Financial Markets

Concept of Financial Market

Market A business is a part of an economic system that consists of two main sectors – households that save funds and business firms which invest these funds. A financial market helps to link the savers and the investors by mobilizing funds between them. In doing so it performs what is known as an allocative function. It allocates or directs funds available for investment into their most productive investment opportunity. When the allocative function is performed well, two consequences follow: 

• The rate of return offered to households would be higher .
• Scarce resources are allocated to those firms which have the highest productivity for the economy. 

There are two major alternative mechanisms through which allocation of funds can be done: via banks or via financial markets. Households can deposit their surplus funds with banks, who in turn could lend these funds to business firms. Alternately, households can buy the shares and debentures offered by a business using financial markets. The process by which allocation of funds is done is called financial intermediation. Banks and financial markets are competing intermediaries in the financial system, and give households a choice of where they want to place their savings. A financial market is a market for the creation and exchange of financial assets. Financial markets exist wherever a financial transaction occurs. Financial transactions could be in the form of creation of financial assets such as the initial issue of shares and debentures by a firm or the purchase and sale of existing financial assets like equity shares, debentures and bonds.

Financial Markets

Financial markets play an important role in the allocation of scarce resources in an economy by performing the following four important functions. 

1. Mobilisation of Savings and Channeling them into the most Productive Uses: 

A financial market facilitates the transfer of savings from savers to investors. It gives savers the choice of different investments and thus helps to channelize surplus funds into the most productive use. 

2. Facilitating Price Discovery: 

You all know that the forces of demand and supply help to establish a price for a commodity or service in the market. In the financial market, the households are suppliers of funds and business firms represent the demand. The interaction between them helps to establish a price for the financial asset which is being traded-in that particular market. 

3. Providing Liquidity to Financial Assets: 

Financial markets facilitate easy purchase and sale of financial assets. In doing so they provide liquidity to financial assets, so that they can be easily converted into cash whenever required. Holders of assets can readily sell their financial assets through the mechanism of the financial market. 

4. Reducing the Cost of Transactions: 

Financial markets provide valuable information about securities being traded in the market. It helps to save time, effort, and money that both buyers and sellers of a financial asset would have to otherwise spend to try and find each other. The financial market is thus, a common platform where buyers and sellers can meet for fulfillment of their individual needs. Financial markets are classified based on the maturity of financial instruments traded in them. Instruments with a maturity of less than one year are traded in the money market. Instruments with longer maturity are traded in the capital market.

Types of Financial Markets

Money Market 

The money market is a market for short term funds which deal in monetary assets whose period of maturity is up to one year. These assets are close money substitutes. It is a market where low risk, unsecured and short term debt instruments that are highly the liquid is issued and actively traded everyday. It has no physical location, but is an activity conducted over the telephone and through the internet. It enables the raising of short-term funds for meeting the temporary shortages of cash and obligations and the temporary deployment of excess funds for earning returns. The major participants in the market is the Reserve Bank of India (RBI), Commercial Banks, Non-Banking Finance Companies, State Governments, Large Corporate Houses and Mutual Funds.

The money market is concerned with the supply and the demand for investible funds. Essentially, it is a reservoir of short-term funds. Money market provides a mechanism by which short-term funds are lent out and borrowed; it is through this market that a large part of the financial transactions of a country are cleared. It is the place where a bid is made for short-term investible funds at the disposal of financial and other institutions by borrowers comprising institutions, individuals and the Government itself. Thus, the money market covers money and financial assets which are close substitutes for money. The money market is generally expected to perform the following three broad functions: 

(i) To provide an equilibrating mechanism to even out demand for and supply of short-term funds.

(ii) To provide a focal point for Central bank intervention for influencing liquidity and general level of interest rates in the economy. 

(iii) To provide reasonable access to providers and users of short-term funds to fulfill their borrowing and investment requirements at an efficient market-clearing price. 

Money Market Instruments 

1. Treasury Bill: 

A Treasury bill is basically an instrument of short-term borrowing by the Government of India maturing in less than one year. They are also known as Zero-Coupon Bonds issued by the Reserve Bank of India on behalf of the Central Government to meet its short-term requirement of funds. Treasury bills are issued in the form of a promissory note. They are highly liquid and have assured yield and negligible risk of default. They are issued at a price that is lower than their face value and repaid at par. The difference between the price at which the treasury bills are issued and their redemption value is the interest receivable on them and is called a discount. Treasury bills are available for a minimum amount of `25,000 and in multiples thereof. Example: Suppose an investor purchases a 91 days Treasury bill with a face value of ` 1,00,000 for `96,000. By holding the bill until the maturity date, the investor receives `1,00,000. The difference of `4,000 between the proceeds received at maturity and the amount paid to purchase the bill represents the interest received by him. 

2. Commercial Paper: 

Commercial paper is a short-term unsecured promissory note, negotiable and transferable by endorsement and delivery with a fixed maturity period. It is issued by large and creditworthy companies to raise short-term funds at lower rates of interest than market rates. It usually has a maturity period of 15 days to one year. The issuance of commercial paper is an alternative to bank borrowing for large companies that are generally considered to be financially strong. It is sold at a discount and redeemed at par. The original purpose of commercial paper was to provide short-term funds for seasonal and working capital needs. For example, companies use this instrument for purposes such as bridge financing. Example: Suppose a company needs long-term finance to buy some machinery. To raise the long term funds in the capital market the company will have to incur floatation costs (costs associated with floating of an issue are a brokerage, the commission, the printing of applications and advertising, etc.). Funds raised through commercial paper are used to meet the floatation costs. This is known as Bridge Financing. 

3. Call Money: 

Call money is short term finance repayable on demand, with a maturity period of one day to fifteen days, used for inter-bank transactions. Commercial banks have to maintain a minimum cash balance is known as cash reserve ratio. The Reserve Bank of India changes the cash reserve ratio from time to time which in turn affects the amount of funds available to be given as loans by commercial banks. Call money is a method by which banks borrow from each other to be able to maintain the cash reserve ratio. The interest rate paid on call money loans is known as the call rate. It is a highly volatile rate that varies from day to day and sometimes even from hour to hour. There is an inverse relationship between call rates and other short-term money market instruments such as certificates of deposit and commercial paper. A rise in call money rates makes other sources of finance such as commercial paper and certificates of deposit cheaper in comparison for banks raise funds from these sources. 

4. Certificate of Deposit: 

Certificates of deposit (CD) are unsecured, negotiable, short-term instruments in bearer form, issued by commercial banks and development financial institutions. They can be issued to individuals, corporations and companies during periods of tight liquidity when the deposit growth of banks are slow but the demand for credit is high. They help to mobilize a large amount of money for short periods. 

 5. Commercial Bill: 

A commercial bill is a bill of exchange used to finance the working capital requirements of business firms. It is a short-term, negotiable, self-liquidating instrument that is used to finance the credit sales of firms. When goods are sold on credit, the buyer becomes liable to make payment on a specific date in the future. The seller could wait till the specified date or make use of a bill of exchange. The seller (drawer) of the goods draws the bill and the buyer (drawee) accepts it. On being accepted, the bill becomes a marketable instrument and is called a trade bill. These bills can be discounted with a bank if the seller needs funds before the bill matures. When a trade bill is accepted by a commercial bank it is known as a commercial bill.

Capital Market 

The term capital market refers to facilities and institutional arrangements through which long-term funds, both debt and equity are raised and invested. It consists of a series of channels through which savings of the community are made available for industrial and commercial enterprises and for the public in general. It directs these savings into their most productive use leading to growth and development of the economy. The capital market consists of the development banks, commercial banks, and stock exchanges. An ideal capital market is one where finance is available at a reasonable cost. The process of economic development is facilitated by the existence of a well functioning capital market. In fact, the development of the financial system is seen as a necessary condition for economic growth. It is essential that financial institutions are sufficiently developed and that market operations are free, fair, competitive and transparent. The capital market should also be efficient in respect of the information that it delivers, minimize transaction costs and allocates capital most productively                                The Capital Market can be divided into two parts: a. Primary Market b. Secondary Market

Primary Market 

The primary market is also known as the new issues market. It deals with new securities being issued for the first time. The essential function of a primary market is to facilitate the transfer of investible funds from savers to entrepreneurs seeking to establish new enterprises or to expand existing ones through the issue of securities for the first time. The investors in this market are banks, financial institutions, insurance companies, mutual funds and individuals. A company can raise capital through the primary market in the form of equity shares, preference shares, debentures, loans, and deposits. Funds raised may be for setting up new projects, expansion, diversification, modernization of existing projects, mergers and takeovers etc.

Secondary Market 

The secondary market is also known as the stock market or stock exchange. It is a market for the purchase and sale of existing securities. It helps existing investors to disinvest and fresh investors to enter the market. It also provides liquidity and marketability to existing securities. It also contributes to economic growth by channelising funds towards the most productive investments through the process of disinvestment and reinvestment. Securities are traded, cleared and settled within the regulatory framework prescribed by SEBI. Advances in information technology has made trading through stock exchanges accessible from anywhere in the country through trading terminals. Along with the growth of the primary market in the country, the secondary market has also grown significantly during the last ten years.

Instruments of Capital Market

1. Equities:

Equity securities refer to the part of ownership that is held by shareholders in a company. In simple words, it refers to an investment in the company’s equity stock for becoming a shareholder of the organization. The main difference between equity holders and debt holders is that the former does not get regular payment, but they can profit from capital gains by selling the stocks. Also, the equity holders get ownership rights and they become one of the owners of the company.                                                                                        When the company faces bankruptcy, then the equity holders can only share the residual interest that remains after debt holders have been paid.                                                                                          Companies also regularly give dividends to their shareholders as a part of earned profits coming from their core business operations.

2. Debt Securities:

They come with defined issue dates, maturity dates, coupon rates, and face values. Debt securities provide regular payments of interest and guaranteed repayment of principal. They can be sold before maturity to allow investors to realize a capital gain or loss on their initial investment.

1. Bonds:

Bonds are fixed-income instruments that are primarily issued by the center and state governments, municipalities, and even companies for financing infrastructural development or other types of projects. It can be referred to as a loaning capital market instrument, where the issuer of the bond is known as the borrower. Bonds generally carry a fixed lock-in period. Thus, the bond issuers have to repay the principal amount on the maturity date to the bondholders.

2. Debentures:

Debentures are unsecured investment options unlike bonds and they are not backed by any collateral. The lending is based on mutual trust and, herein, investors act as potential creditors of an issuing institution or company.

3. Derivatives:

Derivative instruments are capital market financial instruments whose values are determined from the underlying assets, such as currency, bonds, stocks, and stock indexes.                                                      The four most common types of derivative instruments are forwards, futures, options, and interest rate swaps:

• Forward: A forward is a contract between two parties in which the exchange occurs at the end of the contract at a particular price.
• Future: A future is a derivative transaction that involves the exchange of derivatives on a determined future date at a predetermined price.
• Options: An option is an agreement between two parties in which the buyer has the right to purchase or sell a particular number of derivatives at a particular price for a particular period of time.
• Interest Rate Swap: An interest rate swap is an agreement between two parties that involves the swapping of interest rates where both parties agree to pay each other interest rates on their loans in different currencies, options, and swaps.

4. Exchange-Traded Funds:

Exchange-traded funds are a pool of the financial resources of many investors which are used to buy different capital market instruments such as shares, debt securities such as bonds, and derivatives. Most ETFs are registered with the Securities and Exchange Board of India (SEBI) which makes it an appealing option for investors with a limited expert having limited knowledge of the stock market. ETFs having features of both shares as well as mutual funds are generally traded in the stock market in the form of shares produced through blocks.ETF funds are listed on stock exchanges and can be bought and sold as per requirement during the equity trading time.

5. Foreign Exchange Instruments:

Foreign exchange instruments are financial instruments represented on the foreign market. It mainly consists of currency agreements and derivatives. Based on currency agreements, they can be broken into three categories i.e spot, outright forwards, and currency swap.

Commodities Markets

Commodities markets are venues where producers and consumers meet to exchange physical commodities such as agricultural products (e.g., corn, livestock, soybeans), energy products (oil, gas, carbon credits), precious metals (gold, silver, platinum), or "soft" commodities (such as cotton, coffee, and sugar). These are known as spot commodity markets, where physical goods are exchanged for money.

The bulk of trading in these commodities, however, takes place on derivatives markets that utilize spot commodities as the underlying assets. Forwards, futures and options on commodities are exchanged both OTC and on listed exchanges around the world such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).

Cryptocurrency Markets

The past several years have seen the introduction and rise of cryptocurrencies such as Bitcoin and Ethereum, decentralized digital assets that are based on blockchain technology. Today, hundreds of cryptocurrency tokens are available and trade globally across a patchwork of independent online crypto exchanges. These exchanges host digital wallets for traders to swap one cryptocurrency for another, or for fiat monies such as dollars or euros.