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Lecture Session I
Topic: Overview of Financial Markets
1. An Overview of Financial Markets and Institutions
Market
• Institution or
• Arrangement
• That facilitates purchase and sale of
• Goods and Services and
• Other things
Financial Market
• Place where
• People and organizations
• Wanting to borrow money
• Are brought together with
• Those having surplus funds
Location
• May or may not have particular physical existence
• NYSE physically located at Wall Street
• OTC has no fixed place of existence
• Consists of brokers throughout the country who track prices via computer and Telecommunication lines
Role
• Savings Mobilization
• Investment
• National Growth
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• Entrepreneurship growth
Functions
• Intermediary functions
• Financial Functions
Intermediary Functions
• Transfer of Resources
• Enhancing Income
• Productive Usage
• Capital Formation
• Price Determination
• Sale Mechanism
• Information
Financial Functions
• Providing borrowers with funds for Investment
• Providing the lenders with earning assets
• Providing liquidity in the market
Constituents
• Primary Market
• Secondary Market
• Money Market
• Capital Market
• Debt Market
• Eurobond Market
• Equity Market
• Financial Services Market
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• Depository Market
• Non Depository Market
Primary Market
• Deals with the issue of new securities
Secondary Market
• Deals with existing claims
• No new flow of funds for instruments
• Ready market for trading in securities
• Existing financial assets are bought and sold.
• Helps lower transaction costs
• Enhances the liquidity of the financial asset
Money Market
• Short Term Financing
• Nerve center of all operations of the central bank in the country
• Reflects changes in short term parameters such as interest rates, monetary policy, availability of short term credit etc.
• Mechanism of liquidity adjustment
Money Market
• Medium of exchange between
• Holders of short term cash surpluses and short term cash deficits
• Central bank conducts most of its operations in the money market
• Low capital loss (money risk)
• Low risk of default (credit risk)
Sub markets of Money market
• Specialized sub markets such as
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• Central Banks
• Commercial banks
• Cooperative banks
• Savings banks
• Discount houses
• Acceptance houses
• Bill market
• Bullion market etc
Capital Market/Securities Market
• Where long term funds are borrowed and lent.
Features of Capital Markets
• Demand for long term Funds
• Instruments like shares, debentures, bonds etc.
• Supply of funds
• Surplus units to deficit units
• Savings are channelized into investments
• Economic growth of the country
Price Mechanism
• Companies that operate efficiently can sell securities at premium (incentives)
Debt Market
• Markets where funds are borrowed and lent
Uses
• INDIVIDUALS – To finance new purchases like house, car etc.
• CORPORATES – Obtaining working capital and new equipment
• GOVT. – Finance various public expenditures
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Eurobond Market
• Market where bonds are denominated in currency other than that of the country in which they are issued
• French firm may engage a German Investment banking syndicate to sell dollar denominated bonds and so on
Equity Markets
• Where ownership securities are issued and subscribed
• Eg Bombay Stock Exchange
Financial Services Market
• Consists of participants such as commercial banks etc that provide financial services
Financial Services
• ATM
• Credit cards
• Credit rating
• Factoring
• Leasing
• Stock Broking etc
Depository Market
• Consists of depository institutions that
• Accept deposits from
• Individuals and Firms
• And use these funds to
• Participate in debt market
• Depositors loan money to depository institutions who
• Use the funds to purchase other financial asset
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Major types of Depository Institutions
• Commercial Banks
• Savings and Loan Associations
• Mutual savings banks
• Credit Unions
Commercial Banks
• Largest and most important depository Institutions
• Have the largest and most diverse collection of assets
• Main source of funds
• Demand deposits and
• Savings Deposits
Savings and Loan Associations
• Mutual associations (owned by depositors)
• To convert funds from savings accounts to mortgage loans
• Purpose – To ensure a market for financing housing loans
Mutual Savings Banks
• Owned cooperatively
• By members with a common interest
• Eg. Company employees, union members or congregation members
• Accepted deposits and made mortgage loans
Credit Unions
• Cooperative depository institutions
• Depositors are credited upon purchasing shares in the cooperative which they own and operate
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Non Depository Market
• Carry out various functions in financial markets
• Ranging from financial intermediation to selling insurance
Non Depository Market
• Mutual Funds
• Insurance Companies
• Pension Funds
• Brokerage firms
Mutual Funds
• Sell shares to investors
• Invest proceeds in a variety of financial assets
• Money market mutual funds invest in short term safe assets like Govt Securities
Insurance Companies
• Protect individuals against risk
• Accept premium
• In exchange for contracted payment in the event of ---
• Hold long term assets like long term bond and commercial real estate
Pension Funds
• Operated by private and Govt employers
• Provide retirement income to employees
• Regular contribution from employees via payroll deduction
• Fund flowing in are in the nature of fixed deposits
• Can accurately predict payouts
• Hold portfolios consisting mostly of stocks and bonds
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Pension Funds
• Return on the assets are paid out to participating individuals when they reach retirement age.
Brokerage Firms
• Bring buyers and sellers of stock together
• Function as intermediaries
• Earn a fee for each transaction
• Main function to serve as brokers in the
• Secondary debt and Equity Markets
Financial Instruments
• Money Market Instruments
• Capital Market Instruments
Money Market Instruments
• Commercial paper
• Certificates of Deposits
• Treasury Bills
• Treasury Bonds
• Repurchase Agreements
• Eurodollars
• Banker’s acceptances
Commercial Paper
• A form of direct short term finance
• Issued by large creditworthy companies
• Debt instrument sold by one company to another company or financial institution
• To raise immediate funds
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Commercial Paper
• Contains a promise
• To pay back a higher specified amount
• At a designated time
• In the immediate future
• Avoids the process of applying for a loan
• Engages in direct finance
Certificates of Deposit
• Debt Instruments
• Sold by banks and other depository institutions
• A CD pays the depositor
• A specified amount of interest
• During the term of the certificate
• Plus purchase price of the CD at its maturity
Treasury Bills
• Short Term debt Instruments
• Used by Govt to obtain funds
• Issued in 3, 6, 12 month maturities
• No regular interest payments
• Sold at a discount
• Ready market for these securities
• Zero Default Risk
Treasury Bonds
• Popular US Govt Securities
• Include Treasury Bonds having a maturity of 1 to 10 years.
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• Zero Coupon bonds
Repurchase Agreements
• Borrower sells and agrees to buy back a financial instrument, a govt. bond, note or T-Bill
• Popularly known as repo
• A short term loan backed by a security
Eurodollars
• US Dollars deposited in banks located in other countries
Banker’s Acceptances
• Arrangement whereby
• Bank promises to pay on a specific date, which is accepted and guaranteed by another bank.
• Essentially a letter of credit
Capital Market Instruments
• Corporate Stock
• Corporate Bonds
• Mortgages
• Commercial Loans
• Municipal Bonds
Indian Money Market
• Organized Money Market
• Unorganized Money Market
Organized Money Market
• Constituents include RBI, SBI, Commercial Banks, Finance Corporations, Bill market and Bullion Market
• Principal centers are Mumbai, Kolkata and Delhi
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Banking System
• Scheduled Banks
• Non Scheduled Banks
Scheduled Banks
• State Cooperative Banks
• Commercial Banks
Scheduled Commercial Banks
• Consist of both foreign Banks and Indian Banks
• Exist both in the Private sector and the Public sector
Rural Banking
• Regional Rural Banks
RBI
• Exercises adequate control over the operations of the organized money market through various monetary and credit instruments such as
• Cah Reserve Ratio
• Statutory Liquidity Ratio
• Credit Authorization Scheme
• Non Resident Indian Investment Incentive Scheme
Unorganized Money Market
• Indigenous Bankers and Moneylenders
• Outside the control of RBI.
Indian Capital Market
• Where Financial Securities are bought and sold
• Shares, Bonds, Debentures etc.
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Types of securities
• Government Securities
• Industrial Securities
Special Institutions
• Finance
• Development
• Promotion
• Eg. IFCI, ICICI
• Non Banking institutions like UTI, LIC, GIC
• Bank for Agriculture – Nabard
• To cater to the financing needs of exporters and importers – EXIM Bank
National Stock Exchange
• Works on the standardized systems software used all over the world
• Allows trading by Broker Members by simply sitting in their own offices
• All Market Information available continously on the screen
• Identity of the trader is concealed
Third Market
• OTC Market
• Any exchange listed security can be traded in this type of market
• Prices are fixed through negotiation
• Institutional investors are the main customers
• Small brokers, dealers, private individuals and small odd lot customers who are not members of an organized exchange can also actively take part in the market
Fourth Market
• Institutions and Wealthy Investors who buy and sell securities among themselves, directly dispensing with brokerage services
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• Direct Deals through negotiated price
• Only two parties and no broker
Global Financial Markets
• Financial Markets
• Integrated Worldwide
• Uniform Trading practices
• It is possible for firms to raise funds in International Arenas
Global Financial Markets
• Internal Market
• External Market
Internal Market
• National or Domestic market
• Capital issues and issuers are domiciled within the boundaries of a particular country
External Market
• Foreign Market, International Market, Offshore Market, Euro Market
• Deals with issues of securities not domiciled in the country but are sold and traded throughout the world
• Rules are of the regulatory authorities where the security is issued
• If an Indian firm wishes to raise capital in the Global Market, it has to follow the regulations of Indian authorities
External Market
• Yankee market in the US
• Samurai market in Japan
• Bulldog market in UK
• Rembrandt market in Netherlands
• Matador market in Spain
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2. Capital Markets
Meaning
• Market
• For borrowing and Lending
• Long term capital funds
• Also called the securities market
• Dealings through securities like shares, debentures etc
Participants
• Financial Intermediaries like insurance companies, investment companies , pension funds etc
• Non Financial Business Enterprises
Evolution
• Period between 1947 and 1973 marked the development of Infrastructure
• 1973 to 1980 was the New issues stage
1980 to 1992
• Emergence of SEBI as a regulatory body
• Credit rating institutions like CRISIL, CARE and ICRA were set up
• IL &FS set up for Infrastructure Financing and Leasing Services
• OTCEI to provide screen based stock exchange facility
From 1992
• Structural Transformation started taking place
• Technological operations in the realm of stock trading.
• Financial Liberalization
• Computerized online trading
• Constitution of a depository to facilitate scripless trading
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• SEBI Act, 1992
• SEBI was set up as a regulatory body of Indian Securities market in 1988 but vested with statutory powers only in 1992 with SEBI Act.
Constituents of the Indian Capital Market
• Gilt edged Securities Market
• Industrial Securities Market
Primary Market
• Public Issue
• Rights Issue
• Private Placement
The Secondary Market
• 24 Stock Exchanges in India recognized by the Govt.
• In addition a ringless and automated stock market operating at the National Level known as OTCEI
New Financial Institutions
• Venture Fund Institutions
• Mutual Funds
• Factoring Institutions
• Credit Rating Institutions
• OTCEI
• National Stock Exchange
• National Clearance and Depository System
• National Securities Depositories Ltd
• Stockholding Corporation of India
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Venture Fund Institutions
• Form of equity financing designed specially funding new and innovative project ideas.
• Many specialized financial institutions have promoted their own Venture Capital Funds
• Risk capital Foundation of IFCI, Venture fund of IDBI
• SIDBI
• TDICI – Technology Development Infrastructure Corporation of India
Mutual Funds
• Invests funds pooled from shareholders
• Gives them the benefit of a diversified portfolio
• LIC, UTI
• Banks like SBI, Canara Bank etc are carrying out the Business of Mutual Funds
Factoring Institutions
• Assigning receivables
• Factoring Institution undertakes the task of collecting book debts for and on behalf of its clients.
• RBI along with Govt. of India has notified factoring as an eligible banking activity
• SBI Factors and Commercial Services Private Ltd – a subsidiary of SBI
• Canbank Factors Ltd – Subsidiary of Canbank
Credit Rating Institutions
• Guidance to investors/creditors in determining the credit risk associated with a debt instrument/credit obligation
• By an independent , professional and impartial institution
• CRISIL, ICRA
• Onida Investment and Credit Rating Agency of India Ltd
• Credit Analysis and Research Ltd. (CARE)
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OTCEI
• To allow trading of securities across electronic counters throughout the country
• Transparency of Transactions
• Quick deals
• Faster settlements
• Better Liquidity
NSE
• Established under the Companies Act, 1956 in 1992
• Provides a nation wide electronic screen based ‘scripless’ and ‘floorless’ trading system in Securities
National Clearance and Depository System
• Scripless Trading
• Settlement of transaction takes place through a book entry as against the Physical exchange of Securities
• Three segments
• National Trade Comparison and Reporting System
• National Clearing System
• National Depository System
National Trade Comparison and Reporting System
• Prescribes the terms and conditions of the contract for securities market
National Clearing System
• Aims at determining the Net cash and stock liability of each broker on a settlement date
National Depository System
• Arranges to provide for the transfer of ownership of securities in exchange for payment by book entry on Electronic ledgers without any physical movement of transfer deed.
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National Securities Depositories Ltd
• Set up in 1996
• To achieve a time bound dematerialization as well as rematerialization of shares
• In accordance with Depositories Act, 1996
Stock Holding Corporation of India
• Serves as a Central Securities Depository in respect of transactions on Stock Exchanges
• Also takes up the administration of clearing functions at a National Level
Recent Initiatives in the Capital Market
• Settlement cycle shortened to T+3 effective April 1, 2002
• Banning of all deferral products including badla
• Introduction of a market wide circuit breaker system
Capital Market Instruments
• Preference Shares
• Equity Shares
• Non Voting equity shares
• Cumulative convertible preference shares
• Company fixed deposits
• Warrants
• Debentures and Bonds
Preference Shares
• Shares that carry preferential rights in comparison with ordinary shares
• Regarding payment of Dividend
• Claim on liquidation
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Cumulative Preference Shares
• Shares where the arrears of Dividend in times of lean or no profits can be accumulated and paid in the year in which the company earns good profits
Non Cumulative Preference Shares
• Where carry forward of arrears of Dividend is not possible
Participating Preference Shares
• Have the right to participate in the surplus profits or surplus assets on liquidation of the company
Redeemable Preference Shares
• Shares that are to be repaid at the end of the term of the issue
Fully Convertible cumulative preference shares
• Shares consist of two parts – Part A and Part B
• Part A is compulsorily convertible
• Part B will be redeemed at par/converted into equity shares after a lock in period
Preference Shares with Warrants attached
• Attached warrant entitles the holder to apply for equity shares for cash at a premium
Equity Shares
• No specific preferential rights
• Represent proportionate ownership in a company
Stock Dividend
• Dividends distributed as shares by capitalizing reserves
Participating Debentures
• Debentures that entitle the holder to participate in Profits
Debt Equity Swaps
• Offered from an issuer of debt to swap it for equity
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Zero Coupon Note
• Zero Coupon Debentures that can be converted into debt
SPN with detachable warrants
• Secured Premium Notes
• They are redeemable debentures that are issued with detachable warrants
NCDs with detachable equity warrants
• Non Convertible debentures with detachable equity warrants
Zero Interest FCDs
• Zero Interest Fully convertible Debentures
FRBs
• Floating Rate Bonds where the yeild is linked to a benchmark interest ratelike the Prime rate in USA or the LIBOR in London.
Merchant Bankers
• The intermediaries in the stock market who are responsible for Public Issue Management are known as Merchant Bankers or Lead Managers
Underwriters
• A set of all institutions and agencies
• That provide the commitment to take up an issue of securities
• In the event of a failure of an issue to get full subscription from the public, are known as underwriters
Bankers to an Issue
• Bankers who are engaged in the function of acceptance of applications for shares and debentures along with application money from investors in respect of issue of securities and refund of application money to investors to whom securities could not be allotted, are known as Bankers to the issue.
Brokers to an Issue
• Intermediaries that are responsible for procuring the subscription to the issue from prospective investors are called ‘Brokers to the Issue’.
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Registrars to an Issue and Share Transfer agents
• Registrars carry out such functions as keeping a proper record of applications and moneys received from investors
• Assisting issuing companies in determining the basis of allotment of securities in accordance with the stock exchange guidelines
• Assisting in the finalization of allotment of securities
• Processing and dispatching allotment letters
• Assisting in processing and dispatching refund orders, share and debenture certificates etc
• Functioning as depository participants
Share Transfer Agents
• Maintaining records of holders of securities of the company on behalf of the company
• Handling all matters relating to transfer and redemption of the securities of the company
• Functioning as Depository Participants
Share Transfer Agents
• Maintaining records of holders of securities of the company on behalf of the company
• Handling all matters relating to transfer and redemption of the securities of the company
• Functioning as Depository Participants
Debenture Trustees
• Trustees who are appointed to safeguard the interest of debenture holders
• Certificate of Registration has to be obtained from SEBI for this purpose
Debt Market
• Where Fixed income securities of various types are issued and Traded
Government Securities
• Zero Coupon Bonds
• Coupon Bearing Bonds
• Treasury Bills
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• STRIPS
Public Sector Bonds
• Govt guaranteed Bonds
• Debentures
• PSU Bond
• Commercial Paper
Private Sector Bonds
• Debentures
• Bonds
• Commercial Paper
• Floating Rate Bonds
• Zero Coupon Bonds
• Inter Corporate Deposits
• Certificates of Deposit
Secondary Debt Market
• The markets where Bonds are bought or sold.
• It is divided into Wholesale and Retail Debt Market
Wholesale Debt Market
• Outright sale and purchase and Repo trade
• Stock exchanges offer order driven screen based trading facilities for Govt Securities
• Most Trades are put through in broker’s offices and reported to the exchange through their electronic system which provides for reporting of negotiated Deals and Cross Deals
Retail Debt Market
• Comprises of individual Investors, small trusts and other legal entities besides participants in the wholesale Market
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3. Money Markets
Meaning
• A market where short term funds are borrowed and lent
• Dealings may be conducted with or without the help of brokers
• Funds are traded for a amaximum period of one year
Segments
• Call money market
• Collateral loan market
• Bill Market
• Acceptance Market
• Discount market
Call money market
• Extremely short period loans from overnight to a maximum of seven days.
• Funds are demanded by brokers and dealers on stock exchanges
• And are advanced by commercial banks without any collateral securities
• Inter bank call money market
• To meet their statutory obligations pertaining to Reserves
Collateral Loan Market
• Money lent against securities or collatera
• In the event of non payment, the collateral becomes the property of the lender
• Given for short periods vlasting a few months
• Borrowers are mostly brokers and dealers in stocks and shares
• Mostly advanced by commercial banks to private parties
Bill Market
• Deals with purchase and sale of various types of bills
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• Treasury Bills and Bills of Exchange
Bill of exchange
• Seller draws the bill upon the buyer
• Buyer accepts it unconditionally
• Becomes property of the seller
• May retain it with himself till maturity or
• Get it discounted with banker
• Then bill has to be paid by the buyer to the banker instead of to the seller
Acceptance Market
• Consists of a draft issued by a bank and accepting/undertaking to make payment of the money specified on the draft on demand
Discount Market
• Where Banker’s acceptances are discounted
• Banker’s acceptance is payable at a specified future date and not on demand like a cheque
Financial Institutions in the Money Market
• Commercial Banks
• NBFCs
• Acceptance houses
• Central Bank
Commercial Banks
• The most important segment of the money market
• Use short term deposits for providing short term funds to trade and commerce
• They invest funds for discounting commercial and Treasury Bills
NBFCs
• Insurance companies, Leasing companies etc.
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• Make a decisive impact on the money market institutions
Acceptance Houses
• Institutions that specialize in the task of acceptance of commercial bills
• Accept exchange bills on behalf of customers.
• These can be easily discounted in the money market
• Discounting of such accepted bills is done by another specialized agency known as discount houses
Central Bank
• Government’s Banker
• Bankers Bank
DFHI
• Discount and Finance House of India
• Set up in 1988Takes an active part in operations by borrowing and lending funds
• Market maker
Mode of operation of Call Money Market
• Those involving banks – Telephonic Negotiations between borrowers and lenders
• Lender issues RBI Cheque in favour of borrowing bank
• Acknowledged by Call money borrowing receipt
• Reverse day borrower repays the amount by issuing RBI Cheque and lender returns the duly discharged receipt
Mode of operation of Call Money Market
• Those involving DFHI Borrowers and Lenders approach the DHFI spelling out their terms
• Results in exchange of Deal Settlement Advice (DSA)
• Borrowing DFHI issues a call deposit receipt to the lender and in turn receives an RBI Cheque
• On reversal DFHI issues an RBI Cheque and the lender surrenders the duly discharged call receipt.
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Call Money Rate
• Rate of interest on call funds
• Seasonal and daily variations requiring intervention by RBI and other institutions
Commercial Paper
• Debt Instruments
• Issued by Corporate houses
• For raising short term financial resources from the market
• Unsecured
• Issued at a discount
• Multiples of Rs 5 lakhs
• Attract Stamp duty
CP
• Issuing company has to bear all expenses
• No prior approval of RBI is required
• Beginning from 1996, Primary dealers were also permitted by the RBI to issue CPs
• As per guidelines issued by RBI, they are required to be graded by the organization issuing them
CP
• Rate of interest varies greatly
• No benchmark for the rate
• Minimum maturity is 15 days
Satellite Dealers
• Dealers who are enlisted with RBI to deal in the Govt securities market are called satellite dealers
• Allowed to issue CPs with prior approval of RBI.
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Nature of CPs
• In the form of usance promissory note
• Shall be negotiable by endorsement and delivery
Commercial Bill Market
• Market for buying and selling commercial Bills
• State of underdevelopment
• Lack of bill culture, high stamp duty, inadequate credit rating, absence of an active secondary market
• RBI introduced Banker’s scheme in 1952 with a view to developing the Indian Bill market
• However the bill market could not develop well
Certificate of Deposit
• Marketable document
• Of title to a time deposit
• For a specified period
CD
• Negotiable Instruments
• Maturity period from 15 days to one year
• In the form of usance promissory notes
• Negotiable by endorsement and delivery
• A conventional time deposit is not freely negotiable.
CDs
• Launched in 1989
• Institutions that are eligible to issue CDs are Scheduled commercial banks (excluding RRBs) and all India Financial Institutions like IDBI, IFCI,ICICI,SIDBI,IRBI,EXIM Bank etc
• Maturity period from 3 days to 12 months
• Issued at discount to face value
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CDs
• Stamp duty is payable on CDs
• No loans can be granted by banks against CDs
• Offered at interest rates higher than time deposits of Banks
• DFHI acts as a market maker
• Offers bid rate, rate of discount at which it is prepared to buy CDs and offer rate.
Treasury Bills
• Promissory notes
• Issued by government
• Under discount
• For a fixed period
• Not exceeding one year
• Serve as an important tool of money management to infuse or absorb liquidity from the monetary system
Types
• Ordinary Treasury Bills
• Adhoc treasury Bills
Ordinary Treasury Bills
• Freely marketable and issued by Govt to public, , banks and other institutions
Adhoc Treasury Bills
• Issued in favour of RBI only
• Used by RBI as reserve
• Against which RBI issues currency notes
• Also serve as an avenue for staqte govts, , semi govt departments and foreign central banks for parking temporary surplus and for earning income
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Issue Procedure
• 91 day T-Bills are issued on tap basis throughout the week
• 14,28,91 and 364 day T-Bill through fortnightly auction
• The notification mentions the date of the auction and the last date for submitting tenders
Issue Procedure
• Investors are permitted to submit bids through separate tenders
• Result mentioning the price upto which the tenders have been accepted is displayed
• Successful bidders are expected to collect letter of acceptance from RBI and deposit the same together with a cheque on RBI.
SGL is maintained by RBI for facilitating purchases and sales of TBs by investors like commercial banks , DFHI, STCI and other Financial Institutions
Issue Procedure
• Where SGL facility is not available to certain investors, purchase and sale takes place through DFHI
• TBs sold to such investors are held by DFHI on their behalf
Auctioning Method
• Uniform Price auction
• Both competitive and non competitive bidders
• State Govts, Provident Fund and Nepal Rashtra are non competitive bidders
• Commercial Banks and other Financial institution comprise competitive bidders
• Price discovery takes place through the competitive bidders
TBs
• High Liquidity
• No default Risk
• Availability on a steady basis
• Less transaction costs
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• Rediscounting facilities offered by RBI
Govt or Gilt edged Securities
• Marketable debt issued by govt or semi govt bodies
• Represents a claim on the govt
• Dealing takes place through mechanism provided by RBI
• Brokers and Dealers including banks approved by RBI are eligible to deal in these securities
• They offer wide ranging tax incentives to investors
• It is an over the counter market
• The issuers such as Central Govts and State Govts constitute Primary market
• The secondary market comprises banks , financial institutions, insurance companies, provident funds, trusts, individuals, primary dealers and RBI.
Forms
• Inscribed stock
• Stock certificates
• Promissory note
• Bearer bond
Trading
• Trading is narrow
• Mainly traded on the Bombay Stock Exchange
Issue Mechanism
• The Public debt office of the RBI undertakes to sell Govt securities
• Notification for issue of securities
• Subscription: The offices of RBI and branches of RBI receive applications
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Types of Trading
• Grooming: Gradual acquisition of securities nearing maturity through the stock exchanges by the RBI in order to facilitate redemption. Purpose is to keep the process of issue and redemption continous
Switching
• Purchase of a security against sale of another security
Auctioning
• Method of trading where
• Merchants bid against one and another
• Security is sold to the highest bidder
Trading Mechanism
• Direct sales method
• Securities General Ledger Method
• Bank Receipts method
DS Method
• Public Debt Office effects direct sale of Govt. Securities.
• Loan amount is pre specified and the date of opening of subscription for Govt loans
SGL Accounts method
• RBI records transaction as book entries only in the ledger
• In respect of each separate dealing, the purchasing banker maintains a separate SGL account with RBI in respect of the purchase and the balance of the Central Govt Securities
• Selling banker effects transaction by filling out the prescribed SGL Form, which is then lodged with RBI.
Bank Receipts Method
• The bank selling Government securities issues a Bank Receipt
• These are facilitated by the SGL where it is possible to avoid physical transfer of securities
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Repos
• Collateralized and therefore low interest rates
• Securities dealers, commercial banks, DFHI, RBI, STCI and cooperative banks are allowed to participate in the repos market.
• Non bank financial companies, LIC, GIC, UTI and the corporates are also allowed to participate in the repos market
Reverse Repo
• Providing a return for holding securities
• The repo and reverse repos market is dominated by the major players, the banks who hold substantially huge portfolios of tradeable Govt securities
Government Bonds
• Securities with Fixed coupon rates
• Securities with variable coupon rates
• Zero Coupon Bonds
• Installment Securities
• Securities with embedded derivatives
• Tap stock
• Partly paid stock
• Capital Index Bonds
• STRIPS
Dealers in Govt Bonds
• Primary Dealers
• Satellite Dealers
Primary Dealers
• Banks and Institutions that are used by RBI for conducting the activities relating to secondary market are called Primary Dealers
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• To apply for primary dealership, agencies such as subsidiaries of scheduled commercial banks and all india financial institutions and companies incorporated under the companies act, 1956 are eligible.
• These agencies must be predominantly engaged in the securities business particularly in the Govt. securities market.
• Minimum net owned funds of Rs 50 crores
Roles and Obligations
• Bidding
• Underwriting
• Offering Quotes
• Achieving turnover
• Maintaining Capital Adequacy ratios
Authorization Procedure
• Primary dealers make an Application
• Give the RBI an undertaking , agreeing to the terms of approval
• RBI issues an authorization
Satellite Dealers
• Would supplement the PD system and would later on become a primary dealer
• Would engage in the task of setting up a second tier in trading and distribution of Govt securities
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Derivatives Market
Participants
• End users
• Dealers
End Users
• Consist of corporations, govt entities, institutional investors and financial Institutions
Dealers
• Consist mainly of Banks and Securities firms with a few insurance companies and financial institutions
• An institution may participate in Derivatives trading both as an end user and a dealer
Foreign Exchange Market
• Market for sale and Purchase of Foregn Currencies
• Does not have a Physical space
• Trading in Foreign currencies takes place through the electronically linked Network of Banks, Foreign Exchange Brokers and Dealers
• Not to be found in one place
• Are carried out primarily through the worldwide Interbank Market
• Trading is generally done by Telephone , Telex or SWIFT (Society for Worldwide Interbank Financial Telecommunication) system
• An important segment of the FX Market is the inter bank market
3 Constituents of Interbank Market
• Spot Market
• Forward Market
• Swap Market
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Spot Market
• Currencies are vtraded vfor immediate delivary extending for a period not exceeding two Business days after the completion of the transaction
• Spot Market transactions account for a share of 60 per cent of the FX Market
Forward Market
• Delivery of currencies takes place at a future date and the contracts for selling and buying take place at the current date
• Its Transactions account for 10 per cent of the FX Market
Swap Market
• Exchange of Currencies
• Comprises around 30% of the transactions in the FX Market
SWIFT
• It is an International bank communications Network that links electronically all brokers and traders in FX.
Five categories of Participants
• Foreign exchange dealers
• Individuals and Firms
• Speculators and Arbitrageurs
• Central Banks and Treasuries
• Foreign Exchange Brokers
Foreign Exchange Dealers
• Banks and Non Bank agencies
• They are the actual market makers in the Foreign Exchange markets
• Buy and sell Foreign currencies on a continuous basis
• They trade with other banks in their own monetary centers and in other centers of the world
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• Profit comes from buying foreign exchange at a bid price and reselling it at a slightly higher offer/ask price
Individuals and Firms
• Exporters and Importers, International portfolio investors, MNC tourists etc
Speculators and Arbitrageurs
• Speculators buy and sell currency to profit from anticipated changes in Exchange rates without engaging in other sorts of Foreign Exchange dealings for which Foreign Exchange is essential
Central Banks and Treasuries
• National Treasuries or Central Banks may trade in currencies for the purpose of affecting exchange rates
Foreign Exchange Brokers
• Commission agents who bring together
• Suppliers and buyers of Foreign currency
Transactions
• Several types of Transactions
• Significant among them are spot, forward and Swap Transactions
Spot Transactions
• An interbank transaction
• Where purchase, payment and delivery
• Takes place on the following second business day
• Rate quoted is called spot rate
• Date of settlement is called value date
Forward Transaction
• Where the specific amount of one currency is exchanged for a specified amount of another currency,
• At a future value date
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• Rate quoted is called forward rate
• Normally quoted for value dates of 1,2,3,6 and 12 months
Swap Transaction
• The simultaneous purchase and sale
• Of a given amount of Foreign Exchange
• For different value dates
Rates and Quotations
• The price of one currency expressed in terms of another currency
• A statement of willingness to buy and sell at a specified rate and at a specified value date is known as Foreign Exchange Quotation
Inter Bank Quotation
• Foreign Exchange quotations stated by and among the banks trading foreign exchange
• European terms is where the foreign exchange rate is expressed in terms of the US Dollar
• Eg. Rs 46 / $1 means 46 Rupees per Dollar
Direct Quotation
• The home currency per unit of Foreign currency is called ‘Direct Quotation’
• Unit of Foreign currency is kept constant
• Exchange rate is expressed as a change in the unit of home currency
Indirect Quotation
• Foreign currency price of home currency unit is called ‘ Indirect Quotation’
• Unit of home currency is kept constant and any change is expressed in unit of Foreign currency
Bid Quotation
• A quotation in one currency at which a dealer will buy another currency, is known as an ‘ask quotation’
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Cross Rates
• Where the exchange rates of inactively traded currencies are determined through their relationship with a widely traded third currency, it takes the form of cross rates
Forward Premium and Discount
• Where the payment made for forward delivery is more than the payment for the spot delivery of a foreign currency, the forward contract is said to be at a premium
Futures contract
• Standardized
• Standard amount
• Standard time
• Standard place
• Fixed price
Mechanics of Currency Trading
• Contract: Transactions take place in the inter bank market through the Telecommunications media
• Two way Quote: one for buying and other for selling. The bank that proposes the transaction is called the market maker
Bid ask rate
• The rate at which the bank will pay to buy
• The rate which the bank will require to sell
Taking Positions
• If the market maker sells more than it buys – short position
• If the market maker buys more than it sells – long position
Exchange Rates
• Fixed Rate System
• Semi fixed rate systems
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• Floating rate system
Fixed rate system
• Gold Standard
• Bretton Woods
• Pegged Rate
• Currency board
Gold Standard
• A country’s money supply is directly linked to the Gold Reserves owned by its Central Bank
Bretton Woods
• Based on Gold and Foreign Currency
• IMF created its own currency, the SDRs for issue to members for settling debts with one another
Pegged Rate
• A country decides to hold the value of its currency constant in terms of another currency usually that of an important trading partner
Currency Board
• The board issues currency only to the extent that each unit of currency is backed by an equivalent amount of Foreign currency reserves
Semi Fixed rate System
• Bands
• Target Zones
• Pegs and Baskets
• The crawling peg
Bands
• Exchange rate is allowed to stay and float within a certain band
• Central Bank is responsible for adjusting the interest rates to keep the exchange rates within the band
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Target Zones
• Similar to bands
• Except that the Govt’s commitment is non binding
• Possible for a govt to set a target zone unilaterally for its currency against another currency
• Or target zones can be agreed multilaterally by a group of countries
Pegs and Baskets
• Exchange rate is pegged to a basket of currencies rather than just to a single currency
• The peg is set as the average exchange rate against several currencies
The Crawling peg
• Mechanism for adjusting an exchange rate usually in a pre announced way
• Central bank may allow depreciation at a desired rate.
Floating Rate System
• Exchange rates are allowed to move with market forces
Merchant rate
• The rate at which the foreign exchange dealing takes place between a bank and the merchant business is called the ‘merchant rate’
Inter-bank rate
• Also known as the base rate, it refers to exchange rate quoted between banks
• Two types of buying rates – TT buying rate and Bill buying rate are quoted in India
Telegraphic Transfer Rate
• The rate applied when the transaction does not involve any delay in realization of the foreign exchange by the bank
Bill Buying rate
• The rate applied on the purchase of a foreign bill is called ‘bill buying rate’
• These have a transit period
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• The bills buying rate is loaded with the forward margin
Nominal exchange Rate
• The rate that prevails at a certain time
Real Exchange Rate
• Obtained by adjusting the nominal exchange rate for relative prices between the countries under consideration
Effective Exchange Rate
• A measure of appreciation or depreciation of the currency against the weighted basket of currencies
Global Financial Markets
Meaning
• The Financial Markets that operate outside the domain, regulations and legislative framework of a country are collectively known as ‘Global Financial Markets’
• Trading takes the shape of the borrower from one country seeking lenders in other countries in a specific currency
Important Constituents
• Euro Currency Market
• Export Credit facilities
• International Bond Market
• Institutional Finance
Euro Currency Market
• Dominated by Euro dollar deposit in the form of bank deposit and loans
• Dollar denominated time deposits available at foreign branches of US Banks and also at some foreign banks are called Euro dollar deposits
• The basis of Euro currency market is the banks in Europe accepting dollar denominated deposits and making dollar denominated loans to customers
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Export Credit Facilities
• Made available through the medium of EXIM Banks
• Play an important role in the extension of export credit facilities
International Bonds Market
• Also known as the Euro Bonds market provides facilities to raise long term funds by using different types of instruments
• Foreign bonds are also issued in domestic markets of some developed nations
Institutional Finance
• Several International financial Institutions provide finance in foreign currency.
• These include IMF, World Bank, IFC, ADB etc
Global Bond Market
• An international market for the purchase and sale of bonds
Questions for Revision
1. What is meant by the following:
Market
Financial Market
Primary Market
Secondary Market
2. Write a short Note on any two of the following:
Money Market
Capital Markets in India
Debt Market
Foreign Exchange Market
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3. Describe any five instruments used in the Financial Markets ?
