CHAPTER 1

INTRODUCTION

Indian Financial System

Financial System refers to the financial needs of different sectors of the economy and the ways
and means to meet such needs efficiently and economically. Funds are required for meeting
various monetary needs. The financial needs are met from different sources and agencies.

The Indian financial system is as shown in the diagram below.

The formal financial system consists of four components:

 Financial institutions,
 Financial markets,
 Financial instruments and
 Financial services.

The financial system acts as a connecting link between savers of money and users of money and
thereby promotes faster economic and industrial growth. Thus financial system may be defined
as “a set of markets and institutions to facilitate the exchange of assets and risks.”

Efficient functioning of the financial system enables proper flow of funds from investors to
productive activities which in turn facilitates investment.
Classification of Financial Market in India
The types of financial markets are shown in the diagram below.

The financial markets are classified into two groups:

 Capital Market

A. Corporate Market
 Primary Market
 Secondary Market

B. Government Securities Markets

C. Long Term Loans Markets

 Term Loan Markets
 Mortgages Markets
 Financial Guarantees Markets

 Money Market

A. Unorganized Market
 Money Lenders
 Indigenous Bankers
 Chit Funds

B. Organized Money Market

 Treasury Bills
 Commercial Paper (CP)
 Certificate Of Deposit (CD) etc
 Call Money Market
 Commercial Bill Market

Capital Market

A capital market is an organized market. It provides long term finance for business. According to
Shri K.S. “Capital Market refers to the facilities and institutional arrangements for borrowing
and lending long-term funds.”

Capital Market is divided into three groups:

1. Industrial / Corporate Securities Market

It is a market for industrial securities. Corporate securities are equity and preference shares,
debentures and bonds of companies. Industrial security's market is very Sensitive and Active
Financial Market.

It can be divided into two groups: Primary and Secondary Market

 Primary Market: It is a market for new issue of securities, which are issued to the public for
first time. It is also called as New Issue Market.
 Secondary Market: In the secondary market, there is a sale of secondary securities. It is also
called as Stock Market. It facilitates buying and selling of securities.

2. Government Securities Market

In this market, government securities are bought and sold. It is also called as Gilt-Edged
Securities Market. The securities are issued in the form of bonds and credit notes. The buyers of
such securities are Banks, Insurance Companies, Provident funds, RBI and Individuals. These
securities may be of short-term or long term.
3. Long-Term Loans Market

Banks and Financial institutions provide long-term loans to firms, for modernization, expansion
and diversification of business.

Long-Term Loan Market can be divided into:

 Term Loans Market: Banks and Financial Institutions provide term loans to companies for a
period of one year. The financial institutions help in recognizing investment opportunities to
motivate emerging businessmen. They also give encouragement to modernization.
 Mortgages Market: It provides loans against securities of immovable assets like land and
buildings.
 Financial Guarantees Market: Financial Institutions (FIS) and banks provide financial
guarantees on behalf of their clients to third parties.

Money Market

Money Market is the market for short term funds i.e. for a period up to one year.

The money market is divided into two types:

1. Unorganized Market

Unorganized market consists of: Money lenders, Indigenous Bankers, Chit Funds, etc.

 Money Lenders: Money Lenders lend money to individuals at a high rate of interest.
 Indigenous Bankers: They operate like money lenders. They also accept deposits from
public.
 Chit Funds: These collect funds from members and provide loans to members and others.

2. Organized Money Market

Organized Markets work as per the rules and regulations of the RBI. RBI keeps a strict control
over the Organized Financial Market in India. Organized Market consists of: Treasury Bills,
Commercial Paper (CP), Certificate Of Deposit(CD), Call Money Market, Commercial Bill
Market.
 Treasury Bills: To raise short term funds treasury bills are issued by Government. It is
purchased by Commercial Banks. At present, Government issues 91 days and 364 days
treasury bills.
 Commercial Paper (CP): Commercial paper is issued by companies who are listed on Stock
Exchange. CP is issued at discount and repaid at face value. The maturity period ranges from
7 days to one year. CP's are issued in multiple of 5 lakh. The company that is issuing CP
must have tangible net worth of at least 4 crore.
 Certificate Of Deposit (CD): CD's are used by Commercial Banks and Financial Institutions
to raise finance from the market. The maturity period for CD's is between 7 days to 1 year.
CD's is issued at a discount and repaid at face value. CD's is issued for a minimum of 25
lakhs.
 Call Money Market: A loan which is taken or given for a very short period, i.e. for one day is
called Call Money Market. It involves lending and borrowing of money on a daily basis. No
security is required for these very short-term loans.
 Commercial Bill Market (CBM): This market deals with Bills of exchange. The drawer of
the bill can get the bills discounted with Commercial Banks. The Commercial Banks can get
the bills rediscounted with Financial Institutions.

Global Financial Markets

Trading of financial securities, derivatives, and other financial contracts takes place in two
settings:

- formal financial exchanges and

- loosely organized over-the-counter (OTC) markets.

Financial Exchanges

Financial exchanges are formalised trading institutions. Rights to trade are limited to members
and there are detailed and explicit rules governing the conduct of trading and the contracts or
securities that are traded. Exchanges also collect and disseminate pricing information and
facilitate post-trade risk management and final trade settlement.

Over-The-Counter Markets (OTC)

OTC refers to any financial market transaction that does not take place on a formal exchange.
The attraction of an OTC trade is that the buyer and seller are free to negotiate all the contractual
details. Participants do not, however, have the protection of exchange procedures and rules. Most
equity trading takes place through exchanges. The bulk of equity trading, world-wide, is
concentrated in a few major markets, mostly equity exchanges such as the NYSE, NASDAQ and
the London Stock Exchange. The five leading markets account for more than sixty percent of
equity market capitalisation and equity trading.

Other major Global financial markets for debt, foreign exchange and derivatives

Early markets for foreign exchange were the prototype for OTC arrangements. A market was
established at a location where buyers and sellers of currency could approach established dealers
and search for the best available exchange rate.

Modern OTC markets rely on telephones and screens to link buyers and sellers with the market
dealers but the basics of the market remain the same. Dealers quote both bid and ask prices to
prospective buyers and sellers Dealers make a profit from order flow, both directly from the bid-
ask spread and also by anticipating short-term price movements using their privileged access to
information on orders.

In doing so, the dealer is exposed to market risk from its holding of an inventory of currencies.

Inter Dealer Broker

In such OTC markets a key role in the transfer of risk is often played by the 'inter-dealer broker’
perhaps better referred to as the dealer's broker. Specialised firms where dealers may off load or
purchase inventory. They, together with the continuous process of search by buyers and sellers,
are the mechanism linking the market together. Market makers also operate in exchanges.
notably the 'specialists' in the New York Stock Exchange. But, almost all security exchanges
have found it more efficient to replace dealer market making with electronic order books. With
the exception of some government bonds, debt is traded on OTC markets rather than on
exchanges. This is the case even when, as is usual in Europe, bonds are listed on an exchange.

Issuers find it worthwhile to have a listing, demonstrating that they have satisfied certain
exchange rules about accounting and other disclosure standards, even when trading itself still
takes place outside of the exchange.

India Financial Market

The Indian Financial market talks about the primary market, FDIs, alternative investment
options, banking and insurance and the pension sectors, asset management segment as well. With
all these elements in the Indian Financial market, it happens to be one of the oldest across the
globe and is definitely the fastest growing and best among all the financial markets of the
emerging economies. The history of Indian capital markets spans back 200 years, around the end
of the 18th century. It was at this time that India was under the rule of the East India Company.
The capital market of India initially developed around Mumbai; with around 200 to 250
securities brokers participating in active trade during the second half of the 19th century.

Scope of the India Financial Market

The financial market in India at present is more advanced than many other sectors as it became
organized as early as the 19th century with the securities exchanges in Mumbai, Ahmedabad and
Kolkata. In the early 1960s, the number of securities exchanges in India became eight - including
Mumbai, Ahmedabad and Kolkata. Apart from these three exchanges, there was the Madras,
Kanpur, Delhi, Bangalore and Pune exchanges as well. Today there are 23 regional securities
exchanges in India.

The Indian stock markets till date have remained stagnant due to the rigid economic controls. It
was only in 1991, after the liberalization process that the India securities market witnessed a
flurry of IPOs serially. The market saw many new companies spanning across different industry
segments and business began to flourish.

The launch of the NSE (National Stock Exchange) and the OTCEI (Over the Counter Exchange
of India) in the mid 1990s helped in regulating a smooth and transparent form of securities
trading.

The regulatory body for the Indian capital markets was the SEBI (Securities and Exchange Board
of India). The capital markets in India experienced turbulence after which the SEBI came into
prominence. The market loopholes had to be bridged by taking drastic measures.

Potential of the India Financial Market

India Financial Market helps in promoting the savings of the economy - helping to adopt an
effective channel to transmit various financial policies. The Indian financial sector is well-
developed, competitive, efficient and integrated to face all shocks. In the India financial market
there are various types of financial products whose prices are determined by the numerous
buyers and sellers in the market. The other determinant factor of the prices of the financial
products is the market forces of demand and supply. The various other types of Indian markets
help in the functioning of the wide India financial sector.

Purpose of financial markets

 Financial markets help to finance the economy

Financial markets allows companies to finance themselves by raising capital, either by issuing bonds
(debt securities) or shares (titles of property). This allows them to finance business growth and their
projects, by having access to long-term finance, rather than short term finance such as bank loans. For
investors (whether individual savers, institutions, banks, etc.), financial markets offer the opportunity
to invest capital in exchange for a return called a "dividend", and the prospect of added value if their
assets appreciate. In summary, financial markets put companies that need money in contact with
players who have funds to invest.

Financial markets are thus a real means of financing the economy. There are two types of
market: the primary market, which is the part that deals with issuing and listing shares. It is also
referred to using the term, initial public offering (IPO). This is where financial markets enable
companies to finance themselves. Once these shares are in circulation, they can be negotiated on
a daily basis on the “secondary” market. This is how several billion Euros worth of exchanges
take place daily on the London stock market, some investors sell shares and others buy them.

Financial markets help to finance States

States tax investors on the revenues obtained from their investments in financial markets, either
through tax on financial transactions (FTTs) or tax on dividends and capital gains. Although
some investments offer tax benefits, investors using simple securities accounts are taxed at a
relatively high level on their profits, namely at their income tax rate.
Beyond this tax revenue for the State, financial markets also enable States to finance themselves
by issuing government bonds

Financial markets help to provide liquidity

Financial markets are places where supply meets demand, and therefore they offer a significant
level of liquidity. They are the reference markets for international investors to invest their capital:
each day buyers and sellers throughout the world carry out their transactions. It is this high level of
liquidity which benefits both companies and States, because it is an indispensable means of
funding, offering extensive output.

Financial markets, a protective instrument

Financial markets allow all investors in the market to protect themselves against a multitude of
risks (currency risk, interest rate risk, risk of price reductions, etc.), in particular through
derivatives. For example, businesses use currency SWAPs to protect themselves against exchange
risks, or interest rate SWAPs to protect themselves against the interest rate risk. Other derivatives
such as futures, options or forward contracts are used as part of risk management, whether it is
banks managing their exposure or companies protecting themselves against the price variations in
the raw materials they need for their business (oil for an airline for example).

Financial markets, a communication tool

Multinationals now use financial markets as a communication tool, especially through

advertising effects. Although the majority of market players use financial markets for the
traditional function of raising funds, large global companies such as Google and Facebook use
them to impress the competition. Indeed, Facebook’s initial public entry offering created a lot of
talk, a story that certainly made even the most hesitant about new communication techniques
aware of this company’s strength. The respective takeover of Tumblr and Instagram by Yahoo
and Facebook, for overvalued prices, was primarily a communication strategy to impress market
players and spread their financial power.
Financial markets may also enable medium-sized companies to make themselves known
internationally through IPOs. In addition, a publicly traded company is subject to a number of
tax obligations, regulations, etc. which reassure investors and customers by making the company
more trustworthy.