Amity Center for elearning
F-2,Block, Amity Campus
Sec-125, Nodia (UP)
India 201303ASSIGNMENTS
PROGRAM:
SEMESTER-ISubject Name : Financial System
Study COUNTRY : Sudan LC
Permanent Enrollment Number (PEN) : MFC001652014-2016014
Roll Number : AMF107 (T)
Student Name : SOMAIA TAMBAL YOUSIF ELMALIK
INSTRUCTIONS
a) Students are required to submit all three assignment
sets.ASSIGNMENTDETAILSMARKS
Assignment AFive Subjective Questions10
Assignment BThree Subjective Questions + Case Study10
Assignment C45 Objective Questions10
b) Total weightage given to these assignments is 30%. OR 30
Marksc) All assignments are to be completed as typed in word/pdf.d)
All questions are required to be attempted.e) All the three
assignments are to be completed by due dates (specified from time
to time) and need to be submitted for evaluation by Amity
University.f) The evaluated assignment marks will be made available
within six weeks. Thereafter, these will be destroyed at the end of
each semester.
g) The students have to attach a scan signature in the
form.Signature:
Date
:_________30 January 2015_______________________
( ) Tick mark in front of the assignments submittedAssignment
AAssignment BAssignment C
Financial SystemASSIGNMENT- A (Attempt these five analytical
questions)Q1.What do you understand by financial system of a
country? Explain its definition, significance and structure?
Introduction to Financial System: A financial system plays a
vital role in the economic growth of a country. It intermediates
with the flow of funds between those who save a part of their
income to those who invest in productive assets. It mobilizes and
usefully allocates scarce resources of a country. A financial
system is a complex well integrated set of sub systems of financial
institutions, markets, instruments and services which facilitates
the transfer and allocation of funds, efficiently and effectively.
The financial system is possibly the most important institutional
and functional vehicle for economic transformation. Finance is a
bridge between the present and the future and whether it is the
mobilization of savings or their efficient, effective and equitable
allocation for investment, it is the success with which the
financial system performs its functions that sets the pace for the
achievement of broader national objectives.Significance and
Definition: The term financial system is a set of inter-related
activities/services working together to achieve some predetermined
purpose or goal. It includes different markets, the institutions,
instruments, services and mechanisms which influence the generation
of savings, investment capital formation and growth.Van Horne
defined the financial system as the purpose of financial markets to
allocate savings efficiently in an economy to ultimate users either
for investment in real assets or for consumption. Christy has
opined that the objective of the financial system is to "supply
funds to various sectors and activities of the economy in ways that
promote the fullest possible utilization of resources without the
destabilizing consequence of price level changes or unnecessary
interference with individual desires." According to Robinson, the
primary function of the system is "to provide a link between
savings and investment for the creation of new wealth and to permit
portfolio adjustment in the composition of the existing wealth."
From the above definitions, it may be said that the primary
function of the financial system is the mobilization of savings,
their distribution for industrial investment and stimulating
capital formation to accelerate the process of economic growth.
The process of savings, finance and investment involves
financial institutions, markets, instruments and services. Above
all, supervision control and regulation are equally significant.
Thus, financial management is an integral part of the financial
system. On the basis of the empirical evidence, Goldsmith said that
"... a case for the hypothesis that the separation of the functions
of savings and investment which is made possible by the
introduction of financial instruments as well as enlargement of the
range of financial assets which follows from the creation of
financial institutions increase the efficiency of investments and
raise the ratio of capital formation to national production and
financial activities and through these two channels increase the
rate of growth"
The inter-relationship between varied segments of the economy is
illustrated below:
A financial system provides services that are essential in a
modern economy. The use of a stable, widely accepted medium of
exchange reduces the costs of transactions. It facilitates trade
and, therefore, specialization in production. Financial assets with
attractive yield, liquidity and risk characteristics encourage
saving in financial form. By evaluating alternative investments and
monitoring the activities of borrowers, financial intermediaries
increase the efficiency of resource use. Access to a variety of
financial instruments enables an economic agent to pool, price and
exchange risks in the markets. Trade, the efficient use of
resources, saving and risk taking are the cornerstones of a growing
economy. In fact, the country could make this feasible with the
active support of the financial system. The financial system has
been identified as the most catalyzing agent for growth of the
economy, making it one of the key inputs of development.The
Financial Structure of the Financial System in India:The
Organization of the Financial System in India:The Indian financial
system is broadly classified into two broad groups:
(i) Organized sector and (ii) Unorganized sector."The financial
system is also divided into users of financial services and
providers. Financial institutions sell their services to
households, businesses and government. They are the users of the
financial services. The boundaries between these sectors are not
always clear cut.
In the case of providers of financial services, although
financial systems differ from country to country, there are many
similarities. Major constituents of a financial system are as
follows:
(i) Central bank
(ii) Banks
(iii) Financial institutions
(iv) Money and capital markets and
(v) Informal financial enterprises.
(i) Organized Indian Financial System:The organized financial
system comprises of an impressive network of banks, other financial
and investment institutions and a range of financial instruments,
which together function in fairly developed capital and money
markets. Short term funds are mainly provided by the commercial and
cooperative banking structure. Nine-tenth of such banking business
is managed by twenty-eight leading banks which are in the public
sector. In addition to commercial banks, there is the network of
cooperative banks and land development banks at state, district and
block levels. With around two-third share in the total assets in
the financial system, banks play an important role. Of late, Indian
banks have also diversified into areas such as merchant banking,
mutual funds, leasing and factoring.
The organized financial system comprises the following
sub-systems:
1. Banking system
2. Cooperative system
3. Development Banking system
(i) Public sector
(ii) Private sector
4. Money markets and
5. Financial companies/institutions.
Over the years, the structure of financial institutions in India
has developed and become broad based. The system has developed in
three areas - state, cooperative and private. Rural and urban areas
are well served by the cooperative sector as well as by corporate
bodies with national status. There are more than 4, 58,782
institutions channelizing credit into the various areas of the
economy.
(ii) Unorganized Financial SystemOn the other hand, the
unorganized financial system comprises of relatively less
6controlled moneylenders, indigenous bankers, lending pawn brokers,
landlords, traders etc. This part of the financial system is not
directly amenable to control by the Reserve Bank of India (RBI).
There are a host of financial companies, investment companies and
chit funds etc., which are also not regulated by the RBI or the
government in a systematic manner.
However, they are also governed by rules and regulations and
are, therefore within the orbit of the monetary authorities.
Formal and Informal Financial Systems:The financial systems of
most developing countries are characterized by co-existence and
cooperation between formal and informal financial sectors. This
co-existence of two sectors is commonly referred to as financial
dualism The formal financial sector is characterized by the
presence of an organized, institutional and regulated system which
caters to the financial needs of the modern spheres of economy; the
informal sector is an unorganized, non-institutional and
non-regulated system dealing with the traditional and rural spheres
of the economy.
Components of formal financial system:The formal financial
system consists of four segments or components. These are:
Financial Institutions, Financial markets, financial instruments
and financial services.
Financial Institutions: Financial Institutions are
intermediaries that mobilize savings and facilitate the allocation
of funds in an efficient manner.
Financial institutions can be classified as banking and
non-banking financial institutions. Banking institutions are
creators of credit while non-banking financial institutions are
purveyors of credit. While the liabilities of banks are part of the
money supply, this may not be true of non-banking financial
institutions. Financial institutions can also be classified as the
term finance institutions such as IDBI (Industrial development bank
of India) ICICI (Industrial credit and investment corporation of
India) etc.Financial Markets:
Financial markets are the mechanism enabling participants to
deal in financial claims. The markets also provide a facility in
which their demands and requirements interact to set a price for
such claims. The main organized financial markets in a country are
normally money market and capital market. The first is market for
short term securities while the second is a market for long term
securities, i.e. securities having maturity period of one year or
more.
Financial markets are also classified as primary, market and
secondary market. While the primary market deals in new issues, the
secondary market deals for trading in outstanding or existing
securities. There are two components of the secondary market, OTC
(over the counter) market and Exchange traded market. The
government securities market is an OTC market, spot trades are
negotiated or traded for immediate delivery and payment while in
the exchange traded market, trading takes place over a trading
cycle in stock exchanges. Derivatives markets are OTC in some
countries and exchange traded in some other countries.
Financial Instrument: A financial instrument is a claim against
a person or an institution for the payment at a future date a sum
of money and/or a periodic payment in the form of interest or
dividend. The term and/or implies that either of the payments will
be sufficient but both of them may be promised.
Financial securities may be primary or secondary securities.
Primary securities are also termed as direct securities as they are
directly issued by the ultimate borrowers of the funds to the
ultimate savers. Examples of primary or direct securities include
equity shares and debentures. Secondary securities are also
referred to as indirect securities, as they are issued by financial
intermediaries to the ultimate savers. Bank deposits, mutual fund
units, and insurance policies are secondary securities.
Financial instruments differ in terms of marketability,
liquidity, reversibility, type of options, return, risk and
transaction costs. Financial instruments help the financial markets
and the financial intermediaries to perform the important role of
channelizing funds from lenders to borrowers.
Financial Services: Financial intermediaries provide key
financial services such as merchant banking, leasing, hire
purchase, credit-rating, and so on. Financial services rendered by
the financial intermediaries bridge the gap between lack of
knowledge on the part of investors and increasing sophistication of
financial instruments and markets. These financial services are
vital for creation of firms, industrial expansion, and economic
growth.
Before investors lend money, they need to be reassured that it
is safe to exchange securities for funds. This reassurance is
provided by the financial regulator who regulates the conduct of
the market, and intermediaries to protect the investors interests.
The Reserve Bank of India regulates the money market and Securities
and Exchange Board of India (SEBI) regulates capital market.
Interaction among the Components:These four sub-systems do not
function in isolation. They are interdependent and interact
continuously with each other. Their interaction leads to the
development of a smoothly functioning financial system.
Financial institutions or intermediaries mobilize savings by
issuing different types of financial instruments which are traded
in financial markets. To facilitate the credit allocation process,
they acquire specialization and render specialized financial
services.
Financial intermediaries have close links with the financial
markets in the economy. Financial institutions acquire, hold, and
trade financial securities which not only help in the
credit-allocation process but also make the financial markets
larger, more liquid, and stable and diversified. Financial
intermediaries rely on financial markets to raise funds whenever
they are in need of some. This increases the competition between
financial markets and financial intermediaries for attracting
investors and borrowers. The development of new sophisticated
markets has led to the development of complex securities and
complex portfolios. The evaluation of these complex securities,
portfolios, and strategies requires financial expertise which
financial intermediaries provide through financial services.
Functions of the Financial System: A good financial system
serves in the following ways:
One of the important functions of a financial system is to link
the savers and investors and thereby help in mobilizing and
allocating the savings efficiently and effectively. By acting as an
efficient conduit for allocation of resources, it permits
continuous up gradation of technologies for promoting growth on a
sustained basis.
A financial system not only helps in selecting projects to be
funded but also inspires the operators to monitor the performance
of the investment. It provides a payment mechanism for the exchange
of goods and services and transfers economic resources through time
and across geographic regions and industries.
One of the most important functions of a financial system is to
achieve optimum allocation of risk bearing. It limits, pools, and
trades the risks involved in mobilizing savings and allocating
credit. An efficient financial system aims at containing risk
within acceptable limits and reducing the cost of gathering and
analyzing information to assist operators in taking decisions
carefully.
It makes available price-related information which is a valuable
assistance to those who need to take economic and financial
decisions.
A financial system minimizes situations where the information is
asymmetric and likely to affect motivations among operators or when
one party has the information and the other party does not. It
provides financial services such as insurance and pension and
offers portfolio adjustment facilities.
A financial system helps in the creation of a financial
structure that lowers the cost of transactions. This has a
beneficial influence on the rate of return to savers. It also
reduces the cost of borrowing. Thus, the system generates an
impulse among the people to save more.
A well-functioning financial system helps in promoting the
process of financial deepening and broadening. Financial deepening
refers to an increase of financial assets as a percentage of Gross
Domestic Product (GDP). Financial broadening refers to building an
increasing number and a variety of participants and
instruments.
Financial System Designs:
A financial system is a vertical arrangement of a
well-integrated chain of financial markets and financial
institutions for providing financial intermediation. Different
designs of financial systems are found in different countries. The
structure of the economy, its pattern of evolution, and political,
technical and cultural differences affect the design (type) of
financial system.
Two prominent polar designs can be identified among the
varieties that exist. At one extreme is the bank-dominated system,
such as in Germany, where a few large banks play a dominant role
and the stock market is not important. At the other extreme is the
market-dominated financial system, as in the US, where financial
markets play an important role while the banking industry is much
less concentrated.
In bank-based financial systems, banks play a pivotal role in
mobilizing savings, allocating capital, overseeing the investment
decisions of corporate managers, and providing risk-management
facilities. In market based financial systems, the securities
markets share centrestage with banks in mobilizing the societys
savings to firms, exerting corporate control, and easing risk
management.
The other major industrial countries fall in between these two
extremes. In India, banks have traditionally been the dominant
entities of financial intermediation. The nationalization of banks,
an administered interest rate regime, and the government policy of
favouring banks led to the predominance of a bank-based financial
system in India.
Financial MarketsFinancial markets are an important component of
the financial system. A financial market is a mechanism for the
exchange trading of financial products under a policy framework.
The participants in the financial markets are the borrowers
(issuers of securities), lender (buyers of securities), and
financial intermediaries.
Financial markets comprise two distinct types of markets:
(a) Money market
(b) Capital marketMoney market: A money market is a market for
short-term debt instruments (maturity below one year). It is a
highly liquid market wherein securities are bought and sold in
large denominations to reduce transaction costs. Call money market,
certificates of deposit, commercial paper, and treasury bills are
the major instruments/segments of the money market.
The function of a money market is
i. To serve as an equilibrating force that redistributes cash
balances in accordance with the liquidity needs of the
participants;
ii. To form a basis for the management of liquidity and money in
the economy by monetary authorities; and
iii. To provide a reasonable access to the users of short-term
money for meeting their requirements at realistic prices.
As it facilitates the conduct of monetary policy, a money market
constitutes a very important segment of the financial system.
Capital market: A capital market is a market for long-term
securities (equity and debt). The purpose of capital market is
to
i. Mobilize long-term savings to finance long-term
investments;
ii. Provide risk-capital in the form of equity or quasi-equity
to entrepreneurs;
iii. Encourage broader ownership to productive assets;
iv. Provide liquidity with a mechanism enabling the investor to
sell financial assets;
v. Lower the costs of transactions and information; and
vi. Improve the efficiency of capital allocation through a
competitive pricing mechanism.A capital market can be further
classified into primary and secondary markets. The primary market
is meant for new issues and the secondary market is a market where
outstanding issues are traded. In other words, the primary market
creates long-term instruments for borrowings, whereas the secondary
market provides liquidity through the marketability of these
instruments. The secondary market is also known as the stock
market.
Money Market and Capital MarketThere is strong link between the
money market and the capital market:
i. Often, financial institutions actively involved in the
capital market are also involved in the money market.
ii. Funds raised in the money market are used to provide
liquidity for longer-term investment and redemption of funds raised
in the capital market.
iii. In the development process of financial markets, the
development of money market typically precedes the development of
the capital market.Characteristics of Financial Markets:1.
Financial markets are characterized by a large volume of
transactions and a speed with which financial resources move from
one market to another.
2. There are various segments of financial markets such as stock
markets, bond markets primary and secondary segments, where savers
themselves decide when and where they should invest money.
3. There is scope of instant arbitrage among various markets and
types of instruments.
4. Financial markets are highly volatile and susceptible to
panic and distress selling as the behavior of a limited group of
operators can get generalized.
5. Markets are dominated by financial intermediaries who take
investment decisions as well as risks on behalf of their
depositors.
6. Negative externalities are associated with financial markets.
A failure in any one segment of these markets may affect many other
segments of the market, including the non-financial markets.
7. Domestic financial markets are getting integrated with
worldwide financial markets. The failure and vulnerability in a
particular domestic market can have international ramifications.
Similarly, problems in external markets can affect the functioning
of domestic markets.In view of the above characteristics, financial
markets need to be closely monitored and supervised.
Functions of Financial MarketsThe cost of acquiring information
and making transactions creates incentives for the emergence of
financial markets and institutions. Different types and
combinations of information and transaction costs motivate distinct
financial contracts, instruments, and institutions.
Financial markets perform various functions such as
a) Enabling economic units to exercise their time
preference;
b) Separation, distribution, diversification, and reduction of
risk;
c) Efficient payment mechanism;
d) Providing information about companies. This spurs investors
to make inquiries themselves and keep track of the companies
activities with a view to trading in their stock efficiently;
e) Transmutation or transformation of financial claims to suit
the preferences of both savers and borrowers;
f) Enhancing liquidity of financial claims through trading in
securities; g) Portfolio management.A variety of services is
provided by financial markets as they can alter the rate of
economic growth by altering the quality of these services.
Financial System and Economic Development:The role of financial
system in economic development has been a much discussed topic
among economists. Is it possible to influence the level of national
income, employment, standard of living, and social welfare through
variations in the supply of finance?
In what way financial development is affected by economic
development?
There is no unanimity of views on such questions. A recent
literature survey concluded that the existing theory on this
subject has not given any generally accepted model to describe the
relationship between finance and economic development.
The importance of finance in development depends upon the
desired nature of development. In the environment-friendly,
appropriate-technology-based, decentralized Alternative Development
Model, finance is not a factor of crucial importance. But even in a
conventional model of modem industrialism, the perceptions in this
regard vary a great deal.
One view holds that finance is not important at all. The
opposite view regards it to be very important. The third school
takes a cautionary view. It may be pointed out that there is a
considerable weight of thinking and evidence in favor of the third
view also. Let us briefly explain these viewpoints one by one.
In his model of economic growth, Solow has argued that growth
results predominantly from technical progress, which is exogenous,
and not from the increase in labor and capital. Therefore, money
and finance and the policies about them cannot contribute to the
growth process.Effects of Financial System on Saving and
Investment:It has been argued that men, materials, and money are
crucial inputs in production activities. The human capital and
physical capital can be bought and developed with money. In a
sense, therefore, money, credit, and finance are the lifeblood of
the economic system. Given the real resources and suitable
attitudes, a well-developed financial system can contribute
significantly to the acceleration of economic development through
three routes. First, technical progress is endogenous; human and
physical capital is its important sources and any increase in them
requires higher saving and investment, which the financial system
helps to achieve. Second, the financial system contributes to
growth not only via technical progress but also in its own right.
Economic development greatly depends on the rate of capital
formation. The relationship between capital and output is strong,
direct, and monotonic (the position which is sometimes referred to
as capital fundamentalism). Now, the capital formation depends on
whether finance is made available in time, in adequate quantity,
and on favorable terms-all of which a good financial system
achieves. Third, it also enlarges markets over space and time; it
enhances the efficiency of the function of medium of exchange and
thereby helps in economic development.
We can conclude from the above that in order to understand the
importance of the financial system in economic development, we need
to know its impact on the saving and investment processes. The
following theories have analyzed this impact:
(a) The Classical Prior Saving Theory,
(b) Credit Creation or Forced Saving or Inflationary Financing
Theory,
(c) Financial Repression Theory,
(d) Financial Liberalization Theory.
The Prior Saving Theory regards saving as a prerequisite of
investment, and stresses the need for policies to mobilize saving
voluntarily for investment and growth. The financial system has
both the scale and structure effect on saving and investment. It
increases the rate of growth (volume) of saving and investment, and
makes their composition, allocation, and utilization more optimal
and efficient. It activates saving or reduces idle saving; it also
reduces unfructified investment and the cost of transferring saving
to investment. How is this achieved? In any economy, in a given
period of time, there are some people whose current expenditures is
less than their current incomes, while there are others whose
current expenditures exceed their current incomes. In well-known
terminology, the former are called the ultimate savers or
surplus--spending-units, and the latter are called the ultimate
investors or the deficit-spending-units.
Modern economies are characterized:
(a) By the ever-expanding nature of business organizations such
as joint-stock companies or corporations,
(b) By the ever-increasing scale of production,
(c) By the separation of savers and investors, and
(d) By the differences in the attitudes of savers (cautious,
conservative, and usually averse to taking risks) and investors
(dynamic and risk takers).
In these conditions, which Samuelson calls the dichotomy of
saving and investment, it is necessary to connect the savers with
the investors. Otherwise, savings would be wasted or hoarded for
want of investment opportunities, and investment plans will have to
be abandoned for want of savings. The function of a financial
system is to establish a bridge between the savers and investors
and thereby help the mobilization of savings to enable the
fructification of investment ideas into realities. Figure below
reflects this role of the financial system in economic
development.
Relationship between Financial System and Economic
Development
A financial system helps to increase output by moving the
economic system towards the existing production frontier. This is
done by transforming a given total amount of wealth into more
productive forms. It induces people to hold fewer saving in the
form of precious metals, real estate land, consumer durables, and
currency, and to replace these assets by bonds, shares, units, etc.
It also directly helps to increase the volume and rate of saving by
supplying diversified portfolio of such financial instruments, and
by offering an array of inducements and choices to woo the
prospective saver. The growth of banking habit helps to activate
saving and undertake fresh saving. The saving is said to be
institution-elastic i.e., easy access, nearness, better return, and
other favorable features offered by a well-developed financial
system lead to increased saving.
A financial system helps to increase the volume of investment
also. It becomes possible for the deficit spending units to
undertake more investment because it would enable them to command
more capital. As Schumpeter has said, without the transfer of
purchasing power to an entrepreneur, he cannot become the
entrepreneur. Further, it encourages investment activity by
reducing the cost of finance and risk. This is done by providing
insurance services and hedging opportunities, and by making
financial services such as remittance, discounting, acceptance and
guarantees available. Finally, it not only encourages greater
investment but also raises the level of resource allocational
efficiency among different investment channels. It helps to sort
out and rank investment projects by sponsoring, encouraging, and
selectively supporting business units or borrowers through more
systematic and expert project appraisal, feasibility studies,
monitoring, and by generally keeping a watch over the execution and
management of projects.
The contribution of a financial system to growth goes beyond
increasing prior-saving-based investment. There are two strands of
thought in this regard. According to the first one, as emphasized
by Kalecki and Schumpeter, financial system plays a positive and
catalytic role by creating and providing finance or credit in
anticipation of savings. This, to a certain extent, ensures the
independence of investment from saving in a given period of time.
The investment financed through created credit generates the
appropriate level of income. This in turn leads to an amount of
savings, which is equal to the investment already undertaken. The
First Five Year Plan in India echoed this view when it stated that
judicious credit creation in production and availability of genuine
savings has also a part to play in the process of economic
development. It is assumed here that the investment out of created
credit results in prompt income generation. Otherwise, there will
be sustained inflation rather than sustained growth.
The second strand of thought propounded by Keynes and Tobin
argues that investment, and not saving, is the constraint on
growth, and that investment determines saving and not the other way
round. The monetary expansion and the repressive policies result in
a number of saving and growth promoting forces:
(a) If resources are unemployed, they increase aggregate demand,
output, and saving;
(b) If resources are fully employed, they generate inflation
which lowers the real rate of return on financial investments. This
in turn, induces portfolio shifts in such a manner that wealth
holders now invest more in real, physical capital, thereby
increasing output and saving;
(c) Inflation changes income distribution in favour of profit
earners (who have a high propensity to save) rather than wage
earners (who have a low propensity to save), and thereby increases
saving; and
(d) Inflation imposes tax on real money balances and thereby
transfers resources to the government for financing investment.
The extent of contribution of the financial sector to saving,
investment, and growth is said to depend upon its being free or
repressed (regulated). One school of thought argues that financial
repression and the low/ negative real interest rates which go along
with it encourage people
(i) To hold their saving in unproductive real assets,
(ii) To be rent -seekers because of non-market allocation of
investible funds
(iii) To be indulgent which lowers the rate of saving,
(iv) To misallocate resources and attain inefficient investment
profile, and
(v) To promote capital intensive industrial structure
inconsistent with the factor-endowment of developing countries.
Financial liberalisation or deregulation corrects these ill effects
and leads to financial as well as economic development. However, as
indicated earlier, some economists believe that financial
repression is beneficial.
Q2.Financial Markets are an important component of the financial
system, what are different types of financial markets?
ExplainFinancial Markets: A Financial Market can be defined as the
market in which financial assets are created or transferred. As
against a real transaction that involves exchange of money for real
goods or services, a financial transaction involves creation or
transfer of a financial asset. Financial Assets or Financial
Instruments represents a claim to the payment of a sum of money
sometime in the future and /or periodic payment in the form of
interest or dividend. Money Market- The money market is a wholesale
debt market for low-risk, highly-liquid, short-term instrument.
Funds are available in this market for periods ranging from a
single day up to a year. This market is dominated mostly by
government, banks and financial institutions.
Capital Market -The capital market is designed to finance the
long-term investments. The transactions taking place in this market
will be for periods over a year.
Forex Market - The Forex market deals with the multicurrency
requirements, which are met by the exchange of currencies.
Depending on the exchange rate that is applicable, the transfer of
funds takes place in this market. This is one of the most developed
and integrated market across the globe.
Credit Market- Credit market is a place where banks, Financial
Institutions and Non-Banking Financial Corporations lend short,
medium and long-term loans to corporate and individuals.
Constituents of a Financial System:
Financial Intermediation: Having designed the instrument, the
issuer should then ensure that these financial assets reach the
ultimate investor in order to garner the requisite amount. When he
borrower of funds approaches the financial market to raise funds,
mere issue of securities will not suffice. Adequate information of
the issue, issuer and the security should be passed on to take
place. There should be a proper channel within the financial system
to ensure such transfer. To serve this purpose, financial
intermediaries came into existence. Financial intermediation in the
organized sector is conducted by a wide range of institutions
functioning under the overall surveillance of the Reserve Bank of
India. In the initial stages, the role of the intermediary was
mostly related to ensure transfer of funds from the lender to the
borrower. This service was offered by banks, FIs, brokers, and
dealers. However, as the financial system widened along with the
developments taking place in the financial markets, the scope of
its operations also widened. Some of the important intermediaries
operating ink the financial markets include; investment bankers,
underwriters, stock exchanges, registrars, depositories,
custodians, portfolio managers, mutual funds, financial advertisers
financial consultants, primary dealers, satellite dealers,
self-regulatory organizations, etc. Though the markets are
different, there may be a few intermediaries offering their
services in more than one market e.g. underwriter. However, the
services offered by them vary from one market to
another.IntermediaryMarketRole
Stock ExchangeCapital MarketSecondary Market to securities
Investment BankersCapital Market, Credit MarketCorporate
advisory services, Issue of securities
UnderwritersCapital Market, Money MarketSubscribe to
unsubscribed portion of securities
Registrars, Depositories, CustodiansCapital MarketIssue
securities to the investors on behalf of the company and handle
share transfer activity
Primary Dealers Satellite DealersMoney MarketMarket making in
government securities
Forex DealersForex MarketEnsure exchange in currencies
Financial Instruments (a) Money Market Instruments: Money market
is a very important segment of the financial system of a country.
It is the market dealing in monetary assets of short term nature.
Short term funds up to one year and financial assets that are close
substitutes for money are dealt in the money market.
Features: The money Market is a whole sale market. The volumes
are very large and generally transactions are settled on daily
basis. Trading in the money market is conducted over the telephone
followed by written confirmation from both the borrowers and
lenders. There are large numbers of participants in the money
market: commercial banks, mutual funds, investment institutions,
financial institutions, and finally the central bank of a country.
The banks operations ensure that the liquidity and short term
interest rates are maintained at the levels consistent with the
objective of maintaining price and exchange rate stability. The
central bank occupies a strategic position in the money market. The
money market can obtain funds from central bank either by borrowing
or through sale of securities. The bank influences liquidity and
interest rates by open market operations, REPO transactions,
changes in Bank Rate , cash Reserve Requirements and by regulating
access to its accommodation. A well-developed money market
contributes to an effective implementation of the monetary
policy.Some of the important money market instruments are briefly
discussed below;1. Call/Notice Money
2. Treasury Bills3. Term Money4. Certificate of Deposit5.
Commercial Papers 1. Call /Notice-Money Market: Call/Notice money
is the money borrowed or lent on demand for a very short period.
When money is borrowed or lent for a day, it is known as Call
(Overnight) Money. Intervening holidays and/or Sunday are excluded
for this purpose. Thus money, borrowed on a day and repaid on the
next working day, (irrespective of the number of intervening
holidays) is "Call Money". When money is borrowed or lent for more
than a day and up to 14 days, it is "Notice Money". No collateral
security is required to cover these transactions. 2. Inter-Bank
Term Money: Inter-bank market for deposits of maturity beyond 14
days is referred to as the term money market. The entry
restrictions are the same as those for Call/Notice Money except
that, as per existing regulations, the specified entities are not
allowed to lend beyond 14 days.
3. Treasury Bills: Treasury Bills are short term (up to one
year) borrowing instruments of the union government. It is an IOU
of the Government. It is a promise by the Government to pay a
stated sum after expiry of the stated period from the date of issue
(14/91/182/364 days i.e. less than one year). They are issued at a
discount to the face value, and on maturity the face value is paid
to the holder. The rate of discount and the corresponding issue
price are determined at each auction.
4. Certificate of Deposits: Certificates of Deposit (CDs) is a
negotiable money market instrument and issued in dematerialized
form or as a usance Promissory Note, for funds deposited at a bank
or other eligible financial institution for a specified time
period. CDs are similar to traditional term deposits but are
negotiable and can be traded in the secondary market. It is often a
bearer security and there is a single payment principal and an
interest rate at the end of the maturity period. The bulk of the
deposits have a very short duration of 1,3 or 6 months. For long
term CDs there is a fixed coupon or a floating rate coupon. For CDs
with floating rate coupons, the life of CD is subdivided into sub
periods of usually six months. Interest is fixed at the beginning
of each period and is based on LIBOR or US Treasury bill rate or
primary rate5. Commercial Paper: CP is a note in evidence of the
debt obligation of the issuer. On issuing commercial paper the debt
obligation is transformed into an instrument. CP is thus an
unsecured promissory note privately placed with investors at a
discount rate to face value determined by market forces. CP is
freely negotiable by endorsement and delivery. In India a company
shall be eligible to issue CP provided - (a) the tangible net worth
of the company, as per the latest audited balance sheet, is not
less than Rs. 5 crores; (b) the working capital (fund-based) limit
of the company from the banking system is not less than Rs.4 crores
and (c) the borrowed account of the company is classified as a
Standard Asset by the financing banks (d) shares are listed on
stock exchange (e) current ratio is 1:33:1. The minimum maturity
period of CP is 7 days. The minimum credit rating shall be P-2 of
CRISIL or such equivalent rating by other agencies.
Usance: Commercial paper should be issued for a minimum period
of 30 days and a maximum of one year. No grace period is allowed
for payment and if the maturity period falls on a holiday it should
be paid on the previous working day. Every issue of commercial
paper is treated as a fresh issue.
Denomination: Commercial paper is issued in denomination of Rs 5
lakhs. But the minimum lot or investment is Rs 25 lakhs (face
value) per investor. The secondary market transactions can be Rs 5
lakhs of multiples thereof. Total amount to be proposed to be
issued should be raised within two weeks from the date on which the
proposal is taken on record by the bank.
Investor: Commercial paper can be issued to any person, banks,
companies and other registered corporate bodies and unincorporated
bodies. Issue to NRI does can only be on a non-repairable basis and
is non-transferable. The paper issued to the NRI should state that
it is non-repairable and non-endorsable
Procedure of Issue: Commercial paper is issued only through the
bankers who have sanctioned working capital limits to the company.
It is counted as a part of working capital. Unlike public deposits,
commercial paper really cannot augment working capital resources.
There is no increase in the overall short term borrowing
facilities.
(b) Capital Market Instruments: The capital market generally
consists of the following long term period i.e., more than one year
period, financial instruments; in the equity segment Equity shares,
preference shares, convertible preference shares, non-convertible
preference shares etc and in the debt segment debentures, zero
coupon bonds, deep discount bonds etc.
Hybrid Instruments: Hybrid instruments have both the features of
equity and debenture. This kind of instruments is called as hybrid
instruments. Examples are convertible debentures, warrants etc.
CAPITAL MARKET INSTRUMENTS:SHARES: Capital refers to the amount
invested in the company so that it can carry on its activities. In
a company capital refers to "share capital". The capital clause in
Memorandum of Association must state the amount of capital with
which company is registered giving details of number of shares and
the type of shares of the company. A company cannot issue share
capital in excess of the limit specified in the Capital clause
without altering the capital clause of the MA. The following
different terms are used to denote different aspects of share
capital:-1. Nominal, authorized or registered capital means the sum
mentioned in the capital clause of Memorandum of Association. It is
the maximum amount which the company raises by issuing the shares
and on which the registration fee is paid. This limit is cannot be
exceeded unless the Memorandum of Association is altered.
2. Issued capital means that part of the authorized capital
which has been offered for subscription to members and includes
shares allotted to members for consideration in kind also.
3. Subscribed capital means that part of the issued capital at
nominal or face value which has been subscribed or taken up by
purchaser of shares in the company and which has been allotted.
4. Called-up capital means the total amount of called up capital
on the shares issued and subscribed by the shareholders on capital
account. I.e. if the face value of a share is Rs. 10/- but the
company requires only Rs. 2/- at present, it may call only Rs. 2/-
now and the balance Rs.8/- at a later date. Rs. 2/- is the called
up share capital and Rs. 8/- is the uncalled share capital.
5. Paid-up capital means the total amount of called up share
capital which is actually paid to the company by the members. In
India, there is the concept of par value of shares. Par value of
shares means the face value of the shares. A share under the
Companies act, can either of Rs10 or Rs100 or any other value which
may be the fixed by the Memorandum of Association of the company.
When the shares are issued at the price which is higher than the
par value say, for example Par value is Rs10 and it is issued at
Rs15 then Rs5 is the premium amount i.e., Rs10 is the par value of
the shares and Rs5 is the premium. Similarly when a share is issued
at an amount lower than the par value, say Rs8, in that case Rs2 is
discount on shares and Rs10 will be par value.
Types of shares: Shares in the company may be similar i.e. they
may carry the same rights and liabilities and confer on their
holders the same rights, liabilities and duties. There are two
types of shares under Indian Company Law:-
1. Equity shares means that part of the share capital of the
company which are not preference shares.
2. Preference Shares means shares which fulfill the following 2
conditions. Therefore, a share which is does not fulfill both these
conditions is an equity share.
a. It carries Preferential rights in respect of Dividend at
fixed amount or at fixed rate i.e. dividend payable is payable on
fixed figure or percent and this dividend must paid before the
holders of the equity shares can be paid dividend.
b. It also carries preferential right in regard to payment of
capital on winding up or otherwise. It means the amount paid on
preference share must be paid back to preference shareholders
before anything in paid to the equity shareholders. In other words,
preference share capital has priority both in repayment of dividend
as well as capital.
Types of Preference Shares
1. Cumulative or Non-cumulative: A non-cumulative or simple
preference shares gives right to fixed percentage dividend of
profit of each year. In case no dividend thereon is declared in any
year because of absence of profit, the holders of preference shares
get nothing nor can they claim unpaid dividend in the subsequent
year or years in respect of that year. Cumulative preference shares
however give the right to the preference shareholders to demand the
unpaid dividend in any year during the subsequent year or years
when the profits are available for distribution. In this case
dividends which are not paid in any year are accumulated and are
paid out when the profits are available.
2. Redeemable and Non- Redeemable: Redeemable Preference shares
are preference shares which have to be repaid by the company after
the term of which for which the preference shares have been issued.
Irredeemable Preference shares means preference shares need not
repaid by the company except on winding up of the company. However,
under the Indian Companies Act, a company cannot issue irredeemable
preference shares. In fact, a company limited by shares cannot
issue preference shares which are redeemable after more than 10
years from the date of issue. In other words the maximum tenure of
preference shares is 10 years. If a company is unable to redeem any
preference shares within the specified period, it may, with consent
of the Company Law Board, issue further redeemable preference
shares equal to redeem the old preference shares including dividend
thereon. A company can issue the preference shares which from the
very beginning are redeemable on a fixed date or after certain
period of time not exceeding 10 years provided it comprises of
following conditions :-
1. It must be authorized by the articles of association to make
such an issue.
2. The shares will be only redeemable if they are fully paid
up.
3. The shares may be redeemed out of profits of the company
which otherwise would be available for dividends or out of proceeds
of new issue of shares made for the purpose of redeem shares.
4. If there is premium payable on redemption it must have
provided out of profits or out of shares premium account before the
shares are redeemed.
5. When shares are redeemed out of profits a sum equal to
nominal amount of shares redeemed is to be transferred out of
profits to the capital redemption reserve account. This amount
should then be utilized for the purpose of redemption of redeemable
preference shares. This reserve can be used to issue of fully paid
bonus shares to the members of the company.
3. Participating Preference Share or non-participating
preference shares: Participating Preference shares are entitled to
a preferential dividend at a fixed rate with the right to
participate further in the profits either along with or after
payment of certain rate of dividend on equity shares. A
non-participating share is one which does not such right to
participate in the profits of the company after the dividend and
capitals have been paid to the preference shareholders.
Sweat Equity and Employee Stock Options: Sweat Equity Shares
mean equity shares issued by the company to its directors and / or
employees at a discount or for consideration other than cash for
providing know how or making available the rights in the nature of
intellectual property rights or value additions. A company may
issue sweat equity shares of a class of shares already issued if
the following conditions are fulfilled:-i. A special resolution to
the effect is passed at a general meeting of the company
ii. The resolution specifies the number of shares, the current
market price, consideration, if any, and the class of employees to
whom the shares are to be issued
iii. At least 1 year has passed since the date on which the
company became eligible to commence business.
iv. In case of issue of such shares by a listed company, the
Sweat Equity Shares are listed on a recognized stock exchange in
accordance with SEBI regulations and where the company is not
listed on any stock exchange, the prescribed rules are complied
with.
DEBENTURES: A type of debt instrument that is not secured by
physical asset or collateral. Debentures are backed only by the
general creditworthiness and reputation of the issuer. Both
corporations and governments frequently issue this type of bond in
order to secure capital. Like other types of bonds, debentures are
documented in an indenture. Debentures have no collateral. Bond
buyers generally purchase debentures based on the belief that the
bond issuer is unlikely to default on the repayment. An example of
a government debenture would be any government-issued Treasury bond
(T-bond) or Treasury bill (T-bill). T-bonds and T-bills are
generally considered risk free because governments, at worst, can
print off more money or raise taxes to pay these types of debts. A
debenture is a long-term debt instrument used by governments and
large companies to obtain funds. It is defined as "any form of
borrowing that commits a firm to pay interest and repay capital. In
practice, these are applied to long term loans that are secured on
a firm's assets. Where securities are offered, loan stocks or bonds
are termed 'debentures' in the UK or 'mortgage bonds' in the
US.
The advantage of debentures to the issuer is they leave specific
assets burden free, and thereby leave them open for subsequent
financing. Debentures are generally freely transferable by the
debenture holder. Debenture holders have no voting rights and the
interest given to them is a charge against profit
There are two types of debentures:
1. Convertible Debentures, which can be converted into equity
shares of the issuing company after a predetermined period of
time.
2. Non-Convertible Debentures, which cannot be converted into
equity shares of the liable company. They usually carry higher
interest rates than the convertible ones
A convertible note (or, if it has a maturity of greater than 10
years, a "convertible debenture") is a type of bond that can be
converted into shares of stock in the issuing company or cash of
equal value, at some pre-announced ratio. It is a hybrid security
with debt- and equity-like features. Although it typically has a
low coupon rate, the holder is compensated with the ability to
convert the bond to common stock at an agreed upon price and
thereby participate in further growth in the company's equity
value.
From the issuer's perspective, the key benefit of raising money
by selling convertible bonds is a reduced cash interest payment.
However, in exchange for the benefit of reduced interest payments,
the value of shareholder's equity is reduced due to the stock
dilution expected when bondholders convert their bonds into new
shares. The convertible bond markets in the United States and Japan
are of primary global importance. These two domestic markets are
the largest in terms of market capitalization. Other domestic
convertible bond markets are often illiquid, and pricing is
frequently non-standardized.
USA: It is a highly liquid market compared to other domestic
markets. Domestic investors have tended to be most active within US
convertibles
Japan: In Japan, the convertible bond market is relatively more
regulated than other markets. It consists of a large number of
small issuers.
Europe: Convertible bonds have become an increasingly important
source of finance for firms in Europe. Compared to other global
markets, European convertible bonds tend to be of high credit
quality.
Asia (ex Japan): The Asia region provides a wide range of choice
for an investor. The maturity of Asian convertible bond markets
varies widely.
Canada: Canadian convertible bonds are exchange traded. Most of
the Canadian convertible bond market consists of unsecured
sub-investment grade bonds with high yields that are reflective of
the issuer's risk of default.
Non-Convertible Debentures are those that cannot be converted
into equity shares of the issuing company, as opposed to
Convertible debentures, which can be. Non-convertible debentures
normally earn a higher interest rate than convertible debentures
do.
Bonds: In finance, a bond is a debt security, in which the
authorized issuer owes the holders a debt and is obliged to repay
the principal and interest (the coupon) at a later date, termed
maturity. A bond is simply a loan in the form of a security with
different terminology: The issuer is equivalent to the borrower,
the bond holder to the lender, and the coupon to the interest.
Bonds enable the issuer to finance long-term investments with
external funds. Note that certificates of deposit (CDs) or
commercial paper are considered to be money market instruments and
not bonds. Bonds and stocks are both securities, but the major
difference between the two is that stock-holders are the owners of
the company (i.e., they have an equity stake), whereas bond-holders
are lenders to the issuing company. Another difference is that
bonds usually have a defined term, or maturity, after which the
bond is redeemed, whereas stocks may be outstanding indefinitely.
Issuing bonds: Bonds are issued by public authorities, credit
institutions, companies and supranational institutions in the
primary markets. The most common process of issuing bonds is
through underwriting. In underwriting, one or more securities firms
or banks, forming a syndicate, buy an entire issue of bonds from an
issuer and re-sell them to investors. Government bonds are
typically auctioned.Features of bonds: The most important features
of a bond are: Nominal, principal or face amountthe amount on which
the issuer pays interest, and which has to be repaid at the
end.
Issue pricethe price at which investors buy the bonds when they
are first issued, typically $1,000.00. The net proceeds that the
issuer receives are calculated as the issue price, less issuance
fees, times the nominal amount.
Maturity datethe date on which the issuer has to repay the
nominal amount. As long as all payments have been made, the issuer
has no more obligations to the bond holders after the maturity
date. The length of time until the maturity date is often referred
to as the term or tenure or maturity of a bond. The maturity can be
any length of time, although debt securities with a term of less
than one year are generally designated money market instruments
rather than bonds. Most bonds have a term of up to thirty years.
Some bonds have been issued with maturities of up to one hundred
years, and some even do not mature at all. In early 2005, a market
developed in Euros for bonds with a maturity of fifty years. In the
market for U.S. Treasury securities, there are three groups of bond
maturities:
short term (bills): maturities up to one year;
medium term (notes): maturities between one and ten years;
Long term (bonds): maturities greater than ten years.
Couponthe interest rate that the issuer pays to the bond
holders. Usually this rate is fixed throughout the life of the
bond. It can also vary with a money market index, such as LIBOR, or
it can be even more exotic. The name coupon originates from the
fact that in the past, physical bonds were issued which had coupons
attached to them. On coupon dates the bond holder would give the
coupon to a bank in exchange for the interest payment.
Coupon datesthe dates on which the issuer pays the coupon to the
bond holders. In the U.S., most bonds are semi-annual, which means
that they pay a coupon every six months. In Europe, most bonds are
annual and pay only one coupon a year.
Indentures and Covenantsan indenture is a formal debt agreement
that establishes the terms of a bond issue, while covenants are the
clauses of such an agreement. Covenants specify the rights of
bondholders and the duties of issuers, such as actions that the
issuer is obligated to perform or is prohibited from performing. In
the U.S., federal and state securities and commercial laws apply to
the enforcement of these agreements, which are construed by courts
as contracts between issuers and bondholders. The terms may be
changed only with great difficulty while the bonds are outstanding,
with amendments to the governing document generally requiring
approval by a majority (or super-majority) vote of the
bondholders.
Q3.What are characteristics and functions of financial
markets?Characteristics of Financial Markets: Financial markets are
characterized by a large volume of transactions and a speed with
which financial resources move from one market to another.
There are various segments of financial markets such as stock
markets, bond markets primary and secondary segments, where savers
themselves decide when and where they should invest money.
There is scope of instant arbitrage among various markets and
types of instruments.
Financial markets are highly volatile and susceptible to panic
and distress selling as the behavior of a limited group of
operators can get generalized.
Markets are dominated by financial intermediaries who take
investment decisions as well as risks on behalf of their
depositors.
Negative externalities are associated with financial markets. A
failure in any one segment of these markets may affect many other
segments of the market, including the non-financial markets.
Domestic financial markets are getting integrated with worldwide
financial markets. The failure and vulnerability in a particular
domestic market can have international ramifications. Similarly,
problems in external markets can affect the functioning of domestic
markets.In view of the above characteristics, financial markets
need to be closely monitored and supervised.
Functions of Financial Markets:The cost of acquiring information
and making transactions creates incentives for the emergence of
financial markets and institutions. Different types and
combinations of information and transaction costs motivate distinct
financial contracts, instruments, and institutions.Financial
markets perform various functions such as:(i) -Enabling economic
units to exercise their time preference; (ii) -Separation,
distribution, diversification, and reduction of risk;(iii)
-Efficient payment mechanism;
(iv) -Providing information about companies. This spurs
investors to make inquiries themselves and keep track of the
companies activities with a view to trading in their stock
efficiently;
(v) -Transmutation or transformation of financial claims to suit
the preferences of both savers and borrowers;
(vi) -Enhancing liquidity of financial claims through trading in
securities; and
(vii) -Portfolio management.A variety of services is provided by
financial markets as they can alter the rate of economic growth by
altering the quality of these services.
Functions of the Financial System: A good financial system
serves in the following ways:
One of the important functions of a financial system is to link
the savers and investors and thereby help in mobilizing and
allocating the savings efficiently and effectively. By acting as an
efficient conduit for allocation of resources, it permits
continuous up gradation of technologies for promoting growth on a
sustained basis.
A financial system not only helps in selecting projects to be
funded but also inspires the operators to monitor the performance
of the investment. It provides a payment mechanism for the exchange
of goods and services and transfers economic resources through time
and across geographic regions and industries.
One of the most important functions of a financial system is to
achieve optimum allocation of risk bearing. It limits, pools, and
trades the risks involved in mobilizing savings and allocating
credit. An efficient financial system aims at containing risk
within acceptable limits and reducing the cost of gathering and
analyzing information to assist operators in taking decisions
carefully.
It makes available price-related information which is a valuable
assistance to those who need to take economic and financial
decisions.A financial system minimizes situations where the
information is asymmetric and likely to affect motivations among
operators or when one party has the information and the other party
does not. It provides financial services such as insurance and
pension and offers portfolio adjustment facilities.
A financial system helps in the creation of a financial
structure that lowers the cost of transactions. This has a
beneficial influence on the rate of return to savers. It also
reduces the cost of borrowing. Thus, the system generates an
impulse among the people to save more.
A well-functioning financial system helps in promoting the
process of financial deepening and broadening. Financial deepening
refers to an increase of financial assets as a percentage of Gross
Domestic Product (GDP). Financial broadening refers to building an
increasing number and a variety of participants and
instruments.
Functions of Stock Exchange:
Stock Exchanges are established for the purpose of assisting,
regulating and controlling business of buying, selling and dealing
in securities. Stock Exchange provides a market for the trading of
securities to individuals and organizations seeking to invest their
saving or excess funds through the purchase of securities. It
provides a physical location for buying and selling securities that
have been listed for trading on that exchange. It establishes rules
for fair trading practices and regulates the trading activities of
its members according to those rules
The exchange itself does not buy or sell the securities, nor
does it set prices for them. It Provides:
Fair dealing: The exchange assures that no investor will have an
undue advantage over other market participants
Efficient Market: This means that orders are executed and
transactions are settled in the fastest possible way
Transparency: Investor make informed and intelligent decision
about the particular stock based on information. Listed companies
must disclose information in timely, complete and accurate manner
to the Exchange and the public on a regular basis Required
information include stock price, corporate conditions and
developments dividend, mergers and joint ventures, and management
changes etc
Doing Business: People who buy or sell stock on an exchange do
so through a broker The broker takes your order to the floor of the
exchange and looks for a broker representing someone wanting to buy
or sell. If a mutually agreeable price is found the trade is
made
Maintains active Trading: A continuous trading on exchange
increases the liquidity or marketability of the shares traded on
the stock exchange.
Fixation of prices: Price is determined by the transactions that
flow from investors demand and suppliers preferences. Usually the
traded process is made known to the public. This helps investors to
make better decisions.
Ensure safe and fair dealing: The rules regulations and by laws
of the stock exchanges provide a measure of safety to the
investors.
Aids in financing the industry: A continuous market for shares
provides a favorable climate for raising capital. The negotiability
of the securities helps the companies to raise long term funds.
This simulates capital formation.
Dissemination of information: Stock exchanges provide
information through various publications. They publish the shares
prices on daily basis along with the volume traded
Performance inducer: The prices of stocks reflect the
performance of the traded companies. This makes the corporate more
concerned with its public image and tries to maintain good
performance.
Self-regulating Organization: The stock exchanges are
self-regulating organizations .The stock exchanges monitor the
integrity of their members, brokers and listed companies and
clients. Continuous internal audit safeguards the investors against
unfair trade practices.
Regulatory Framework:
A three tier regulatory structure consists of Ministry of
Finance, the Financial Market regulator and the Central bank of the
country.
Ministry of Finance: The ministry of finance has the power to
approve the appointments of executive chiefs and nomination of
public representatives in the governing Boards of the stock
exchanges. It has the responsibility of preventing undesirable
speculation.
Central bank of a country: Central bank of a country through its
operations keeps a check on the operations of the stock market. It
regulates the business of stock exchange, other security market and
even the mutual funds. Registration and regulation of other market
intermediaries are also carried out by Central bank.
Financial Market Regulators: Other financial market regulators
are market intermediaries (Securities and Exchange Commission).They
function particularly when market is poorly organized.
They set minimum entry standards;
Requires to comply with standards for internal organization and
control;
Sets limits for initial and ongoing capital;
It ensures proper management of risk;
It sets high standards of conducts;
Provides procedures for dealing with the failure of an
intermediary.
Global Depositary Receipt (GDR):
Global Depository Receipt means any instrument in the form of a
depository receipt or certificate created by the overseas
depository bank outside India and issued to non-resident investors
against the issue of ordinary shares or Foreign Currency
Convertible Bonds of issuing company.
Among the Indian Companies, Reliance Industries Ltd. was the
first company to raise funds through a GDR issue.
Characteristics:
Global Depository Receipt (GDR) - certificate issued by
international bank, which can be subject of worldwide circulation
on capital markets.
A financial instrument used by private markets to raise capital
denominated in either U.S. dollars or euros.
GDR's are emitted by banks, which purchase shares of foreign
companies and deposit it on the accounts.
Global Depository Receipt facilitates trade of shares,
especially those from emerging markets. Prices of GDR's are often
close to values of related shares.
Indian companies are allowed to raise equity capital in the
international market through the issue of GDR/ADRs/FCCBs.
These are not subject to any ceilings on investment.
An applicant company seeking Government's approval in this
regard should have a consistent track record for good performance
(financial or otherwise) for a minimum period of 3 years. This
condition can be relaxed for infrastructure projects such as power
generation, telecommunication, petroleum exploration and refining,
ports, airports and roads. There is no restriction on the number of
GDRs/ADRs/FCCBs to be floated by a company or a group of companies
in a financial year. There are no end-use restrictions on GDRs/ADRs
issue proceeds, except for an express ban on investment in real
estate and stock markets. External Commercial Borrowings (ECB)
includes:
1. Commercial Bank Loans,
2. Buyers Credit,
3. Suppliers Credit,
4. Securitized Instruments Such As Floating Rate Notes, Fixed
Rate Bonds etc.
5. Credit From Official Export Credit Agencies,
6. Commercial Borrowings From The Private Sector Window Of
Multilateral Financial Institutions e.g. IFC
7. Investment by Foreign Institutional Investors (FIIs) In
Dedicated Debt Funds.
Characteristics of ECBs
ECB can be raised from any internationally recognized source
like banks, export credit agencies, suppliers of equipment, foreign
collaborations, foreign equity - holders, international capital
markets etc. ECBs can be used for any purpose (rupee-related
expenditure as well as imports) except for investment in stock
market and speculation in real estate. They are a source of finance
for Indian corporates for expansion of existing capacity as well as
for fresh investment. ECBs provided an additional source of funds
to the Indian companies, allowing them to supplement domestically
available resources and to take advantage of lower international
interest rates. The focus of the ECB policy is to provide
flexibility in borrowings by Indian corporates, and at the same
time maintain prudent limits for total external borrowings. The
guiding principles of the policy are to keep borrowing maturities
long, costs low, and encourage infrastructure and export sector
financing, which are crucial for the overall growth of the
economy.ECB entitlement for new projects
All infrastructure and Greenfield projects 50% of the total
project cost
Telecom Projects Up to 50% of the project cost (including
license fees)
Rights Issue: A rights issue involves selling securities in the
primary market by issuing rights to the existing shareholders. In
this method the company gives the privilege to its existing
shareholders for the subscription of the new shares on prorate
basis. A company making a rights issue sends a letter of offer
along with a composite application form consisting of four parts A,
B, C, and D. Part A is meant for acceptance of the offer. Part B is
used if the shareholder wants to renounce his rights in favor of
someone else. Part C is filled by the person in whose favor the
renunciation has been made. Part D is used to request the split of
the shares. The composite application form must be mailed to the
company within a stipulated period, which is usually 30 days. The
shares that remain unsubscribed will be offered to the public for
subscription. Sometimes an existing company can come out with a
simultaneous 'Right cum Public Issue'.The important characteristics
of rights issue are:
1) The number of shares offered on rights basis to each existing
shareholder is determined by the issuing company. The entitlement
of the existing shareholder is determined on the basis of existing
shareholding. For example one Rights share may be offered for every
2 or 3 shares held by the shareholder.
2) The issue price per Rights share is left to the discretion of
the company.
3) Rights are negotiable. The holder of rights can transfer
these rights shares to any other person, i.e. he can renounce his
right to subscribe to these shares in favor of any other person,
who can apply to the company for the allotment of these shares in
his name.
4) Rights can be exercised during a fixed period, which is
usually 30 days. If it is not exercised within this period, it
automatically lapses.
Financial System and Economic Development:The role of financial
system in economic development has been a much discussed topic
among economists. Is it possible to influence the level of national
income, employment, standard of living, and social welfare through
variations in the supply of finance?
In what way financial development is affected by economic
development?
There is no unanimity of views on such questions. A recent
literature survey concluded that the existing theory on this
subject has not given any generally accepted model to describe the
relationship between finance and economic development.
The importance of finance in development depends upon the
desired nature of development. In the environment-friendly,
appropriate-technology-based, decentralized Alternative Development
Model, finance is not a factor of crucial importance. But even in a
conventional model of modem industrialism, the perceptions in this
regard vary a great deal.
One view holds that finance is not important at all. The
opposite view regards it to be very important. The third school
takes a cautionary view. It may be pointed out that there is a
considerable weight of thinking and evidence in favor of the third
view also. Let us briefly explain these viewpoints one by one.
In his model of economic growth, Solow has argued that growth
results predominantly from technical progress, which is exogenous,
and not from the increase in labor and capital. Therefore, money
and finance and the policies about them cannot contribute to the
growth process.
Effects of Financial System on Saving and Investment:It has been
argued that men, materials, and money are crucial inputs in
production activities. The human capital and physical capital can
be bought and developed with money. In a sense, therefore, money,
credit, and finance are the lifeblood of the economic system. Given
the real resources and suitable attitudes, a well-developed
financial system can contribute significantly to the acceleration
of economic development through three routes. First, technical
progress is endogenous; human and physical capital is its important
sources and any increase in them requires higher saving and
investment, which the financial system helps to achieve. Second,
the financial system contributes to growth not only via technical
progress but also in its own right. Economic development greatly
depends on the rate of capital formation. The relationship between
capital and output is strong, direct, and monotonic (the position
which is sometimes referred to as capital fundamentalism). Now, the
capital formation depends on whether finance is made available in
time, in adequate quantity, and on favorable terms-all of which a
good financial system achieves. Third, it also enlarges markets
over space and time; it enhances the efficiency of the function of
medium of exchange and thereby helps in economic development.
We can conclude from the above that in order to understand the
importance of the financial system in economic development, we need
to know its impact on the saving and investment processes. The
following theories have analyzed this impact:
(a) The Classical Prior Saving Theory,
(b) Credit Creation or Forced Saving or Inflationary Financing
Theory,
(c) Financial Repression Theory,
(d) Financial Liberalisation Theory.
The Prior Saving Theory regards saving as a prerequisite of
investment, and stresses the need for policies to mobilize saving
voluntarily for investment and growth. The financial system has
both the scale and structure effect on saving and investment. It
increases the rate of growth (volume) of saving and investment, and
makes their composition, allocation, and utilization more optimal
and efficient. It activates saving or reduces idle saving; it also
reduces fructified investment and the cost of transferring saving
to investment. How is this achieved? In any economy, in a given
period of time, there are some people whose current expenditures is
less than their current incomes, while there are others whose
current expenditures exceed their current incomes. In well-known
terminology, the former are called the ultimate savers or
surplus--spending-units, and the latter are called the ultimate
investors or the deficit-spending-units.
Modern economies are characterized:
(a) By the ever-expanding nature of business organizations such
as joint-stock companies or corporations,
(b) By the ever-increasing scale of production,
(c) By the separation of savers and investors, and
(d) By the differences in the attitudes of savers (cautious,
conservative, and usually averse to taking risks) and investors
(dynamic and risk takers).
In these conditions, which Samuelson calls the dichotomy of
saving and investment, it is necessary to connect the savers with
the investors. Otherwise, savings would be wasted or hoarded for
want of investment opportunities, and investment plans will have to
be abandoned for want of savings. The function of a financial
system is to establish a bridge between the savers and investors
and thereby help the mobilization of savings to enable the
fructification of investment ideas into realities. Figure below
reflects this role of the financial system in economic
development.
Relationship between Financial System and Economic
Development
A financial system helps to increase output by moving the
economic system towards the existing production frontier. This is
done by transforming a given total amount of wealth into more
productive forms. It induces people to hold fewer saving in the
form of precious metals, real estate land, consumer durables, and
currency, and to replace these assets by bonds, shares, units, etc.
It also directly helps to increase the volume and rate of saving by
supplying diversified portfolio of such financial instruments, and
by offering an array of inducements and choices to woo the
prospective saver. The growth of banking habit helps to activate
saving and undertake fresh saving. The saving is said to be
institution-elastic i.e., easy access, nearness, better return, and
other favorable features offered by a well-developed financial
system lead to increased saving.
A financial system helps to increase the volume of investment
also. It becomes possible for the deficit spending units to
undertake more investment because it would enable them to command
more capital. As Schumpeter has said, without the transfer of
purchasing power to an entrepreneur, he cannot become the
entrepreneur. Further, it encourages investment activity by
reducing the cost of finance and risk. This is done by providing
insurance services and hedging opportunities, and by making
financial services such as remittance, discounting, acceptance and
guarantees available. Finally, it not only encourages greater
investment but also raises the level of resource allocation
efficiency among different investment channels. It helps to sort
out and rank investment projects by sponsoring, encouraging, and
selectively supporting business units or borrowers through more
systematic and expert project appraisal, feasibility studies,
monitoring, and by generally keeping a watch over the execution and
management of projects.
The contribution of a financial system to growth goes beyond
increasing prior-saving-based investment. There are two strands of
thought in this regard. According to the first one, as emphasized
by Kalecki and Schumpeter, financial system plays a positive and
catalytic role by creating and providing finance or credit in
anticipation of savings. This, to a certain extent, ensures the
independence of investment from saving in a given period of time.
The investment financed through created credit generates the
appropriate level of income. This in turn leads to an amount of
savings, which is equal to the investment already undertaken. The
First Five Year Plan in India echoed this view when it stated that
judicious credit creation in production and availability of genuine
savings has also a part to play in the process of economic
development. It is assumed here that the investment out of created
credit results in prompt income generation. Otherwise, there will
be sustained inflation rather than sustained growth.
The second strand of thought propounded by Keynes and Tobin
argues that investment, and not saving, is the constraint on
growth, and that investment determines saving and not the other way
round. The monetary expansion and the repressive policies result in
a number of saving and growth promoting forces:
(a) If resources are unemployed, they increase aggregate demand,
output, and saving;
(b) If resources are fully employed, they generate inflation
which lowers the real rate of return on financial investments. This
in turn, induces portfolio shifts in such a manner that wealth
holders now invest more in real, physical capital, thereby
increasing output and saving;
(c) Inflation changes income distribution in favor of profit
earners (who have a high propensity to save) rather than wage
earners (who have a low propensity to save), and thereby increases
saving; and
(d) Inflation imposes tax on real money balances and thereby
transfers resources to the government for financing investment.The
extent of contribution of the financial sector to saving,
investment, and growth is said to depend upon its being free or
repressed (regulated). One school of thought argues that financial
repression and the low/ negative real interest rates which go along
with it encourage people
(i) To hold their saving in unproductive real assets,
(ii) To be rent -seekers because of non-market allocation of
investible funds
(iii) To be indulgent which lowers the rate of saving,
(iv) To misallocate resources and attain inefficient investment
profile, and
(v) To promote capital intensive industrial structure
inconsistent with the factor-endowment of developing countries.
Financial liberalisation or deregulation corrects these ill effects
and leads to financial as well as economic development. However, as
indicated earlier, some economists believe that financial
repression is beneficial.
Q4.What are money market instruments? Explain
Money market instruments are:
Commercial bills Treasury Bills Certificate of deposit
Commercial paper Other instruments: FCCB, ADR, GDR
Financial Instruments: (a) Money Market Instruments Money market
is a very important segment of the financial system of a country.
It is the market dealing in monetary assets of short term nature.
Short term funds up to one year and financial assets that are close
substitutes for money are dealt in the money market.
Features: The money Market is a whole sale market. The volumes
are very large and generally transactions are settled on daily
basis. Trading in the money market is conducted over the telephone
followed by written confirmation from both the borrowers and
lenders. There are large numbers of participants in the money
market: commercial banks, mutual funds, investment institutions,
financial institutions, and finally the central bank of a country.
The banks operations ensure that the liquidity and short term
interest rates are maintained at the levels consistent with the
objective of maintaining price and exchange rate stability. The
central bank occupies a strategic position in the money market. The
money market can obtain funds from central bank either by borrowing
or through sale of securities. The bank influences liquidity and
interest rates by open market operations, REPO transactions,
changes in Bank Rate , cash Reserve Requirements and by regulating
access to its accommodation. A well-developed money market
contributes to an effective implementation of the monetary
policy.Some of the important money market instruments are briefly
discussed below;
1. Call/Notice Money
2. Treasury Bills3. Term Money4. Certificate of Deposit5.
Commercial Papers 1. Call /Notice-Money Market Call/Notice money is
the money borrowed or lent on demand for a very short period. When
money is borrowed or lent for a day, it is known as Call
(Overnight) Money. Intervening holidays and/or Sunday are excluded
for this purpose. Thus money, borrowed on a day and repaid on the
next working day, (irrespective of the number of intervening
holidays) is "Call Money". When money is borrowed or lent for more
than a day and up to 14 days, it is "Notice Money". No collateral
security is required to cover these transactions.
2. Inter-Bank Term Money
Inter-bank market for deposits of maturity beyond 14 days is
referred to as the term money market. The entry restrictions are
the same as those for Call/Notice Money except that, as per
existing regulations, the specified entities are not allowed to
lend beyond 14 days. 3. Treasury Bills
Treasury Bills are short term (up to one year) borrowing
instruments of the union government. It is an IOU of the
Government. It is a promise by the Government to pay a stated sum
after expiry of the stated period from the date of issue
(14/91/182/364 days i.e. less than one year). They are issued at a
discount to the face value, and on maturity the face value is paid
to the holder. The rate of discount and the corresponding issue
price are determined at each auction.
4. Certificate of Deposits
Certificates of Deposit (CDs) is a negotiable money market
instrument and issued in dematerialized form or as a usance
Promissory Note, for funds deposited at a bank or other eligible
financial institution for a specified time period. CDs are similar
to traditional term deposits but are negotiable and can be traded
in the secondary market. It is often a bearer security and there is
a single payment principal and a interest rate at the end of the
maturity period. The bulk of the deposits have a very short
duration of 1,3 or 6 months. For long term CDs there is a fixed
coupon or a floating rate coupon. For CDs with floating rate
coupons, the life of CD is subdivided into sub periods of usually
six months. Interest is fixed at the beginning of each period and
is based on LIBOR or US Treasury bill rate or primary rate
5. Commercial Paper: CP is a note in evidence of the debt
obligation of the issuer. On issuing commercial paper the debt
obligation is transformed into an instrument. CP is thus an
unsecured promissory note privately placed with investors at a
discount rate to face value determined by market forces. CP is
freely negotiable by endorsement and delivery. In