Unit 4

Financial market and instruments

Meaning and definition

Financial markets refer to platforms or systems where individuals, institutions, and governments can
buy and sell various financial instruments, such as stocks, bonds, currencies, commodities, and
derivatives. These markets facilitate the exchange of funds between investors and borrowers, allowing
for efficient allocation of capital and risk.

Role and functions of financial markets

1. Capital Allocation: Financial markets facilitate the allocation of funds from savers,
investors, and institutions to individuals, businesses, and governments that need capital for
various purposes. This allocation enables productive investments, which can lead to
economic growth and job creation.
2. Price Determination: Financial markets provide a platform where the prices of financial
assets are determined through the interaction of supply and demand. These prices reflect the
market's assessment of the underlying assets' value and expected future performance.
3. Liquidity: Financial markets enhance the liquidity of financial assets, making it easier for
investors to buy or sell their holdings quickly without significantly affecting the asset's price.
This liquidity promotes investor confidence and market stability.
4. Risk Sharing and Diversification: By enabling the trading of various financial instruments,
markets allow investors to diversify their portfolios and spread risk. This risk-sharing
function helps individuals and institutions manage their exposure to uncertain events.
5. Resource Mobilization: Financial markets enable companies, governments, and other
entities to raise funds by issuing stocks, bonds, and other securities. These funds can be used
for business expansion, infrastructure development, and other projects.
6. Price Discovery: Financial markets provide a platform for participants to express their
opinions on the value of assets. Through the process of buying and selling, markets facilitate
 price discovery, which helps investors make informed decisions based on market sentiment
and fundamental analysis.
7. Efficient Allocation of Resources: Well-functioning financial markets channel funds to the
most productive uses based on market signals. This efficient allocation of resources leads to
better utilization of capital and improved overall economic efficiency.
8. Hedging and Risk Management: Financial markets offer various derivative instruments that
allow investors and businesses to hedge against price fluctuations, interest rate changes, and
other risks. This risk management function is crucial for stabilizing financial positions and
managing uncertainties.
9. Market Transparency: Regulatory frameworks require financial markets to operate
transparently, disclosing relevant information to all participants. This transparency ensures
that investors have access to accurate and timely information to make informed decisions.
10. Savings and Investment: Financial markets encourage individuals and households to save
and invest their money by offering opportunities to grow wealth through investments in
various financial assets.
11. Monetary Policy Transmission: Financial markets play a role in the transmission of
monetary policy set by central banks. Changes in interest rates, which affect the cost of
borrowing and saving, are transmitted through financial markets and influence economic
activity.
12. Global Capital Flows: International financial markets enable the movement of capital across
borders, allowing for investments and funding from different countries. This globalization of
financial markets promotes economic integration and diversification.

Constituents of financial markets

1. Investors: Investors are individuals, institutions, or entities that provide capital with the aim
of generating returns on their investments. They play a critical role in the functioning of
financial markets as they provide the funds that are allocated to various assets. Types of
investors include:
  Individual Investors: These are retail investors who buy and sell financial assets for
their personal portfolios. They include individuals investing in stocks, bonds, mutual
funds, and other securities.
 Institutional Investors: These are larger entities that invest on behalf of others, such
as pension funds, insurance companies, hedge funds, mutual funds, and endowments.
They often manage significant amounts of capital and have a more diversified
approach to investing.
 Foreign Investors: Investors from other countries participate in financial markets to
diversify their portfolios, seek higher returns, or gain exposure to specific markets.
2. Issuers: Issuers are entities that raise capital by issuing financial instruments to investors.
These instruments can include stocks, bonds, and other securities. Issuers utilize financial
markets to fund their operations and projects. Types of issuers include:
 Corporations: Companies issue stocks and bonds to raise capital for business
expansion, research and development, acquisitions, and other corporate purposes.
 Governments: Governments issue bonds to fund public infrastructure projects, social
programs, and other government expenditures.
 Municipalities: Local governments issue municipal bonds to raise funds for public
projects like schools, roads, and utilities.
3. Intermediaries: Intermediaries facilitate the smooth functioning of financial markets by
connecting investors with issuers, providing various services, and ensuring market liquidity.
These intermediaries include:
 Brokerage Firms: These firms act as intermediaries between investors and financial
markets, executing trades on behalf of clients. They provide investment advice,
research, and trading platforms.
 Exchanges: Stock exchanges (e.g., NYSE, NASDAQ) and other trading platforms
facilitate the buying and selling of financial instruments. They provide a centralized
marketplace where orders are matched and executed.
 Banks: Banks offer a range of financial services, including underwriting new
issuances, providing loans, and offering investment products. Investment banks, in
particular, assist companies in issuing stocks and bonds to the public.
 Mutual Funds and ETFs: These are investment vehicles that pool money from
multiple investors to invest in a diversified portfolio of assets. They provide access to
 a broad range of investments without requiring investors to directly buy individual
securities.
 Market Makers: These are individuals or firms that facilitate trading by providing
liquidity to markets. They stand ready to buy or sell a security at a quoted price,
helping to maintain market efficiency and reduce bid-ask spreads.
 Clearinghouses and Settlement Systems: These entities ensure the smooth
settlement of trades by handling the confirmation, settlement, and delivery of
securities and funds between buyers and sellers.

Money market instruments

1. Treasury Bills (T-Bills): Treasury bills are short-term debt securities issued by governments
to raise funds. They are considered one of the safest money market instruments since they are
backed by the government's creditworthiness. T-Bills are sold at a discount to their face value
and mature in a few weeks to one year. Investors earn a return by buying T-Bills at a discount
and receiving the full face value at maturity.
2. Commercial Paper (CP): Commercial paper is a short-term unsecured promissory note
issued by corporations and financial institutions. It is used to meet short-term funding needs,
such as financing working capital or covering temporary cash shortfalls. Commercial paper is
typically issued at a discount to its face value and matures in a few days to a few months.
3. Certificates of Deposit (CDs): Certificates of deposit are time deposits offered by banks and
other financial institutions. They have fixed maturities and pay a specified interest rate. CDs
are often considered low-risk investments, and they are insured by the government up to a
certain limit (e.g., FDIC insurance in the United States).
4. Banker's Acceptances (BAs): Banker's acceptances are short-term drafts or bills of
exchange issued by a corporation and guaranteed by a bank. They are commonly used in
international trade transactions as a way to provide financing for the movement of goods.
BAs typically have maturities ranging from one to six months.
5. Repurchase Agreements (Repos): Repos are short-term borrowing arrangements in which
one party sells a security to another party with an agreement to repurchase it at a specified
future date and price. Repos are commonly used by financial institutions to manage their
short-term liquidity needs and by central banks for monetary policy operations.
6. Money Market Funds (MMFs): Money market funds are investment funds that pool money
from individual and institutional investors to invest in a diversified portfolio of money market
instruments. MMFs aim to maintain a stable net asset value (NAV) of $1 per share and offer
investors a way to earn a return while maintaining high liquidity.
7. Short-Term Government Bonds: Short-term government bonds, such as Treasury notes and
Treasury bonds with maturities of less than one year, can also be considered money market
instruments. These bonds are relatively low-risk and highly liquid.
8. Short-Term Municipal Notes: Similar to short-term government bonds, municipalities can
issue short-term notes to raise funds for specific projects. These notes are often used to meet
short-term cash needs while awaiting longer-term financing.

Capital market and instruments

1. Equity Instruments: Equity instruments represent ownership in a company. When investors

buy shares of a company's stock, they become shareholders and have a claim on the
company's assets and earnings. The primary type of equity instrument is common stock,
which entitles shareholders to voting rights and a share of the company's profits through
dividends.
2. Debt Instruments: Debt instruments represent loans made by investors to borrowers,
typically companies or governments. In exchange for borrowing funds, the issuer agrees to
pay interest periodically and repay the principal amount at maturity. Types of debt
instruments in the capital market include:
 Bonds: Bonds are fixed-income securities issued by governments, municipalities, and
corporations. They have a fixed maturity date, and investors receive interest payments
(coupon payments) over the bond's life.
  Notes: Similar to bonds, notes are debt securities with shorter maturities, usually
ranging from one to ten years. They can be issued by governments, corporations, and
other entities.
 Debentures: Debentures are unsecured debt instruments issued by corporations.
Unlike secured bonds, debentures are not backed by specific assets; instead, they rely
on the issuer's creditworthiness.
3. Preferred Stock: Preferred stock is a hybrid instrument that combines characteristics of both
equity and debt. Preferred shareholders have a higher claim on the company's assets and
earnings compared to common shareholders. They receive dividends before common
shareholders but usually do not have voting rights.
4. Convertible Securities: Convertible securities, such as convertible bonds or convertible
preferred stock, give the investor the option to convert the security into a predetermined
number of common shares at a specified conversion ratio. These instruments allow investors
to participate in potential equity appreciation while retaining the option for fixed-income
benefits.
5. Derivative Instruments: Some derivative instruments, such as options and futures, are
traded in the capital market. These instruments derive their value from an underlying asset,
such as stocks or commodities, and are often used for hedging, speculation, and risk
management.
6. Rights and Warrants: Rights and warrants are options that allow investors to purchase
additional shares of a company's stock at a specified price within a specific timeframe. Rights
are often issued to existing shareholders during capital-raising events, while warrants can be
traded on the secondary market.
7. Structured Products: Structured products are financial instruments that combine various
elements of traditional securities with derivatives. They are designed to offer customized risk
and return profiles to investors.

SEBI guidelines for listing of shares and issue of

commercial papers
 Listing of Shares:

1. Initial Public Offering (IPO): An IPO is the process through which a company offers its
shares to the public for the first time. SEBI regulations govern the requirements for
companies to launch an IPO. Some key aspects of IPO guidelines include:
 Disclosure requirements in the prospectus.
 Minimum public shareholding requirements.
 Pricing of the shares.
 Allotment of shares to different categories of investors.
 Restrictions on insider trading and market manipulation during the IPO process.
2. Continuous Listing Requirements: Companies listed on stock exchanges are subject to
continuous listing requirements. These requirements include timely disclosure of material
information, financial reporting obligations, corporate governance norms, and compliance
with SEBI regulations.
3. Delisting Guidelines: SEBI provides guidelines for companies seeking to delist their shares
from stock exchanges. The process involves a series of steps to protect the interests of
minority shareholders.
4. Offer for Sale (OFS): Companies can offer shares to the public through an OFS. This allows
existing shareholders to sell their shares without the company raising fresh capital.

Issuance of Commercial Papers (CPs):

1. Eligibility Criteria: SEBI guidelines specify the eligibility criteria for companies seeking to
issue commercial papers. Generally, companies with a good credit rating and financial track
record are eligible to issue CPs.
2. Issuer and Investor Limits: Guidelines set limits on the maximum amount that a company
can issue as CPs and the maximum amount that an investor can hold.
3. Credit Rating: Companies issuing CPs need to obtain a credit rating from recognized credit
rating agencies. The credit rating reflects the issuer's creditworthiness and helps investors
assess the risk associated with the CPs.
4. Maturity Period: CPs typically have a maturity period of up to one year from the date of
issue. They are short-term instruments used to raise working capital.
5. Discount Rate: CPs are issued at a discount to their face value, and the difference between
the face value and the issue price represents the investor's return.
6. Secondary Market Trading: CPs can be traded in the secondary market, allowing investors
to buy and sell them before maturity.