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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