FINANCIAL MARKET (UNIT – 10)

UNIT – 10

FINANCIAL MARKET

Meaning – Financial market is a market for the creation and exchange of financial assets such as shares, debentures, bonds and government securities. It is a network of institutions which provide short, medium and long term funds. Financial markets make possible the transfer of money from the investors to the entrepreneurial borrowers. Actually they bring together the lenders of funds and borrowers of funds. 

Allocation of funds – There are two alternatives through which allocation of funds can be done – banks and financial markets. Household savers can deposit their surplus funds with banks. Banks then lend these funds to business firms. Household savers can also invest their savings in financial market directly by purchasing shares and debentures offered by business firms. Both banks and financial markets are competing financial intermediaries.

Functions of financial market

1. Mobilize savings and channelize them into most productive purposes – It offers the investors different investment avenues and helps to channelize surplus funds into productive use.

2. Price discovery – Price of any product is determined by the forces of demand and supply. The interaction between savers(investors) and business firms facilitates the price determination for the financial assets, which is being traded in a particular market.

3. Providing liquidity – Financial markets provide liquidity to financial assets as they can be converted into cash by selling them in the market very easily.

4. Reducing cost of transaction – Financial markets provide a common platform where buyers and sellers meet and to trade their securities without much cost and time.

Classification of financial markets

Financial markets are mainly of two types, Money market (Market for short term funds) and Capital market (Market for medium and long term funds)

Money Market – Meaning

Money market is the market for short term funds. Short term funds are meant for a period of up to one year. Money market is not usually located at a particular place. It is a term used to describe all organizations and institutions that deal in short term debt instruments. It makes possible the raising of short term funds for meeting the working capital needs and temporary deployment of excess funds to get returns.

Features of Money Market

1. Participants – RBI, Commercial banks, non-banking finance companies, State governments, large corporate houses and mutual funds.

2. Instruments – Short term debt instruments are traded.

3. Investment outlay – Huge sums of money is being transacted.

4. Duration – One day to one year.

5. Liquidity – It enjoys high degree of liquidity.

6. Safety – Short term duration ensures grater safety.

7. Location – No physical location, activities conducted over telephone or internet.

8. Returns – Comparatively less returns.

9. Unsecured – Instruments traded are unsecured.

Money market instruments

1. Treasury Bills (T-Bills / Zero Coupon Bonds) – These are issued by RBI on behalf of Central Government. Maturity less than one year. It is an instrument for short term borrowings by Government of India. They are issued in the form of promissory notes and freely transferable as it comes under Negotiable Instrument Act They are issued at a price which is lower than their face value and repaid at par, the difference between issue price and redemption value is called discount. It is available for a minimum amount of Rs. 25,000 and in the multiples thereof.

2. Commercial Paper (CP) – Issuing commercial paper in India as a money market instrument took place in 1989-90. It is an unsecured promissory note issued to the public with a fixed maturity period ranging from 15 days to 1 year. Since being unsecured, this is issued by highly reputed corporate entities. This serves as an important source of working capital and for bridge financing for raising long term funds from capital market in order to meet flotation cost, brokerage, advertising, printing share applications etc. Commercial banks and mutual funds contribute towards this kind of instruments.

3. Call Money – This is an important part of money market where day-to-day surplus funds of banks and other financial institutions are dealt with. The banks with surplus funds lend other banks that are facing deficiency. The duration of call money caries from one day to 15 days and is repayable on demand, either by the lender or by the buyer. Interest paid on call money is called Call rate. Call money is a method by which banks borrow mutually to maintain CRR (Cash Reserve Ratio), CRR is the minimum balance a commercial bank should maintain with RBI.

4. Certificate of Deposit (CD) – It is an unsecured, negotiable, short term instrument in bearer form, issued by commercial banks and financial institutions to individuals, corporations and companies. Maturity period 3 months to 12 months. These are issued at a discount and redeemed at par.

5. Commercial Bill (Trade Bill) – This is a bill of exchange used to finance working capital requirements of a business. It is a short period, negotiable and self-liquidating instrument used to finance credit sales. On credit sales, the seller (drawer) draws the bill and the buyer (drawee) accepts it, by putting his signature on it. On acceptance, the bill becomes a marketable instrument and is called a trade bill. This bill can be discounted with a bank if the seller requires funds before maturity. When a trade bill is accepted (discounting of bills) by a commercial bank, it is known as commercial bill.

Capital Market – Meaning

Capital market is an institutional arrangement by which savings are channelized into investment avenues. It enables the borrowers to raise funds for their purpose. Similarly, it gives opportunities to the lenders to wisely invest their funds. The borrowers raise required funds through issue of securities like shares, debentures, bonds etc. A security means a certificate of title evidencing investment made in the capital or debt of any entity.

Features of Capital Market

1. Participants – Financial institutions, banks, corporate entities, foreign investors and individual investors.

2. Instruments – Equity shares, preference shares, debentures, bonds etc.

3. Small Investment outlay – The value of one unit is Rs.10, Rs. 100 etc. and they are traded in lot of 1, 5, 50, 100 etc.

4. Duration – Medium and long term.

5. Liquidity – High liquidity as they are marketable in stock exchanges.

6. High risk – there is no much safety of investment and returns.

7. Expected Return – Normally the return on investment is higher than the money market.

Distinction between Money market and Capital market

Money Market                                                                             Capital Market

1. It is a market for short term instruments             1. It is for medium and long term instruments 

having maturity period of more than one                having a maturity period of less than one year.

year.

2. It helps to meet the working capital needs.        2. It helps in meeting fixed capital needs.

3. The instruments in money market are Bill         3. The instruments are equity shares,

of exchange, treasury bills, certificate of                 preference shares, debentures, bonds etc.

deposits, commercial papers etc.

4. It is a wholesale market. The instruments         4. It is a retail market where the instruments 

have large face value.                                               have small face value.

5. The central bank, commercial banks and            5. Stock exchanges, Merchant banks, Issue

other financial institutions take part in the             houses and many financial intermediaries

market.                                                                    take part in the market.

6. Money market instruments do not have an         6. Capital market instruments have both

active secondary market.                                        primary and secondary markets.

7. Money market transactions normally take         7. Capital market transactions normally take

place over telephone and other ways.                      place at stock exchanges.

8. The market regulator is the central bank of        8. There is a separate regulator in the capital

the country. In India it is RBI.                                  market. In India it is SEBI.

Capital market consists of two major segments, namely, primary market and secondary market.

Primary Market (New issue market)

This is the market which deals in new securities issued by new companies or existing companies. Therefore, it is also called New Issue Market (NIM). If it is issued by new companies it is called Initial Public Offerings (IPOs) and if it is issued by existing companies it is called Seasoned Equity Offerings (SEOs). The securities offered are equity shares, preference shares, debentures, bonds, innovative types of securities like deep discount bonds, zero interest bonds etc.

Methods of flotation of new issue

1. Offer through prospectus – It is the most common form of raising capital from the primary market. Prospectus is an invitation for subscription or purchase of shares or debentures of a company.

2. Offer for sale – This is an indirect method of public issue. Securities are offered to an issue house or other intermediaries like brokers through a “letter of offer” at a negotiated price. They, in turn, will sell them to the public generally at a higher price, by means of advertisement of their own. This enables the company to get funds in advance and they are relieved from the tedious process of public issue.

3. Private placement – It means the direct sale by a company of its securities to a limited number of specified investors. Here the issuing company may appeals to selected investors to subscribe to or purchase the securities either directly or through brokers. The main advantage of this method is that there is no risk of uncertainty in raising capital and it is a cost effective method of raising finance as compared to public issue.

4. Rights issue – It is a method of raising additional capital from existing shareholders by offering equity shares or debentures on pro-rata basis. This is known as ‘pre-emptive right’. According to Companies Act, if a public company wants to issue additional shares, it must first be offered to the existing shareholders, in proportion to the amount paid up on those shares. When the issue price is less than market price, the rights have a market value.

5. e-IPOs - In case a company wishes to issue capital to the public through on-line system should enter into an agreement with the stock exchange. This method of new issue is called e-IPOs.

Secondary Market (Stock Exchange)

Secondary market is the market for the purchase and sale of second hand or listed securities. Shares, debentures, bonds etc. which have already been issued by companies or government are traded in this market. It consists of buyers and sellers of securities and brokers as intermediaries. The investors can buy and sell securities only through brokers. Secondary markets are also known as stock exchanges.

Comparison between Primary market and secondary market

Primary market                                                                            Secondary market

1. It deals with new securities.                                           1. It deals with existing securities.

2. Securities are sold only once.                                        2. It provides regular and continuous market.

3. It links the issuing company and investors.                   3. Transactions are made between investors.

4. Investors can only purchase securities.                          4. Investors can purchase and sell securities.       

5. It provides capital to the companies.                             5. Issuing company has no direct role.

6. It does not have any physical existence.                        6. It has physical existence.

7. Prices of securities are determined by the                    7. Price is based on demand and supply of

Co.                                                                                       securities

8. Securities can be sold without listing.                           8. Only listed securities can be traded.

Stock Exchange

Stock exchange is an organized market where second hand securities are bought and sold. The Securities Contracts (Regulation) Act 1956 defines a stock exchange as “an association organization or body of individuals whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing in securities”.  Stock exchanges are located at definite places. Trading in securities takes place inside the stock exchange at a place known as the trading ring. Only the members (brokers) are authorized to trade here. In the traditional method of trading on the ring, trading actually resembles an auction. Brokers of intending sellers and buyers will shout quoting their prices. When the prices coincide, a deal will be struck. Online trading in securities is facilitated through a computer network wherein one can buy or sell securities just by sitting in front of the broker’s computer. Computer will match the buyer’s quotation and a deal is struck.

Functions of stock exchanges

1. Liquidity and marketability to investment – Secondary market provides a continuous market to the listed securities, so that investors enjoy liquidity to their investment. They could sell securities with them and buy another.

2. Pricing of securities – A security is issued in the market at a price known as the issue price. Over a period of time, it reaches its true level through the interaction of the forces of demand and supply in stock exchange.

3. Safety of transactions – The rules and regulations ensures safety and fair dealings to investors.

4. Contributes to economic growth – through capital formation.

5. Spreading of equity cult (trend) – Stock exchanges can take effective measures in educating public about investments.

6. Providing scope for speculation – A reasonable degree of healthy speculation is needed to ensure liquidity and price continuity in securities.

7. Economic barometer – Business conditions like booms and depressions, important events; both national and international will affect the stock prices. In this sense we can say that the stock exchange is an economic barometer (indicator). Trading and settlement procedure

Online trading – Trading in securities is now carried out through online, screen based electronic trading system. Buying and selling of securities are effected through computer terminal. Shares can be held either in physical form or in electronic form. In physical form, a share certificate is issued and it is a proof of ownership of securities. The electronic form is called the dematerialized form.

When the securities are bought or sold, it must be settled within 2 days of the trade, i.e., on a T+2 (Trade +2 days) basis. This system of settlement is called rolling settlement.

Steps in Trading and Settlement Procedure (Purchase and Sale of securities)

1. Selection of a broker.

2. Open a Demat account with the Depository Participant.

3. Placing order for purchase or sale of securities with the broker.

4. Execution of order through computer terminal.

5. Delivery of contract note to the investor, which contains details regarding name of security, number of securities bought or sold, rate at which the deal was made, brokerage etc.

6. Effecting changes in the Demat account.

7. Making/receiving payment of money.

Advantages of online trading

1. Transparency – It allows the participants to view the prices of all securities on a real  time basis.

2. Efficient information – Computer screen displays the capital market developments

that influence the share prices instantly.

3. Efficient operations – It reduces time, cost and effort.

4. Wide coverage – People from all over the world can participate in buying and selling of securities by sitting in front of a computer.

5. Single platform – All trading centers spread across the world is brought into a single online platform.

Dematerialization and Depository Services

A depository is an organization where the securities of shareholders are held in electronic form at the request of the shareholders through the medium of depository participant. In the depository system, securities are held in depository account, which is just like holding money in a bank account. It is an electronic record of share ownership. The depository system leads the capital market towards scripless trading through dematerialization of securities. Dematerialization is a process by which physical share certificates are converted into electronic form and credited in the investors account. To trade in dematerialized form, a Demat account is to be opened. The organization that offers this facility is called Depository Participant (DP). In India, two depositories are operating in the market, namely, National Securities Depository Limited (NSDL) and Central Depository Services Limited (CDSL). Many share brokers firms and commercial banks act as depository participants.

Process of dematerialization

1. Investors surrender certificates to DP for dematerialization.

2. DP informs the depository through electronic media.

3. DP sends original certificate to the Registrar for verification and cancellation.

4. Depository sends formal request for dematerialization to the Registrar.

5. Registrar informs depository of cancellation of certificates and electronic credit given to

the customer.

6. Depository updates its account and informs the DP concerned.

7. DP informs the customer about the credit in his account.

National Stock Exchange (NSE)

Established in 1992 at Mumbai – set up by LIC, GIC, Commercial banks and other financial institutions with a paid up capital of Rs.25crores.

Features and objectives of NSE

1. Nationwide coverage – satellite linked trading facility – more than 6000 trading terminals in 370 cities.

2. On-line Trading (Electronic Trading system) – It has adopted a computer based trading system – main computer at NSE is linked with the computers of trader members through satellite link.

3. Transparency in dealing – Screen based trading ensures complete transparency. Investors can verify the rate at which transactions took place.

4. Matching of orders – The computer itself matches the buy and sell orders of securities.

5. Trading in dematerialized form – Trading is carried on dematerialized form and settlement of transactions are made on rolling settlement basis. Rolling settlement helps traders to settle the accounts quickly. At present T+2 pattern is followed, which means settlement is made within 2 days from the date of transaction.

Securities and Exchange Board of India (SEBI)

SEBI was established by Government of India on 12 April 1988 as an interim administrative body to promote orderly and healthy growth of securities market and for investor protection. It was given a statutory status on 30 January 1992 through an ordinance which was later replaced by an Act of Parliament known as the SEBI Act, 1992. It seeks to protect the interest of investors in new and second hand securities.

Objectives of SEBI

1. To regulate stock exchange and the securities market to promote their orderly functioning.

2. To protect the rights and interests of investors and to guide & educate them.

3. To prevent mal-practices in trade such as insider trading.

4. To regulate and develop a code of conduct and fair practices by intermediaries like brokers, merchant bankers etc.

Functions of SEBI

The SEBI performs three important functions

1. Regulatory functions: These functions are performed by SEBI to regulate the business in stock Exchange.

2. Developmental functions: These functions are performed by SEBI to promote and develop activities in stock market.

3. Protective functions: These functions are performed by SEBI to protect the interest of investors and provide safety of investments

Functions of SEBI

• Check on Price Rigging: Making manipulations with sole objective of inflating

or depressing the market price of securities is called ‘Price Rigging’. Such

practises are prohibited by law because they can defraud or cheat investors.

FUNCTIONS OF SEBI

Regulatory Functions                           Development Functions                        Protective Functions

1. Framing Rules &                            1. Training of                                     1. Prohibiting of

   Regulations                                         intermediaries                                 fraudulent & unfair

                                                                                                                      trade practices.

2. Registration of brokers                  2. Conducting                                    2. Check on insider

 & sub-brokers.                                      Research &                                   trading.

                                                             Publishing useful

                                                             information.

3. Registration of                                3. Undertaking                                 3. Ensure investors

collective investment                              measures to                                       protection.

schemes & mutual                                 to develop 

funds.                                                  capital market

4. Regulation of stock                      4.  Educating Investors                        4. Promote fair

broker, port folio                                   to broaden their                                practices & code of

exchanges, under                                  understanding                                   conduct in securities

writers & merchant bankers                                                                           market

5. Regulation of take                       5. Permitting Internet                           5. Check on price

over bids by                                       trading through                                    rigging.

companies.                                         registered stock

Levying fee or other                         brokers

charges as per act.

• Check on Price Rigging: Making manipulations with sole objective of inflating or depressing the market price of securities is called ‘Price Rigging’. Such practices are prohibited by law because they can defraud or cheat investors.

• Check on Unfair Trade Practices: SEBI does not allow the companies to make misleading statements in prospectus which are likely to induce the sale or purchase of securities by any other person. • Check on Insider Trading: SEBI prohibits ‘insider trading’ and imposes penalties for such practices. An insider is any person connected with the company who is having price sensitive information (in respect of securities of the company), which is not available to the general public. Directors, promoters, etc. are the insiders. When such directors, promoters, etc. of the company use inside information to make individual profits, it is referred to as ‘insider trading’