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financial system

Financial system", implies a set of complex and closely connected


or interlined institutions, agents, practices, markets, transactions,
claims, and liabilities in the economy.
is the system that allows the transfer of money between savers
(and investors) and borrowers.
is the set of Financial Intermediaries, Financial Markets and
Financial Assets.
helps in the formation of capital.
meets the short term and long term capital needs of households,
corporate houses, Govt. and foreigners.
its responsibility is to mobilize the savings in the form of money
and invest them in the productive manner.
FLOW OF FUNDS IN THE FINANCIAL
SYSTEM
Functions of the Financial
system
To link the savers & investors.
To inspire the operators to monitor the performance of
the investment.
To achieve optimum allocation of risk bearing.
It makes available price - related information.
It helps in promoting the process of financial deepening
and broadening
Organization / Structure of financial
system

Financial
system

Financial Financial Financial


Intermediarie Markets Assets
s
Financial intermediaries

Come in between the ultimate borrowers and ultimate


lenders
provide key financial services such as merchant banking,
leasing, credit rating, factoring etc.
Services provided by them are: Convenience( maturity and
divisibility), Lower Risk(diversification), Expert Management
and Economies of Scale.
Types of Financial intermediaries

Financial
Intermediarie
s

Insurance
Banks NBFCs Mutual Funds Organizations
Types of Financial intermediaries

1. commercial banks

Collect savings primarily in the form of deposits and traditionally


finance working capital requirement of corporates
With the emerging needs of economic and financial system banks
have entered in to:
Term lending business particularly in the infrastructure sector,
Capital market directly and indirectly,
Retail finance such as housing finance, consumer finance
Enlarged geographical and functional coverage
2. Non-banking finance companies
(NBFC)
A Non-Banking Financial Company (NBFC) is a company
registered under the Companies Act, 1956 engaged in the
business of loans and advances, acquisition of shares/stocks/
bonds/debentures/securities issued by Government or local
authority or other marketable securities of a like nature,
leasing, hire-purchase, insurance business, etc.
Provide variety of fund/asset-based and non-fund
based/advisory services.
Their funds are raised in the form of public deposits ranging
between 1 to 7 years maturity.
Depending upon the nature and type of service provided, they
are categorised into:
Asset finance companies
Housing finance companies
Venture capital funds
Merchant banking organisations
Credit rating agencies
Factoring and forfaiting organisations
Housing finance companies
Stock brokering firms
Depositories
3. Mutual funds

A mutual fund is a company that pools money from many


investors and invests in well diversified portfolio of
sound investment.
issues securities (units) to the investors (unit holders) in
accordance with the quantum of money invested by
them.
profit shared by the investors in proportion to their
investments.
set up in the form of trust and has a sponsor, trustee,
asset management company and custodian
advantages in terms of convenience, lower risk, expert
management and reduced transaction cost.
Mutual Fund Operation
Flow Chart
4. Insurance organizations

They invest the savings of their policy holders in exchange


promise them a specified sum at a later stage or upon the
happening of a certain event.
Provide the combination of savings and protection
Through the contractual payment of premium creates the desire
in people to save.
Financial Market

It is a place where funds from surplus units are transferred to


deficit units.
It is a market for creation and exchange of financial assets
They are not the source of finance but link between savers and
investors.
Corporations, financial institutions, individuals and governments
trade in financial products on this market either directly or
indirectly.
COMPONENTS OF FINANCIAL
MARKET
Financial
Market

Capital/
Money Securities
Market Market

Primary
Market

Secondary/
Stock Market
Money market

A market for dealing in monetary assets of short term nature,


less than one year.
enables raising up of short term funds for meeting temporary
shortage of fund and obligations and temporary deployment of
excess fund.
Major participant are: RBI and Commercial Banks
Major objectives:
equilibrium mechanism for evening out short term surpluses and
deficits
focal point for influencing liquidity in economy
access to users of short term funds at reasonable cost
COMPONENTS OF MONEY
MARKET

Money
Market

Call T-bills Bills CP CD Repo


Market Market Market Market Market Market
Capital market

A market for long term funds


focus on financing of fixed investments
main participants are mutual funds, insurance organizations,
foreign institutional investors, corporate and individuals.
two segments: Primary market and secondary market
Primary/new issue market

A market for new issues i.e. a market for fresh capital.


provides the channel for sale of new securities, not previously
available.
provides opportunity to issuers of securities; government as well
as corporates.
to raise resources to meet their requirements of investment
and/or discharge some obligation.
does not have any organizational setup
performs triple-service function: origination, underwriting and
distribution.
Secondary market/
stock market
A market for old/existing securities.
a place where buyers and sellers of securities can enter into
transactions to purchase and sell shares, bonds, debentures etc.
enables corporates, entrepreneurs to raise resources for their
companies and business ventures through public issues.
has physical existence
vital functions are:
nexus between savings and investments
liquidity to investors
continuous price formation
Financial instruments : the commodities that are traded in
financial market are financial assets/securities or instruments.

Financial
Instruments

Primary Securities Indirect Securities Derivatives


PRIMARY SECURITIES

Securities issued by the non-financial economic


units

Equity Shares: An equity share are the ownership


securities. They bear the risk and enjoy the rewards
of ownership.
Preference Shares: Holders enjoy preferential
right as to: (a) payment of dividend at a fixed rate
during the life time of the Company; and (b) the
return of capital on winding up of the Company
Debentures: An creditorship security. Holders are
entitled to predetermined interest and claim on the
assets of the company.
Innovative Debt instruments: A variety
of debt innovative instruments emerges
with the growth of financial system to
make them more attractive.
Participative Debentures: participate in
the excess profits of the company after
the payment of dividend.
Convertible debentures with options:
Third party convertible debentures:
entitle the holder to subscribe to the equity
of another firm at a preferential price.
Convertible debenture redeemable at
premium: issued at face value with option
to sell at premium.
Debt equity swap: offers to swap
Warrants: entitles the holder to purchase specified
number of shares at a stated price before a stated
date. Issued with shares or debentures.
Secured premium notes with detachable
warrants:
redeemable after lock-in period
warrants entitle the holder to receive shares after the
SPN is fully paid
no interest during lock-in period
option to sell back SPN to company at par after lock-in.
no interest/ premium on redemption if option exercised
right to receive principal+interest in instalments, in
case of redemption after expiry of the term
detachables required to be converted in to shares
within specified period.
Non -Convertible debenture with
detachable equity warrants: option
to buy a specified no. of share at a
specified price and time.
Zero interest Fully Convertible debentures:
carries no interest and convertible in to shares after lock-in
period.
Secured zero interest partly convertible debentures
with detachable and separately tradable warrants:
Having two parts
Part A convertible at a fixed amount on the date of
allotment
Part B redeemable at par after specified period from date of
allotment.
Carries warrants of equity shares at a price to be determined
by company
Fully convertible debentures with
interest(optional):
No interest for short period
After that option to apply for equities at premium
without paying for premium.
Interest is made from first conversion date to the
second/final conversion date
INDIRECT SECURITIES/
FINANCIAL ASSETS:

Issued by financial intermediaries.


such as units of mutual funds, policies of
insurance companies, deposits of banks, etc.
Better suited to small investors
Benefits of pooling of funds by intermediaries
Convenience, lower risk and expert management.
DERIVATIVES

Derivative is a product whose value is derived from the


value of one or more basic variables called base, in a
contractual manner
The underlying asset can be equity/forex or any other
assets.
The Securities Contracts (Regulation) Act, 1956 (SCIA)
defined derivative to include-
1. A security derived from a debt instrument, share, loan
whether secured or unsecured, risk instrument or
contract for differences or any other form of security.
2. A contract which derives its value from the prices, or
index of prices, of underlying securities.
Derivative
s

Forward Indirect
Options
Contract Securities
Forward contract

is a customized contract between two entities, where


settlement takes place on a specific date in the future at today's
pre-agreed price.

At the end offsetting is done by paying the difference in the


price.
future contract

is an agreement between two parties to buy or sell an asset at a


certain time in the future at a certain price.

They are special types of forward contracts which are


standardized exchange-traded contracts.
Options

Contracts that give the buyer the right to buy or sell


securities at a predetermined price within/at the end of
a specified period.
Two types - calls and puts.
Calls give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given
price on or before a given future date.
Puts give the buyer the right, but not the obligation to
sell a given quantity of the underlying asset at a given
price on or before a given date.