Indian Financial System PDF
Indian Financial System PDF
Indian Financial System PDF
System
For B Com Honours Degree Course of
University of Calcutta
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Sujatra Bhattacharyya
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Published in India by
Oxford University Press
Ground Floor, 2/11, Ansari Road, Daryaganj, New Delhi 110002, India
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prior permission in writing of Oxford University Press, or as expressly permitted
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by law, by licence, or under terms agreed with the appropriate reprographics
rights organization. Enquiries concerning reproduction outside the scope of the
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above should be sent to the Rights Department, Oxford University Press, at the
address above.
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You must not circulate this work in any other form
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and you must impose this same condition on any acquirer.
ISBN-13: 978-0-19-947935-1
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ISBN-10: 0-19-947935-6
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Tables
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Table 1.2 Differences between fund-based financial services and fee-based financial services
Basis of Difference Fund-based Services Fee-based Services
The chapters contain
Nature They provide funds to the business units to meet They provide advisory services to their clients and
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numerous detailed their requirements charge fees against their services
tables to support Risk These institutions provide funds and reduce risks They only provide advisory services
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Objective The main objective is the provision of capital Their main objective is provision of various
the text. technical, financial, and project-related advices
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Remuneration They earn interest on capital They earn fees against their advices
Example Hire-purchase and leasing companies, insurance Merchant banking, portfolio consultancy, issue
services, bill discounting, etc management, etc
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1. Discuss the importance of financial intermediary in the financial system. 5
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OR Distinguish between banking and non-banking financial intermediary. 5
2. What are the functions of ICICI in Indian financial market? 5
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OR State the importance of SFC in the development of small-scale industries. 5
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Question Bank
Question Bank
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A financial system is an integral part of the economy. It plays a pivotal role in the overall economic growth
of a nation. We can define financial system as a combination of various complex and mutually interdepend-
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ent financial activities that also acts as connecting link between savers and investors to fulfil a certain and
predetermined objective. The financial system acts as an intermediary, which ensures the flow of funds from
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surplus to deficit units. The financial system performs its basic activities through the components and involves
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Financial system is closely interlinked with economic development. Basically economic development indicates
both qualitative and quantitative aspects. Economists and financial experts relentlessly try to determine the
impact of the changes in the financial indicators on economic activities. Some serious efforts have been made
to assess the impact of financial activities on capital formation and economic development. The various the-
oretical and empirical findings are suggestive of significant effects of financial indicators on economic devel-
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opment. However, these financial indicators are not the only ones to affect economic growth. Actually they
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have a considerable amount of influence over the factors of economic development. Thus it is often believed
that a strong and sound financial system acts as a catalyst to economic development. It enhances the standard
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of living of the people as well as ensures the well-being of the population.
One important aspect of the financial system is its capability to encourage the rate of savings and invest-
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ment in the economy. An ideal and efficient financial system has the capability of filling the gap between
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investment and savings potential of the economy and thereby, mobilizing the savings. The specialty of the
financial system is that it not only initiates investment but also directs the investible fund into the productive
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sectors of the economy. This definitely leads to greater possibilities of economic development. On the other
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hand, the economic development of a nation increases the efficiency of the financial system. Thus we observe
some sort of complementarity between a financial system and economic development.
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India is one of the emerging developing nations which is expected to be a superpower in the near future.
The recent development in the nation owes significantly to the financial sector reforms since 1991, when the
country adopted the strategy of liberalization, privatization, and globalization. Naturally the robust growth
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of the economy is a matter of interest among the economists and financial experts. The book Indian Financial
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System comprises various financial aspects of Indian economy and presents a detailed idea about the oper-
ations in the financial market. The Indian financial system is now going through a phase of alterations and
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introduction of new techniques, rules, and regulations. This is a part of the strategy of turning the Indian
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financial system compatible with the financial systems of the developed nations. The financial sector reforms
are going to change the financial habits of the population. The government puts emphasis on the digitaliza-
tion of the financial transactions. A combination of all these changes and the existing traditional modes make
the Indian financial system an interesting one. This has motivated me to write a book on the Indian financial
system in a lucid manner so that it is easily comprehensible to the students.
are not available in the existing books. Besides, I have tried to explain the contents of the chapters in a lucid
manner for the benefit of the students. Thus we are hopeful that this book will not merely be an addition to
the already existing corpus in this field, but will also be able to create a unique and separate identity due to
its special features.
The key features of the book are as follows:
• The book clearly mentions the learning objectives at the beginning of the chapters which will enable the
students to be focused.
• The chapters are written in a simple lucid style so that the students can independently extract the matters
for their use.
• The contents are prepared with the objective of providing conceptual understanding and logical expla-
nations to the students.
• One of the most important features of the book is the simple diagrammatic representation of most of
the subject matter through figures and flow charts.
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• Current and latest data are incorporated in the subject matter for better understanding of the trends of
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various macroeconomic indicators.
• Some topics are accompanied by graphical representation so that the students can grasp the subject
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matter conveniently.
• All chapters end with multiple choice questions and review questions which will help the students apply
the concepts learnt in the chapters.
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• The detailed summary and glossary at the end of every chapter will help the students in a quick under-
standing of the contents and subject matter.
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• The important and extremely relevant portions of the subject matter are highlighted so that the students
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CONTENTS
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This book is comprised of 10 chapters which present the Indian financial system in a detailed manner.
Chapter 1 deals with the basics of the financial system and its components. It mainly focuses on the activ-
ities of financial intermediaries and also provides description about the structure of Indian financial system
and its recent changes.
Chapter 2 provides a fair idea about money and banking. Here, I have explained the different variations of
money, structure, and functions of the commercial banks and finally the functions and monetary policies of
Reserve Bank of India (RBI) and the recent changes.
Chapter 3 illustrates the objectives and functions of development banks like IFCI, IDBI, ICICI, NABARD,
SFC, EXIM Bank, etc. and focuses on the operational activities of them.
Chapter 4 covers other financial institutions like LICI, GICI, and UTI. The chapter not only focuses on
the objectives and functions of these institutions but also discusses their activities after liberalization. Besides
this, the chapter provides information about mutual funds and IRDA.
Chapter 5 explains the interest rate structure of the economy and differentiates gross and net interest. It
shows the methods of determination of equilibrium rate of interest and also identifies the reasons for the
differential interest rate.
Chapter 6 gives an overview of the financial markets by mentioning different financial instruments and
derivative techniques like forward, future, and options.
Chapter 7 focuses on the features, functions, and different types of money market. It further discusses call
money market in detail and informs about the money market reforms after liberalization.
Chapter 8 provides detailed analyses of features, functions, divisions, and participants of capital market.
The chapter clearly distinguishes the features of primary and secondary market and also discusses every
aspect of the stock exchange.
Chapter 9 shows the protection measures for the investors and provides remedies to the investors’ griev-
ances. It assesses the role of SEBI, court, and media in protecting the interest of the investors.
Chapter 10 describes the details of financial services. In this chapter the merchant banks and the credit
rating agencies are analysed. It also provides a detailed view of the objectives and activities of the merchant
banks and the credit rating agencies.
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ACKNOWLEDGEMENTS
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I have received active support and motivation from a number of persons for writing this book. My parents
have always been there to inspire me throughout this long journey. I am grateful to my teachers who taught
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me the basics of the subject. The support I have received from my elder brother Mr Dipra Bhattacharya,
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my sisters-in-law Aishee and Writi, and my in-laws is fabulous. My wife Prof. Debashree Bhattacharya has
not only helped me focus only on the writing by sharing the entire burden at home singlehanded but also
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rendered assistance to prepare the content. My student Prof. Sucharita Bhattacharyya of Barasat College
has actively participated in preparing study material by investing her time and hard work affectionately. My
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student Prof. Soumya Mukherjee of Maharaja Manindrachandra College has also helped me in different
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publication-related matters.
I am also indebted to my supervisors Prof. Arup Mitra of Institute of Economic Growth, New Delhi, and
Dr Asim Karmakar, my Principal Dr Shyamal Kumar Chakraborty, Prof. Sidhdhartha Majumdar of City
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College, and Prof. Asis Sana of University of Calcutta for continuous guidance and advice. Prof. Biswajit
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Chatterjee of Jadavpur University, Prof. Santanu Ghosh of Maulana Azad College, and Dr Indrani Saha of
Sri Sikhshayatan College have always encouraged me to pursue this sort of work. My colleagues of Maharaja
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Srischandra College are as usual cooperative and I should name Prof. Soma Sengupta, Dr Sunanda Ray, Dr
Sonali Banerjee, Debjani Kundu, Anindita Bhattacharyya, Debasis Mukherjee, Bidyut Sarkar, Dr Asim Das,
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Dr Avijit Chakraborty, Dr Debasree De, Sara Basu, Prof. Pradip Mukherjee, Prof. Prabir Dutta, Sarita Mal,
and Amrita Kundu for their tremendous support. The teachers of the Department of Commerce—Arup Kr
Bhattacharya, Dr Supti Kotal, Krishnapada Dash, Sreya Basu, Debjani Kundu, and Camellia Sarkar have
also motivated me a lot during this project. Supriya Bhattacharyya has provided relevant advice and inputs in
constructing the subject matter. Nabarun Bhattacharyya, Kuntal Mitra, Amit Ray, and Sudipta Bhattacharyya
were always present with their extended hands of cooperation, technical support, and motivation throughout
the journey. Prof. Debjani Lahiri of our college and Mita Dutta, the educator at Dakshineswar Sri Sri Sarada
Devi Balika Vidyamandir have also rendered their assistance in preparing the course material.
My heartfelt thanks and gratitude to those friends who helped me, choosing to remain invisible themselves.
I am also extremely grateful to the editorial and sales teams of Oxford University Press for their patience
and inspiration which boosted me to complete the project finally.
Feedback and suggestions for improving the future editions are always welcome and can be sent to the
author at sujatra_bh@rediffmail.com.
Sujatra Bhattacharyya
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1.1 Finance 1
2.6 Different Measures of Money Supply in
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1.1.1 Role of Finance 1
India 35
1.2 Financial System 2
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2.7 Indian Banking System 36
1.2.1 Role or Significance of the
2.7.1 Features of the Indian Banking
Financial System 3
System 36
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1.2.2 Functions of a Financial
2.7.2 Types of Banks in India 38
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System 4
1.2.3 Components of a Financial 2.7.3 Structure of the Banking System
in India 40
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System 6
1.2.4 Classification of Financial 2.7.4 Weakness of the Indian Banking
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Institutions 13 System 41
2.7.5 Remedial Measures Adopted to
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3.6.1 Introduction 95
3. Development Banks 72
3.6.2 Current Status of NABARD 95
3.1 Introduction 72 3.6.3 Capital Structure of
3.2 Definition of Development Bank 73 NABARD 95
3.2.1 Objective of Development
3.6.4 Share Holding Pattern of
Bank 73
NABARD 95
3.2.2 Role/Functions of Development
3.6.5 Management of NABARD 96
Banks 75
3.6.6 Objectives of NABARD 97
3.3 Industrial Finance Corporation of India
3.6.7 Functions of NABARD 97
(IFCI) 76
3.7 Export–Import Bank of India
3.3.1 Introduction 76
(EXIM Bank) 100
3.3.2 Current Status of IFCI 77
3.7.1 Introduction 100
3.3.3 Capital Structure of IFCI 77
3.7.2 Objectives of EXIM Bank 100
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3.3.4 Share Holding Pattern IFCI 77
3.7.3 Role/Functions of EXIM
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3.3.5 Management of IFCI 78
Bank 101
3.3.6 Objectives of IFCI 78
3.8 State Finance Corporation (SFC) 101
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3.3.7 Role/Functions and Operating
Policies of IFCI 80 3.8.1 Introduction 101
3.8.2 Objectives of SFC 102
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3.3.8 Subsidiary Functioning 82
3.8.3 Role/Functions of SFC 102
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3.4 Industrial Development Bank of India
(IDBI) Limited 83 3.9 Small Industries Development Bank of
India (SIDBI) 103
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3.4.1 Introduction 83
3.4.2 Current Status of IDBI Bank 3.9.1 Introduction 103
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IRDA 126 5.8.2 Liquidity Premium Theory 151
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4.7 Unit Trust of India 127 5.8.3 Market Segmentation
4.7.1 Origin and History of the Theory 151
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Evolution of UTI 127 5.9 Differential Interest Rate: Causes
4.7.2 Organizational Set Up of of Variations or Differences in the
UTI 128
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4.7.3 Management of UTI 128 5.9.1 Difference in Pure Interest 152
4.7.4 Objectives of UTI 128 5.9.2 Difference in Gross Interest
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6.4.5 Insurance Regulatory 8.3 Funtions of Capital Market 218
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Development Authority 186 8.4 Structure of Capital Market 220
8.5 Participants or Constituents of Capital
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7. Money Market 189 Market 220
7.1 Introduction 189 8.6 Indian Capital Market 222
7.2 Money Market—Concept and
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Significance 189 Growth of Indian Capital
7.3 Participants in the Money Market 190 Market 222
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7.4 Conditions for Developed Money 8.6.2 Nature and Features of the Indian
Market 190 Capital Market 223
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9.4 Grievance Redressal Cell in Stock 10.4.1 Origin of Merchant
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Exchanges 285 Banking 307
9.4.1 Objectives and Functions of 10.4.2 Evolution of Merchant Banking
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Grievance Redressal Cell 285 in India 307
9.5 Securities and Exchange Board of India 10.4.3 Nature and Features of Merchant
(SEBI) 287
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9.5.1 Organization and 10.4.4 Functions of Merchant
Structure 287 Banks 309
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9.6 Company Law Board (CLB) 293 Merchant Bank Activities 314
9.6.1 Power of CLB 294 10.5 Credit Rating 319
9.6.2 Functions of CLB 295 10.5.1 Concepts of Credit Rating 319
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9.6.3 National Company Law Tribunal 10.5.2 Origin of Credit Rating 321
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MODULE 1
Unit Topic Details Chapter
Unit I Financial System Meaning and significance; Role of finance in an economy; Components (instruments, 1
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markets, etc.); Kinds of finance – Rudimentary finance, direct and indirect finance;
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Role of financial intermediaries; The structure of Indian financial system
Unit II Money and Indian Functions; Alternate measures to money supply in India – Their different 2
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Banking System components; Commercial banks – Importance and functions; Structure of
commercial banking system in India; Distinction between commercial and central
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bank; Credit creation process of commercial banks; High powered money – meaning
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and uses – Concept of money multiplier
The Reserve Bank of India: Functions; Instruments of monetary and credit control;
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Main features of monetary policy since independence
Unit III Development Banks Concept of development banks, and their needs in Indian financial system – 3
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Differences with commercial banks – Major development banks and their functions
(IFCI, IDBI, ICICI, EXIM Bank, SIDBI, SECs, NABARD)
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Unit IV Other Financial Introduction; Life Insurance Corporation of India, General Insurance Corporation of 4
Institutions India, Unit Trust of India
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Unit V Interest Rate Meaning – gross and net interest rate – their difference; Nominal and real interest 5
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Structure rate – their difference; Differential interest rate, Causes of variation of interest rate,
relationship between interest rate and economic progress; Administered and market-
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MODULE 2
Unit Topic Details Chapter
Unit I Overview An Overview of Financial Markets in India 6
Unit II Money Market Concept; Structure of Indian money market, Acceptance houses; Call money market; 7
Recent trends of Indian money markets
Unit III Capital Market Concept; Security market, Primary and secondary markets – Functions and role; 8
Functionaries of stock exchanges – Brokers, sub-brokers, jobbers, consultants,
institutional investors, and NRIs
Unit IV Investor’s Protection Grievances concerning stock exchange dealings and their removal, Grievance 9
redressal cell in stock exchanges; Role of the SEBI; Company Law Board, Judiciary
and media
Unit V Financial Services Merchant banking – Functions and roles; SEBI guidelines; Credit rating – concept & 10
types, functions and limitations; Profile of Indian rating agencies
6
An Overview of
Financial Markets in India
Learning Objectives
After studying this chapter, you should be able to
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• understand the features, roles, and classifications of the financial market
• identify the variations in the organized and unorganized financial market
• recognize the features and functions of the foreign exchange market
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• explain the features of the derivatives
• classify the different derivatives
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• understand the concepts and features of forward, future, options, and swaps
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• distinguish between forward and future, future and options, and call option and put option
• identify the regulators of the Indian financial market
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6.1 INTRODUCTION
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Financial market refers to a centre that provides the facilities of sale and purchase of financial claims and ser-
vices. The individuals, financial institutions, corporations, and government trade in this market either directly
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or indirectly through brokers and dealers. If we want to analyse the financial market of a nation, then initially,
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we should concentrate on the various financial markets of that nation, various financial institutions operating
on those markets, and the financial instruments and services available in those markets.
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The financial market generally plays a vital role in transferring funds of the surplus units into the produc-
tive sectors of the economy. Thus, this market is involved in proper channelization of savings, which in turn
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leads to the capital formation and economic development. Allocation of funds into the productive sectors of
the economy implies a growth in the national income (Fig. 6.1).
Financial markets
Foreign exchange
Money markets Capital markets Derivative markets
markets
Organized Unorganized
1. Call money
2. Commercial bill
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3. Treasury bill
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Equity Debit
4. Commercial paper
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5. Certificate of deposit
6. Repo and reverse repo
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Primary Secondary
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Reserve Bank of India (RBI), Security and Exchange Board of India (SEBI), etc. Conversely, the par-
ticipants in the unorganized segment are beyond the control of the regulators. The rural moneylenders
occupy a significant portion of unorganized market.
2. Insufficient participation In India, the per capita income is low, which leads to a low rate of savings
and investment. The low rate of savings is responsible for insufficient participation of investors in the
financial market.
3. Mobilization of savings The financial market acts as the medium in the process of transfer of funds
from savers to investors. Indian financial market also ensures flow of funds from savers to the productive
sectors of the economy.
4. Presence of regulatory bodies The Indian financial market comprises both money and capital
market, which are regulated by some institutions such as Ministry of Finance, RBI, SEBI, Insurance
Regulatory and Development Authority (IRDA), and National Company Law Tribunal (NCLT).
5. Faulty banking network In India, most of the scheduled commercial banks are interested to estab-
lish their branches in the urban areas for profit motive. Hence, the number of banks in the rural areas is
very limited. This leads to an unbalanced development in the banking sector.
6. Inefficient capital market The efficiency of the Indian capital market is not up to the mark. Before
the adoption of the new economic policy in 1991, the capital market was ill-developed. However, after the
adoption of new economic policy, there were a lot of positive changes in the capital market. Foreign cap-
ital was flown to Indian capital market. Thus, there was an improvement but was definitely insufficient.
7. Limited coordination Since a significant portion of the financial market in India is characterized by
unorganized segment, there was clearly a lack of coordination between the different units of the Indian
financial market.
8. Lopsided development The financial markets in India are not equally developed in different
regions. The financial markets are fragmented, and accordingly, the coordination among them is not so
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strong. Thus, the Indian financial market is characterized by lopsided development.
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9. Parallel economy In India, besides the conventional economy, we observe a parallel economy where
the transactions occur without any specific rules and regulations. This leads to the generation of unac-
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counted or black money in the financial system.
10. Paucity of financial instruments As the financial market in India is not that vast, the possibility of
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introducing new financial markets is very limited. Though, after 1991, when the new economic policy
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was adopted, some measures were taken to develop the capital market. Some new financial instruments
are introduced in recent times also. However, there is a long way to travel, as still we have a very limited
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usage of the financial instruments compared to the other developed nation of the world.
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11. Huge corruptions and scam The Indian financial market experienced huge corruptions and scams.
The scams related to Harshad Mehta and Ketan Parekh destroyed the faith of investors on the financial
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market. Government of India established SEBI in 1992 to prevent the malpractices specifically in the
Indian financial market.
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However, the financial market in India helps to develop the financial system, assists in the process of capital
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formation, helps in transaction, and plays an important part in increasing the volume of trade. Apart from
this, an efficient financial market leads to creation of new job opportunities in India.
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are channelized into the hands of fund seekers. Here, the short term refers to the time period between 1 day
and 1 year. The main instruments for the short-term transactions in this market are bank draft, cheques, bill
of exchange, and pay-orders.
Indian money market can be subdivided into
(i) organized money market (ii) unorganized money market
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1. Call money market The part of the money market where day-to-day transactions of surplus funds
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occur is known as call money market. This market provides short-term funds, and the time of repayment
varies from 1 to 14 days. Call money has the maximum liquidity and considered as a very safe loan.
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In India, the scheduled commercial banks, discount and finance house of India, and many primary deal-
ers participate in this market. The other financial institutions and mutual funds can only provide loans in
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this market. The call money market basically meets the temporary crisis of funds and protects the cash
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reserve ratio of the banks. In India, the call money market is very much controlled and narrow. The entry
is restricted, and, hence, there are a number of borrowers in the market but the number of lenders is
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very few. That is why the participants in this market do not get any active market. However, the situations
have changed after 1985 where committees of both Chakraborty and Bhagal recommended increasing
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2. Commercial bill market The market in which we observe the transactions of commercial bills is
known as the commercial bill market. Now, commercial bills refer to the bills against which the industrial
and business concerns receive short-term loans from the commercial banks. These short-term loans are
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The commercial bills involve three parties such as drawer or bill-preparer, drawee or bill-subscriber, and
payee. The commercial bills are in the written form, which should be signed for authenticity. Generally,
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the use of commercial bills enhances the size of goods market, provides liquidity, and expands credit
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Certificate of deposit was introduced in India in June 1989. The commercial banks accept the term-de-
posits by issuing this type of certificates. This certificate is transferable in nature whose tenure varies from
15 days to 1 year. The minimum amount deposited is fixed at `100,000.
5. Commercial paper market The commercial paper, that is negotiable in nature, implies a short-
term promissory note issued by the big and highly rated companies. The market that deals with commer-
cial papers is known as commercial bill market. These are issued by the companies to raise the short-term
fund required for working capital. The commercial papers are unsecured and can be exchanged.
Commercial papers are used in India since 1990. An individual, an institution, a company, or a bank can
invest in commercial papers. Generally, the tenure varies from 7 days to 1 year, and the minimum amount
required for investment is `5 million. In India, the commercial paper market plays a significant role.
6. Repo and reverse repo Repo and reverse-repo are one of the latest inclusions in the money market,
which are compatible with the recent diversifications in the financial market in India. All these diversifi-
cations actually strengthen the financial markets of India.
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Repo or repurchase agreement is the transaction in which a financial institution or a bank receives funds
immediately by selling securities with an agreement to repurchase the same at a specified pre-determined
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price after a specific time period. Hence, repo is applicable only if there is a short-term crisis of funds.
Conversely, in case of reverse repo, a financial institution or a bank purchases a security with an agree-
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ment to sell it back on a specific date at a pre-determined price.
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Apart from the above-mentioned components, the mutual funds and inter-bank participation certificates are
also notable, which will be discussed elaborately in the subsequent chapters.
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The part of the money marker where all the transaction occurs without any regulations or norms is known as
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unorganized money market. In the unorganized market, there is a very weak linkage among the various units.
In India, the unorganized market occupies a significant portion of the money market. Often, their activities
are beyond the control of RBI.
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The important components of the unorganized financial market in India are local moneylenders, rural
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moneylenders, chit funds, business person, shroffs, etc. The organized sectors are not interested to operate
in the rural economy due to low profit potential. Hence, the unorganized sector grabs the opportunities of
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investing in the rural economy of India. Naturally, the lending rate is very high in the rural sector, which leads
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to a considerable amount of exploitation of the rural mass. The economic development varies inversely with
the presence of unorganized sector in the economy.
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6.3.2.2 Debt market
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Debt market essentially indicates the bond market. The debt market occupies a major portion of the financial
market, and actually, it covers more than the equity market in terms of volume. The debt market can be clas-
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sified as corporate debt market, government securities market, and public sector undertaking bond market.
This market is able to maintain the liquidity of the financial market. It provides finance to government for
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developmental activities. However, the principal function of this market is to channelize the surplus fund of
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the savers to the productive sectors of the economy.
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Foreign exchange market refers to a market in which domestic currency or claims are exchanged for foreign
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currencies. In an open economy, foreign exchange market has a vital role to play. It refers to a centre where
we observe the transactions between buyers and sellers of foreign exchange. In other words, it is the market in
which currency of one nation is exchanged for the currency of the other nation (Fig. 6.2).
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1. International transactions The transactions of one nation with other nations are known as inter-
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national transactions. The foreign exchange market is the centre of international transactions.
International transaction
Currency of one nation is
exchanged for currency of Round the clock functions
another nation Voluminous transactions
Lower trading cost
Sufficient liquidity
Arbitrage hedging
Foreign exchange market Features
speculation
High transparency
Big players’ market
Worldwide presence
Transaction of foreign Exchange rate fluctuations
exchanges
Emerging activities
2. Round the clock functions Except for the weekends, foreign exchange market is open 24 hours a
day. It should be noted that it is the only market that is always open except for the weekends.
3. Huge volume of transactions The foreign exchange market is characterized by the presence of a
number of big players. Thus, the volume of transactions executed in forex market is huge.
4. Lower trading costs The trading cost in the forex market is comparatively low. So, it is possible for
the small, individual investors to make a considerable amount of profit from various transactions.
5. Liquidity Owing to the presence of numerous big players in the market, the transactions are volumi-
nous. This leads to sufficient liquidity in this market.
6. Transparency Transparency in the forex market implies the free access to the trading information.
The players in the forex market have the full access to the data and relevant information, which are nec-
essary to perform a profitable transaction. In that sense, forex market is extremely transparent.
7. Big players’ market The big and reputed banks and the governments of different countries par-
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ticipate in the foreign exchange market as the players. Hence, forex market is known as the big players’
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market.
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8. Worldwide presence As the forex market is present in every nation, it can be said that they are
located everywhere in the world geographically. This is naturally a unique feature of the forex market.
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9. Exchange rate fluctuations Since the demand and supply conditions in the foreign exchange mar-
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ket are continuously changing, the market is characterized by exchange rate fluctuations.
10. Emerging activities The fluctuations in the exchange rate of the forex market give birth to some
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activities or professions namely arbitrage, speculation, and hedging. Arbitrage refers to the buying of a
currency from the financial centre where it is cheap and simultaneously selling of it where it is expensive.
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Hedging implies covering or minimizing the risk. Conversely, speculation is the deliberate assumption of
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Financial derivative is treated as an integral part of the financial market in these days. It is a well-known
fact that the financial market is quite volatile, and, hence, the investors have to take the possibility of risk
into consideration for every transaction. This calls for the introduction of the concept of derivative. The
derivatives become the most modern financial instruments for minimizing the risk. These instruments
are known as ‘derivatives’ because they derive their values from some underlying assets such as agricul-
tural commodities, shares, currencies, gold, silver, and other commodities. Hence, it is evident that the
derivative techniques can be applied in capital, commodity, and foreign exchange markets.
Thus, derivatives are defined as written contracts between two different parties, which have no
intrinsic value of its own, but it is derived from the underlying assets such as currencies, commodities,
and gold. The risk-averse people interact with the risk-lovers through derivatives, and the common
place of interaction between them is known as derivative market. In this context, derivatives act as
risk-shifting instrument (Fig. 6.3).
• It has no intrinsic value of its own—its value is derived from underlying assets such as commodity, currency, and
capital.
• Derivatives involve low transaction costs and raise liquidity in the financial system.
• Sometimes, derivatives assist the traders as they predict the market movements.
• The presence of derivatives in the financial market strengthens the composition and depth of the market.
• Derivatives in the financial market are used for hedging and speculation.
• Derivatives are traded globally that indicates their popularity in the financial market.
• The types of derivatives are forward, future, options, swaps, and warrants.
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• future contracts • swaps
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We will briefly explain these different derivative techniques of the financial market.
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1. Forward contracts
The derivative contract where a buyer and a seller are agreed to exchange a commodity or instru-
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ment for cash at a pre-determined price at a pre-determined date, agreed upon today, is known as
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forward contract.
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The stipulated or the pre-determined price is known as forward price.
Let on 15 August 2016, company A makes an agreement with company B, that on 15 November 2016, it
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will buy 2 kg of gold at `2.5 million/kg. Let on 15 November, the market price (also known as spot price)
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of per kilogram gold becomes `30 million which implies a gain of (2 × 30 million − 2 × 25 million) or
`10 million for the buyer. If the contract is cash-settled, then the seller will just pay the profit, that is
`10 million to the buyer rather than giving him 2 kg of gold.
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a) Features of forward contract The salient features of the forward contracts are:
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i. Customized contract The contract between buyer and seller is made according to their mutual
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decisions. The contract is customized in the sense that it can vary from parties to parties depend-
ing on mutual decision-making, which serves the needs of both the parties.
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Customized and
Written contract between Forward
OTC contract
two different parties
Low transaction cost Standardized and exchange
based contract
Predict market movements Future
Call
Derivatives Types
Contractual agreement with
Strengthen the depth of the Options right but no obligation
market
Increase liquidity Put
Value is derived from the Customized contracts to
underlying assets Swap exchange cash flow
ii. Settlement of future transactions In this type of contract, the agreement is made for a transaction in
future while the future price and date of transaction are agreed upon today.
iii. Associated risk Naturally, the parties involved in the forward contract are exposed to risk during
the validity of the contract.
iv. Settlement The contract is settled at its date of expiry, when one of the parties make profit in
terms of cash or other assets. The forward contracts can be settled by physical delivery of the
asset or cash settlement at the date of expiry or delivery date.
v. Vast applicability The forward contract can be observed in foreign exchange market, capital
market, or commodity market, which shows its vastness and wide acceptability.
vi. Bilateral The forward contract is bilateral in nature, which involves a buyer and a seller. The
agreements about pre-determined price, delivery date, etc. are negotiated bilaterally by the par-
ties involved.
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vii. Absence of direct cost One of the reasons for the popularity of the forward contract is the absence
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of direct cost in this agreement. In case of a cash settlement, the buyer or seller has to pay only
the cash difference between agreed upon price and spot price. There is no exchange of money
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between the parties at the time of making the contract.
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viii. Over-the-counter trade Forward contracts trade over the counter. Trading of forward contracts on
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any recognized stock exchange is not familiar.
2. Future contracts A future contract refers to a standardized contract between two parties to purchase
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or sell an asset at a specified time in future for a certain price agreed by the parties involved. It is often
termed as a special type of the forward contract, which is standardized in nature and exchange traded.
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a) Features of future contract The future contract has the following features:
i. Standardized in nature The future contracts are standardized in nature. It is characterized
by few standardized specifications such as date and month of delivery, quantity, and price
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quotations.
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ii. Liquidity Future contracts are highly liquid in nature, which makes it popular in the financial
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market.
iii. Period of contract The period of future contracts generally varies from 3 to 21 months.
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iv. Exchange traded Unlike forward contracts, future contracts are standardized and exchange
traded. This implies future contracts are traded on the exchange subject to the specific rules and
regulations of the exchange.
v. Presence of margin payments The future contract is characterized by the margin requirements.
Margin money should be paid by both buyers and sellers.
vi. Limited number of contracts The number of contracts is limited in case of future contracts. It is
generally limited between 4 and 12 in a year (Table 6.1).
3. Options
An option refers to a contractual agreement that ensures a right, but not the obligation, to buyer or
the seller to buy (in a call option) or to sell (in a put option) a specific instrument at a per-determined
price (which is known as strike price) on or before the specified date in the future.
The maker of the option is known as option writer and the holder of the option as option buyer. The
holder of the options has to pay the price of the options, which is known as ‘premium’. The premium is
determined by the expected variance in price in future, market liquidity, rate of interest, dividend, etc.
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Regulation Generally traded in an unregulated market Financial regulators regulate the transactions
Contract price Not disclosed publicly Publicly disclosed
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Settlement of date They are settled in the maturity date They can be settled on or before maturity date
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Profit or loss It is realized when the contract matures sit It is realized on daily basis
It should be noted that, if the option buyer does not exercise the option, then he/she will only lose the
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amount of premium.
a) Features of option The option is an important derivative technique practiced all over the world
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i. Transaction right The options provide the opportunities to buy and sell some underlying assets
such as securities, currencies, and commodities. It is only exercisable by the option holder.
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ii. No obligation Though the option holder has the right to buy or sell the underlying assets such as
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securities, commodities, and currencies, there is complete absence of obligation. In case of huge
losses, the holder will not exercise the option and, instead, only pay the premium prices.
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The price at which the transactions of underlying assets have been performed is known as
the strike price. It is also known as the ‘exercise price’.
iv. Time limit European option can be exercised only on the date of maturity. However, American
option can be exercised any time prior to the maturity date or in the maturity date.
v. Types of options The options are of two types call options and put options. In case of call
options, the holder has the right to purchase the assets if market price is greater than strike price.
Conversely, in case of put option, the holder has the right to sell the assets if market price falls
below the strike price.
vi. Difference from shareholder An option holder and share holder is completely different from each
other in terms of various rights. The shareholders enjoy voting rights, dividends, etc. An option
holder has no such rights.
b) Types of option As we have mentioned earlier, options are of two types call option and put option.
i. Call option Call options offer the right (not obligation) to the investor or option holder, to pur-
chase the underlying assets such as commodity, currency, or securities by a specified date or
before at a certain price. If the option holder exercises his right, then the seller has the obligation
to fulfil the contract. An investor opts for call if he/she expects that market price will go above
the strike price.
We can explain the process of call option through the following example. Let the listing price of
the share X in the share market be `100. The premium price per share is determined at `20.
Let an investor or the option holder purchase a call option to buy 100 shares at `250 after 3
months. Now, let the spot/market price becomes `350 after 3 months. Here, the option holder
will definitely exercise his right by paying `25,000 to the seller. Here, his/her net gain will be
[(spot/market price - strike price) - premium price] × no of shares, that is `[(350 − 250) − 20]
× 100 = `8000. However, if after 3 months, the market price of X falls to `75, then naturally,
the option holder will not exercise his/her option to avoid the possible loss, as he/she has no
obligation. In that case, he/she has to pay only the premium price, that is `20 × 100 = `2000.
Thus, his/her maximum loss will be the premium price.
ii. Put option Put option offers the right (not obligation) to the investor or option holder to sell the
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underlying assets such as currency, commodity, and securities by a certain date at a pre-deter-
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mined price. If the option holder exercises his right, then the buyer has the obligation to fulfil
the contract. An investor opts for put if he/she expects that spot or market price will fall below
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the strike price.
We can illustrate this fact through the following example. Let the listing price of the share Y in
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the share market is `100. The premium price per share is determined at `20. Let an investor or
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the option holder purchases a put option to sell 100 shares at `250 after 3 months. Now, let the
spot/market price becomes `150 after 3 months. Here, the option holder will definitely exercise
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his right and sell these 100 shares for `250. Here, his/her net gain will be [(strike price - spot/
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market price) - premium price] × no of shares, that is `[(250 − 150) − 20] × 100 = `8000.
However, if after 3 months, the market price of share of company Y rises to `350, then natu-
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rally the option holder will not exercise his/her option to avoid the possible loss, as he/she has no
obligation. In that case, he/she has to pay only the premium price, that is `20 × 100 = `2000.
Thus, his/her maximum loss will be the premium price (Tables 6.2 and 6.3).
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4. Swaps
Swaps are defined as the customized contracts between two parties to exchange cash flow in the
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future on the basis of a pre-determined formula. It is a type of financial instrument concerned with
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exchange mechanism.
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Margin Only the seller has to pay the margin money Both buyer and trader have to pay margin money
Users Small traders with low risk Traders with high risk
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Policy Option holder can avoid trading if transaction is not Transaction in stipulated date is mandatory
profitable
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Swap technique is used in the conditions of changing rate of interest, undulating fluctuations in the
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a) Currency swaps To minimize the risk associated with volatility of the currency rates, these
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types of swaps are used. It refers to the agreement where the currencies are exchanged at a certain
exchange rate. In other words, a currency swap or a cross-country swap refers to a foreign exchange
derivative between two institutions to exchange the principal and/or interest payments of a loan in
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one currency for equivalent amounts, in terms of net present value, in another currency (Wikipedia).
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b) Interest rate swaps (IRS) These indicate the arrangements interlinked to only the interest
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related cash flows between the different parties in the same currency. IRS implies a liquid financial
derivative instrument in which the two parties involved agree to exchange interest rate cash flows.
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Apart from this, the Ministry of Finance along with RBI have adopted various regulatory measures in
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the plan period. These measures were adopted to ensure the discipline of the financial market. Ministry of
Finance have a close look on the activities of the capital and money markets. In accordance with this, ministry
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of finance takes regulatory measures to remove the problems of the money and capital markets.
gained enormous power. It gained the power of controlling all the commercial banks in the financial system.
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To regulate the commercial banks in the system, RBI imposed various quantitative and qualitative control
measures in the system. The important quantitative control measures adopted by RBI are bank rate, open
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market operations, variable reserve ratio (i.e., cash-reserve ratio), and statutory liquidity ratio. The qualitative
control measure implies the selective credit control measures. In fact, since bank nationalization in 1969, the
regulating power of RBI in money market has increased significantly. RBI also has the power to control the
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In Indian stock market, the existing shares of the companies are traded. Now companies are governed
through Company Act. Thus, Company Act has a close relationship with the share market. The Company
Act of 1956 was amended in 1963. In this amendment, it was mentioned that central government will
construct a separate board for regulation of companies whose name will be Board of Company Law
Administration or Company Law Board. Company Law Board was established in 1964. The basic objective
of the board was to ensure transparency in the company management. The board also tries to make the
company management free from corruption. As per New Companies Act, 2013, Company Law Board is
replaced by NCLT.
corruptions in the capital market and, thus, strengthens the financial base of the nation. At the same time,
SEBI introduces code of conduct for the subsidiaries so that it can impose control over them.
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SUMMARY
• Financial market refers to a centre that provides the facilities of sale and purchase of financial claims and services. The individuals, financial
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institutions, corporations, and government trade in this market either directly or indirectly through brokers and dealers.
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• Indian financial market is classified into money market, capital market, foreign exchange market, and derivative market.
• Money market is divided into organized and unorganized markets.
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• Indian money market comprises call money market, certificate of deposit market, and commercial paper market.
• The capital market is classified into equity market and debt market. Equity market is divided into primary and secondary markets.
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• In the foreign exchange market, currency of one nation is exchanged for the currency of another nation. Foreign exchange market facilitates
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• In India, forward, future, options, and swaps are the main variations of the derivative.
• The derivative contract where a buyer and a seller are agreed to exchange a commodity or instrument for cash at a pre-determined price
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at a pre-determined date, agreed upon today, is known as forward contract. It is OTC traded.
• A future contract is often termed as a special type of the forward contract, which is standardized in nature and exchange traded.
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• An option refers to a contractual agreement that ensures a right, but not the obligation, to buyer or the seller to buy (in a call option) or to
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sell (in a put option) a specific instrument at a per-determined price (which is known as strike price) on or before the specified date in the
future. The maker of the option is known as option writer and the holder of the option as option buyer. Options are of two types call option
and put option.
• Swaps are defined as the customized contracts between two parties to exchange cash flow in the future on the basis of a pre-determined formula.
• The regulators in the Indian financial market are central government, RBI, SEBI, IRDA, and company law board.
GLOSSARY
Call options offer the right (not obligation) to the investor or option holder, to purchase the underlying assets such as commodity, currency,
or securities by a specified date or before at a certain price.
Call money market is the part of the money market where day-to-day transactions of surplus funds occur. This market provides short-term
funds, and the time of repayment varies from 1 to 14 days.
Certificate of deposit market is the market that deals with certificate of deposits. Certificate of deposits, which are issued by the commercial
banks and development financial institutions in bearer forms, refer to the short-term and unsecured negotiable instruments.
Commercial bill market is the market in which we observe the transactions of commercial bills.
Commercial paper market deals with the commercial paper, which is negotiable in nature, and implies a short-term promissory note issued
by the big and highly rated companies.
Derivative market is the place of interaction between risk-averse people and risk-lovers through derivatives.
Equity market refers to that part of capital market that deals with shares and debentures of various joint stock companies.
Foreign exchange market refers to a market in which domestic currency or claims are exchanged for foreign currencies.
Forward contract is the derivative contract where a buyer and a seller are agreed to exchange a commodity or instrument for cash at a
pre-determined price at a pre-determined date, agreed upon today.
Future contract refers to a standardized contract between two parties to purchase or sell an asset at a specified time in future for a certain
price agreed by the parties involved.
Option refers to a contractual agreement that ensures a right, but not the obligation, to buyer or the seller to buy (in a call option) or to sell
(in a put option) a specific instrument at a per-determined price (which is known as strike price) on or before the specified date in the future.
Primary or new issue market is the financial market that deals with new financial claims or securities. As this part of financial market deals
with new securities, it is known as ‘new issue market’.
Put options offer the right (not obligation) to the investor or option holder to sell the underlying assets such as currency, commodity, and
securities by a certain date at a pre-determined price.
Repo or repurchase agreement is the transaction in which a financial institution or a bank receives funds immediately by selling securities
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with an agreement to repurchase the same at a specified pre-determined price after a specific time period.
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Reverse repo in this, a financial institution or a bank purchases a security with an agreement to sell it back on a specific date at a pre-de-
termined price.
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Secondary market is the part of the financial market that deals with the already existing or new securities. Thus, in the secondary market,
existing securities are sold and purchased. Secondary market is also known as ‘stock market’.
Swaps are defined as the customized contracts between two parties to exchange cash flow in the future on the basis of a pre-determined
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formula. It is a type of financial instrument concerned with exchange mechanism.
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Treasury bill market is the market in which the transactions of the treasury bills occur. Treasury bill refers to a commercial bill or a financial
instrument issued by the central bank on behalf of the government in order to meet the short-term liquidity problem. The market in which the
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(a) Increases the size of goods market (a) 1–14 days (b) 3–21 days
(b) Provides liquidity (c) 3–21 months (d) 1–2 years
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(c) Expands credit facilities 9. Strike price in case of option is also known as
(d) All of the above (a) Shadow price (b) Equilibrium price
3. The treasury bills are issued by (c) Exercise price (d) Premium price
(a) Reserve bank of India 10. Which of the following cannot be regarded as a type of
(b) Commercial banks swap?
(c) Merchant banks (a) Currency swaps (b) Warrant swaps
(d) Development banks (c) Interest rate swaps (d) Warrant swaps
4. Which is not a type of treasury bills? 11. Forward contract involves
(a) 15 days (b) 91 days (a) Generally a single delivery date
(c) 182 days (d) 364 days (b) Liquidity
5. Certificate of deposit was introduced on India in (c) No credit risk
(a) 1991 (b) 1990 (d) Margin requirements
(c) 1989 (d) 1988 12. Which of the following is not a feature of the future
6. New issue market refers to contract?
(a) Commodity market (b) Primary market (a) They are exchange traded
(c) Secondary market (d) Stock market (b) Highly liquid
7. Which of the following is not a feature of the derivatives? (c) They involve credit risk
(a) It increases the market risk (d) Buyers and sellers have to pay margin money
13. Which of the following is not a feature of put option? 14. RBI was established in
(a) Buyer’s risk is unlimited but the seller’s risk is restricted (a) 1935 (b) 1940
(b) Provides an obligation to sell an underlying asset (c) 1937 (d) 1952
(c) The trader remains pessimistic in nature 15. IRDA was formed in
(d) Direct relationship with stock market (a) 1998 (b) 1999
(c) 2000 (d) 2001
EXERCISES
1. What do you mean by financial markets? 9. What are options? How do the options ensure profit for the
2. Define financial market. Mention its role and significance. option holder?
3. What is an equity market? What are its divisions? 10. What are the types of options? Discuss the features of the
4. Define derivatives. What are the features of a derivative? different types of options.
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5. Define foreign exchange market. How does the foreign 11. Distinguish between call options and put options.
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exchange market assist in the international transactions? 12. Distinguish between options and futures.
6. Define forward contract. What are the features of a forward 13. Discuss the uses and trading mechanism of forward
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contract? contract.
7. What do you mean by future contract? Discuss the features 14. Define swaps. What are its types? Discuss the features of
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of the same. swap.
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8. Distinguish between forward and future contracts.
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