capital market.

·       The returns in the securities of the capital market are higher compared to the financial instruments of the money market.

·       Overall, the capital market is comparatively more organized than the money market.