18MBH461T - UNIT II: INTRODUCTION TO FINANCIAL MARKETS

Financial Market
The financial market is a broad term describing any marketplace where trading of securities
including equities, bonds, currencies and derivatives occur.
A financial market is a mechanism that allows people to buy and sell (trade) financial securities
(such as stocks and bonds), commodities (such as precious metals or agricultural goods), and
other fungible items of value at low transaction costs and at prices that reflect the efficient-
market hypothesis.
Financial markets can be domestic or they can be international.
Some financial markets are small with little activity, while some financial markets like the New
York Stock Exchange (NYSE) trade trillions of dollars of securities daily.
In finance, financial markets facilitate:
• The raising of capital (in the capital markets)
• The transfer of risk (in the derivatives markets)
• International trade (in the currency markets)
• And are used to match those who want capital to those who have it.

TYPES OF FINANCIAL MARKETS

Segments / Types of Financial Markets

• Capital market
1
 • Money market
• Foreign exchange market
• Government Securities market
• Derivative market
• Commodity market

Capital market
• It is the market where long term funds (shares and debentures) are traded.
• Both individuals and institutions trade in financial securities here.
• Different organizations belonging to public and private sectors also sell their securities in
secondary market to raise funds.
• Thus this market consists of primary and secondary market both.
• Capital market does not deal in goods and it is more concerned with raising of fund.
• Two major participants here are borrowers: those who demands funds and lender: those
who supply fund.

• Stock markets, which provide financing through the issuance of shares or common
stock, and enable the subsequent trading thereof.
• Bond markets, which provide financing through the issuance of bonds, and enable the
subsequent trading thereof.

Primary Market:
Primary market refers to the sale of shares, directly by the company at the time of promotion and
the investors directly buy the shares from the company through application.
Newly formed (issued) securities are bought or sold in primary markets. The share price will be
mostly at par.

2
Secondary Market:
• Secondary markets allow investors to sell securities that they hold or buy existing
securities.
• Here sale and purchase of securities will take place through the recognized stock
exchanges.
• Only authorized persons are allowed to deal in the securities in the secondary market,
who are known as brokers.
• Only listed securities will be traded in the stock exchanges.
2. Money Market

Organised Money Market

3
2. Money market
• Short term funds are traded in money market.
• Provides short term debt financing and investment which is usually overnight or some
days.
• It is a segment of financial market where financial instruments which are highly liquid
and have short term maturities are traded.
• In fact there is no fixed place as money market.
• The term money market refers to a collective name given to all the institutions which are
dealing in short term funds.
• Money market provides working capital.

3. Foreign Exchange Markets

Foreign exchange market - Also known as forex market or currency market.

• Facilitates the trading of foreign exchange
• Foreign exchange is bought and sold and the different forms of foreign currency are
dealt.
• In India, foreign exchange is held by RBI which is the exchange control authority.
• Foreign Exchange Regulation Act (FERA) which is now renamed as Foreign Exchange
Management Act (FEMA) to deal with Foreign exchange.
• This is the world's largest and most liquid market.
• Traders are attracted to trade here because they can earn some really good returns which
is comparatively higher then returns offered by other market.
• Also trading in currency pairs can be done at any time of the day as it is open 24 hours a
day.
4
 • Major participants of this market are central banks, financial institutions, institutional
investors and currency speculators.

4. Government Securities Market

This market can be divided as Treasury bills and bonds. When government is in need of funds to
meet its budgetary deficits, it goes for the issue of treasury bills and bonds.
Treasury bills: Treasury bills are issued for raising short term funds and mainly to meet revenue
expenditure.
Bonds are issued for raising long term loans and these are repayable over a period of 15 or 20
years. Normally they are subscribed by financial institutions as these securities carry attractive
interest rates and they can be sold easily in the market. It is for this reason; they are called as
liquid assets.

5. Derivative market
This market facilitates trading in futures and options contracts. It is named so because value here
is derived from the underlying assets. Along with traders, speculators also exist here. The main
reason trader prefers to trade in this market is to hedge against future price risk. Every derivative
contracts has its own specification which are to be fulfilled by its holders.

6. Commodity market
Commodity market is a market where buyers and sellers meet for the exchange of different
commodities. Major components of commodity market are agricultural commodities, oils and
gas. These commodities are traded over two popular exchanges of this market known as MCX
and NCDEX. Having commodities as a part of portfolio along with stocks helps in diversifying
risk of overall portfolio.

The main functions of financial market

• To facilitate creation and allocation of credit and liquidity
• To serve as intermediaries for mobilization of savings
• To assist process of balanced economic growth
• To provide financial convenience
• Financial markets serve six basic functions. These functions are briefly listed below:

5
1. Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power)
from one agent to another for either investment or consumption purposes.
2. Price Determination: Financial markets provide vehicles by which prices are set both for
newly issued financial assets and for the existing stock of financial assets.
3. Information Aggregation and Coordination: Financial markets act as collectors and
aggregators of information about financial asset values and the flow of funds from lenders to
borrowers.
4. Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
5. Liquidity: Financial markets provide the holders of financial assets with a chance to resell or
liquidate these assets.
6. Efficiency: Financial markets reduce transaction costs and information costs.

Participants in financial Market

1. Banks
2. Primary Dealers (PDs)
3. Financial Institutions (FIs)
4. Stock Exchanges
5. Brokers
6. Investment Bankers (Merchant Bankers)
7. Foreign Institutional Investors (FIIs)
8. Custodians
9. Depositories

1. Banks
• Banks participate in the capital market and money market.
• Within the capital market, banks take active part in bond markets.
• Banks may invest in equity and mutual funds as a part of their fund management.
• Banks take active trading interest in the bond market and have certain exposures to the
equity market also.
• Banks also participate in the market as clearing houses.
2. Primary Dealers (PDs)
• PDs deal in government securities both in primary and secondary markets.
6
 • Their basic responsibility is to provide two-way quotes and act as market makers for
government securities and strengthen the government securities market.
3. Financial Institutions (FIs)
• FIs provide/lend long term funds for industry and agriculture.
• FIs raise their resources through long-term bonds from financial system and borrowings
from international financial institutions like
• International Finance Corporation (IFC),
• Asian Development Bank (ADB),
• International Development Association (IDA),
• International Bank for Reconstruction
• Development (IBRD), etc.
4. Stock Exchanges
• A Stock exchange is duly approved by the Regulators to provide sale and purchase of
securities by “open cry” or “online” on behalf of investors through brokers.
• The stock exchanges provide clearing house facilities for netting of payments and
securities delivery.
• Such clearing houses guarantee all payments and deliveries.
• Securities traded in stock exchanges include equities, debt, and derivatives.
• Currently, in India, only dematerialized securities are allowed to be traded on the stock
exchanges.
• Settlement in securities account is made by depositories through participants’ accounts.
• It is essential that stock exchanges are corporatised and de-mutualised so that there can be
greater transparency in the trades and better governance in markets.
5. Brokers
• Only brokers approved by Capital Market Regulator can operate on stock exchange.
• Brokers perform the job of intermediating between buyers and seller of securities.
• They help build up order book, price discovery, and are responsible for a contract being
honoured.
• For their services brokers earn a fee known as brokerage.
6. Investment Bankers (Merchant Bankers)
• These are agencies/organisations regulated and licensed by SEBI, the Capital Markets
Regulator.

7
 • They arrange raising of funds through equity and debt route and assist companies in
completing various formalities like filing of the prescribed document and other compli-
ances with the Regulator and Regulators.
• They advise the issuing company on book building, pricing of issue, arranging registrars,
bankers to the issue and other support services.
• They can underwrite the issue and also function as issue managers.
• They may also buy and sell on their account.
7. Foreign Institutional Investors (FIIs)
• FIIs are foreign based funds authorized by Capital Market Regulator to invest in
countries’ equity and debt market through stock exchanges.
• They are allowed to repatriate sale proceeds of their holdings, provided sales have been
made through an authorized stock exchange and taxes have been paid.
• FIIs enjoy de-facto capital account convertibility.
• FII operations provide depth to equity and debt markets and result in increased turnover.
• In India, these activities have brought in technological advancements and foreign funds in
equity and debt market.

8. Custodians
• Custodians are organizations which are allowed to hold securities on behalf of customers
and carry out operations on their behalf.
• They handle both funds and securities of Qualified Institutional Borrowers (QIBs)
including FIIs.
• Custodians are supervised by the Capital Market Regulator.
• In view of their position and as they handle the payment and settlements, banks are able
to play the role of custodians effectively.
• Thus most banks perform the role of custodians.

9. Depositories
• Depositories hold securities in demat (electronic) form, maintain accounts of depository
participants who, in turn, maintain accounts of their customers.
• On instructions of stock exchange clearing house, supported by documentation, a
depository transfers securities from buyers to sellers’ accounts in electronic form.
• Depositories are important for ensuring efficiency in the market.
8
 • They facilitate lending against securities and ensure avoidance of settlement risk or bad
delivery.

Regulatory Environment
• Financial system is regulated by different government agencies.
• The relationships among other participants, the trading mechanism and the overall flow
of funds are managed, supervised and controlled by these statutory agencies.
• In India, two basic agencies regulating the financial market are the RBI and SEBI.
• RBI, being the Central Bank, has the primary responsibility of maintaining liquidity in
the money market.
• It undertakes the sale and purchase of T-Bills on behalf of the Government of India.
• SEBI has a primary responsibility of regulating and supervising the capital market.
• It has issued a number of Guidelines and Rules for the control and supervision of capital
market and investors protection.
• Besides, there is an array of legislations and government departments also to regulate the
operations in the financial system.

Indian Capital Market

Primary Market or New Issues Market
Primary market is the place where debt-based, equity-based or any other asset based securities
are created, under written and sold off to investors.
In simple words, it is a part of the capital market where new securities are created are directly
purchased by the investors from the issuer.

9
Methods of floating new issues
Following are the various methods being adopted by corporate entities for marketing the
securities in the New Issue Market:
1. Public Issue
2. Private Placement
3. Rights Issue
4. Preferential Allotment

1. Public Issue
This term refers to the company’s issuing of new securities through its initial public offer (IPO)
and is “going public”. A large number of investors can purchase these newly issued securities in
this open primary market.
Features
• Exclusive subscription: Here, the new issues of a company are offered for exclusive
subscription of the general public.
• Issue Price: Direct offer is made by the issuing company to the general public to
subscribe to the securities as a stated price.
• Underwriting: Public issue through the pure prospectus method is usually underwritten.
This is to safeguard the interest of the issuer in the event of an unsatisfactory response
from the public.
• Prospectus: A document that contains information relating to the various aspects of the
issuing company, besides other details of the issue is called a Prospectus. The document
is circulated to the public. The general details include the company’s name and address of
its registered office, the names and addresses of the company s promoters, manager,

10
 managing director, directors, company secretary, legal adviser, auditors, bankers, brokers,
etc.
Recent IPOs in India

Price Band
Issuer Company IPO Size (Rs.) Issue Date
(Rs.)

Kalyan Jewellers IPO NA NA Upcoming

Mindspace REIT IPO 4,500 Cr. 274 – 275 27-July-20

Yes Bank IPO (FPO) 15,000 Cr. 12 – 13 15-July-20

Rossari Biotech IPO 497 Cr. 423 – 425 13-July-20

NCDEX IPO 500 Cr. NA Upcoming

Bajaj Energy IPO 5450 Cr. N/A Upcoming

Montecarlo Limited IPO 550 Cr. N/A Upcoming

UTI Amc IPO 3000 Cr. N/A Upcoming

LIC IPO Coming Soon N/A Upcoming

Lodha Developers IPO 5500 Cr. N/A Upcoming

Large Cap IPOs (more than 500 crore) – Upcoming

IPO Size Price Band

Issuer Company Issue Date
(Rs.) (Rs.)

Angel Broking IPO 600 Cr. N/A Upcoming

NSE IPO 4000 Cr. N/A Upcoming

Policy Bazaar IPO 1200 Cr. N/A Upcoming

11
SME IPOs or Midcap IPOs (50 to 500 crore)

Issuer Company IPO Size (Rs.) Price Band (Rs.) Issue Date

Barbeque Nation IPO 350 Cr. – Upcoming

BMW Ventures Limited

400 Cr. – Upcoming
IPO

Chartered Speed IPO 250 Cr. – Upcoming

Suratwwala Business IPO 6.9 Cr. 15 5-Aug-20

Upcoming IPOs of August 2020

• Park Hotels IPO
• ESAF Small Finance Bank IPO
• Mindspace REIT IPO
• Home First Finance IPO
• Puranik Builders IPO
• Equitas Bank IPO
• Harsha Engineers IPO
• EaseMyTrip IPO
• Burger King IPO

Advantages
This method offers the following advantages to the issuer and the investors alike:
Benefits to investors:
The pure prospectus method of marketing the securities serves as an excellent mode of disclosure
of all the information pertaining to the issue. Besides, it also facilitates satisfactory compliance
with the legal requirements of transparency, etc.
Benefits to issuers:
This is the most popular method among the larger issuers. In addition, it provides for wide
diffusion of ownership of securities contributing to reduction in the concentration of economic
and social power.

12
Drawbacks
The raising of capital through the pure prospectus method is fraught with a number of drawbacks
as specified below:
• High issue costs: A major drawback of this method is that it is an expensive mode of
raising funds from the capital market. Costs of various hues are incurred in mobilizing
capital.
• Time Consuming: The issue of securities through prospectus takes more time, as its
requires the due compliance with various formalities before an issue could take place.

2. Rights Issue
Rights issue is an invitation to the existing shareholders to purchase additional new shares (in the
proportion of their holdings) within a fixed time period.
Some Recent Rights Issues

Company Rights Ratio Face Value Premium Date

SRL 2:15 5 70 11-02-20

PVR 7:94 10 774 08-06-20

Shriram Trans 3:26 10 560 15-06-20

Aditya Birla F 9:77 10 100 27-05-20

Reliance 1:15 10 1247 30-04-20

Bajaj Electric 13:118 2 308 06-01-20

3. Private Placement
A method of marketing of securities whereby the issuer makes the offer of sale of individuals
and institutions privately without the issue of a prospectus is known as Private Placement
Method.
It refers to raising equity capital (not public) from selected investors like Venture Capital, Funds,
and insurance companies.
Features of Private Placement Method
Under this method, securities are offered directly to large buyers with the help of share brokers.

13
This method works in a manner similar to the Offer for Sale Method whereby securities are first
sold to intermediaries, such as, issues houses, etc.

Advantages of Private Placement Method

• Private placement of securities offers the following advantages:
• Less expensive as various types of costs associated with the issue are borne by the issue
houses and other intermediaries.
• Placement of securities suits the requirements of small companies.
• The method is also resorted to when the stock market is dull and the public response to
the issue is doubtful.

Disadvantages of Private Placement Method

• The major weaknesses of the private placement of securities are as follows:
• Concentration of securities in a few hands.
• Creating artificial scarcity for the securities thus jacking up the prices temporarily and
misleading general public.
• Depriving the common investors of an opportunity to subscribe to the issue, thus
affecting their confidence levels.

4. Preferential Allotment
It is the process by which allotment of shares is done on a preferential basis to a select group of
investors.

INDIAN STOCK MARKET

14
History of Stock Market in India
Meaning and Definition of Stock Market or Exchange
• The stock exchange or market is a place where stocks, shares and other long-term
commitments or investment are bought and sold.
• The Securities Contracts (Regulation) Act of 1956 defines, a stock exchange as “an
association, organisation or body of individuals, whether incorporated or not, established
for the purpose of assisting, regulating and controlling, business in buying, selling and
dealing in securities.”

Importance of Stock Exchange

• Stock Exchanges are noted as “an essential concomitant of the Capitalistic System of
economy.
• It is indispensable for the proper functioning of corporate enterprise.
• It brings together large amounts of capital necessary for the economic progress of a
country.
• It is a citadel of capital and pivot of money market.
• It provides necessary mobility to capital and indirect the flow of capital into profitable
and successful enterprises.
• It is the barometer of general economic progress in a country and exerts a powerful and
significant influence as a depressant or stimulant of business activity.”

History of Stock Exchange in India

• Indian Stock Market is one of the oldest Stock Market in Asia.
• East India Company used to transact Loan Securities by the end of 18th Century.
• In the 1830s, trading on corporate stocks and shares in Bank and Cotton presses took
place in Bombay.
• The first organised stock exchange in India was started in 1875 at Bombay and it is stated
to be the oldest in Asia.
• In 1894 the Ahmedabad Stock Exchange was started to facilitate dealings in the shares of
textile mills there.
• The Calcutta stock exchange was started in 1908 to provide a market for shares of
plantations and jute mills.

15
 • Then the madras stock exchange was started in 1920. At present there are 24 stock
exchanges in the country, 21 of them being regional ones with allotted areas.
• Two others set up in the reform era, viz., the National Stock Exchange (NSE) and Over
the Counter Exchange of India (OICEI), have mandate to have nation-wise trading.
• They are located at Ahmedabad, Vadodara, Bangalore, Bhubaneswar, Mumbai, Kolkata,
Kochi, Coimbatore, Delhi, Guwahati, Hyderabad, Indore, Jaipur’ Kanpur, Ludhiana,
Chennai Mangalore, Meerut, Patna, Pune, Rajkot.
• The Stock Exchanges are being administered by their governing boards and executive
chiefs.
• Policies relating to their regulation and control are laid down by the Ministry of Finance.
Government also Constituted Securities and Exchange Board of India (SEBI) in April
1988 for orderly development and regulation of securities industry and stock exchanges.

Establishment of BSE
• Few informal groups of Stock Brokers organized themselves in 1875 and were formally
organized as Bombay Stock Exchange (BSE).
• In 1956, the Government of India recognized the Bombay Stock Exchange as the first
Stock Exchange in the country under the Securities Contracts (Regulation) Act.
• But still there was no means to measure the overall performance of the exchange.
• So, in 1986, Bombay Stock Exchange developed BSE Sensex (Sensex = Sensitive
Index), an index of top 30 companies, which gave a means to measure the overall
performance of the Exchange.

Establishment of SEBI (Securities and Exchange Board of India)

• Until late 1980s, BSE ran with low transparency and an unreliable clearing and
settlement systems.
• Towards the end of the 1980s, new economic forces, the economic growth and currency
crisis emphasized the need for modernization of the financial system.
• Government created the Securities and Exchange Board of India (SEBI) in 1988.

Establishment of National Stock Exchange

• In April 1992, Bombay Stock Exchange crashed due to Harshad Mehta Scam.

16
 • Finance minister Mr. Manmohan Singh urged the need of other Stock Exchange in
competition to BSE.
• He tapped the Industrial Development Bank (IDB) to take the lead of the project of
creating competition for BSE.
• In November 1992, NSE (National Stock Exchange) was established as the first
electronically traded Stock Exchange in India.
• After a few years of operations, the NSE has become the largest stock exchange in India.
• BSE also automated the systems in 1995 but it never caught up with NSE Spot Market
turnover.
• Three segments of the NSE trading platform were established one after another.
• The Wholesale Debt Market (WDM) commenced operations in June 1994 and the
Capital Market (CM) segment was opened at the end of 1994.
• Finally, the Futures and Options segment began operating in 2000.
• Today the NSE takes the 14th position in the top 40 futures exchanges in the world.
• In 1996, the National Stock Exchange of India launched S&P CNX Nifty. CNX Nifty
(Nifty = National Fifty) is a diversified index of 50 stocks from 25 different economy
sectors.
• In 1998, the National Stock Exchange of India launched its web-site and was the first
exchange in India that started trading stock on the Internet in 2000.
• Today, NSE has roughly 66% of equity spot turnover and roughly 100% of equity
derivatives turnover.

Role of SEBI in Regulating Indian Capital Market

SEBI is regulator to control Indian capital market. Since its establishment in 1992, it is doing
hard work for protecting the interests of Indian investors. SEBI gets education from past cheating
with naive investors of India. Now, SEBI is stricter with those who commit frauds in capital
market. The role of SEBI in regulating Indian capital market is very important because
government of India can only open or take decision to open new stock exchange in India after
getting advice from SEBI. But if it is against its rules and regulations, SEBI can ban on any stock
exchange to trade in shares and stocks.
1. Power to make rules for controlling stock exchange
SEBI has power to make new rules for controlling stock exchange in India. For example, SEBI
fixed the time of trading 9.15 AM and 3.30 PM in stock market.
17
2. To provide license to dealers and brokers
SEBI has power to provide license to dealers and brokers of capital market. If SEBI can also
control any financial product of capital nature and its dealers. For example ULIPs case. SEBI
said, " It is just like mutual funds and all banks and financial and insurance companies who want
to issue it, must take permission from SEBI."
3. To Stop fraud in Capital Market
SEBI has many powers for stopping fraud in capital market. It can ban the trading of those
brokers who are involved in fraudulent and unfair trade practices relating to stock market. It can
impose the penalties on capital market intermediaries if they involve in insider trading.
4. To Control the Merger, Acquisition and Takeover of companies
Many big companies in India want to create monopoly in capital market. So, these companies
buy all other companies or enter into deal of merging. SEBI sees whether this merger or
acquisition is for development of business or to harm capital market.
5. To audit the performance of stock market
SEBI uses its powers to audit the performance of different Indian stock exchanges for bringing
transparency in the working of stock exchanges.
6. To make new rules on carry - forward transactions
Share trading transactions carry forward can not exceed 25% of broker's total transactions. 90
day limit for carry forward. (The carry forward facility enables an investor to defer or postpone
his commitments to the next settlement period).
7. To create relationship with ICAI
ICAI is the authority for making new auditors of companies. SEBI creates good relationship with
ICAI for bringing more transparency in the auditing work of company accounts because audited
financial statements are mirror to see the real face of company used by investors to decide to
invest or not. Moreover, investors of India can easily trust on audited financial reports. After
Satyam Scam, SEBI is investigating with ICAI, whether CAs are doing their duty by ethical way
or not.
8. Introduction of derivative contracts on Volatility Index
For reducing the risk of investors, SEBI has now been decided to permit Stock Exchanges to
introduce derivative contracts on Volatility Index.
9. To Require report of Portfolio Management Activities

18
SEBI has also power to require report of portfolio management to check the capital market
performance. Recently, SEBI sent the letter to all Registered Portfolio Managers of India for
demanding report.
10. To educate the investors
Time to time, SEBI arranges scheduled workshops to educate the investors. Investors can get
education through SEBI leaders.

INDIAN MONEY MARKET

Indian money comprises of the following components:

1. Call Money Market
2. Treasury Bills Market
3. Commercial Paper
4. Certificate of Deposit
5. Commercial Bills
1. Call Money Market
• Call money market is that part of the national money market where the day-to-day
surplus funds, mostly of banks, are traded in.
• Mostly the call money market helps the banks to borrow the money without collateral
from other banks to maintain the cash reserve ratio (CRR) with RBI.
• The loans made in this market are of a short-term nature, their maturity varying between
one day to a fortnight.
Call Money Market in India
• That part of national money market where the day-to-day surplus funds, mostly of banks
are traded in.
• Banks borrow from other banks in order to meet a sudden demand for funds, large
payments, large remittances, and to maintain cash or liquidity with the RBI.

19
 • Major Participants in the call money market
– Scheduled Commercial Banks
– Non-Scheduled Commercial Banks
– Foreign Banks
– State, District and Urban Co-operative Banks
– Discount and Finance House of India(DFHI)
– Securities Trading Corporation of India(STCI)
• As on June 13, 2014 the standalone and bank primary dealers, which are existing in
India are as follows:
– ICICI Securities Primary Dealership Limited,
– Morgan Stanley India Primary Dealer Pvt. Ltd.,
– Nomura Fixed Income Securities Pvt. Ltd., SBI DFHI Ltd.,
– STCI Primary Dealer Limited, Goldman Sachs (India) Capital Markets Pvt. Ltd.,
– Bank of America,
– Bank Of Baroda,
– Canara Bank,
– Citibank N.A,
– Corporation Bank,
– HDFC Bank Ltd.,
– Hongkong and Shanghai Banking Corpn. Ltd.(HSBC),
– J P Morgan Chase Bank N.A, Mumbai Branch,
– Kotak Mahindra Bank Ltd., Standard Chartered Bank,
– Axis Bank Ltd., IDBI Bank Limited, and
– Deutsche Bank AG
• Non-bank institutions (other than PDs) are not permitted in the call/notice money market.
• All the money market transactions should be reported on the electronic platform called
the Negotiated Dealing System (NDS).
• These transactions take place in the OTC market and are required to be reported on
FIMMDA platform within 15 minutes of the trade for dissemination of information.
Call Rates
The rate of interest paid on call loans is known as the call rate. The call rate is highly variable
from day to day, and often from hour to hour. It is very sensitive to changes in demand for and

20
supply of call loans. The call rate has been freely determined by the market forces since 1989.
Mostly the call rate in India is defined as interbank call rate.

Mumbai Inter-Bank Bid Rate (MIBID) and Mumbai Inter-Bank Offer Rate (MIBOR)
It is the interest rate at which banks can borrow funds, in marketable size, from other banks in
the Indian interbank market. It is calculated daily by the National Stock Exchange of India
(NSE). It is calculated on the basis of data collected from the panel of 30 banks and primary
dealers. The panel has a mix of public sector banks including SBI, CBI; private sector banks
including Axis Bank Ltd, HDFC Bank Ltd; foreign banks including Citibank NA and Deutsche
Bank; and primary dealers including ICICI Securities Ltd and PNBGilts Ltd.

London Inter-Bank Offer Rate (LIBOR)

It is an interest rate at which banks can borrow funds in marketable size from other banks in the
London interbank market. The LIBOR is fixed on a daily basis by the British Bankers’
Association (BBA). LIBOR formally measures the cost of this inter-bank lending and setting out
the average rate banks pay to borrow from one another.

Term Money Market and Repo Market

In term money market where the tenor of the transactions is from 15daystooneyear. • Repo or
ready forward contact is an instrument for borrowing funds by selling securities with an
agreement to repurchase the said securities on a mutually agreed future date at an agreed price
which includes interest for the funds borrowed.
The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against
buying of securities with an agreement to resell the said securities on a mutually agreed future
date at an agreed price which includes interest for the funds lent.

2. Treasury Bills Market

A Particular type of Finance Bill or Promissory note put out by the Govt. of the country to meet
the needs of supplementary short-term Finance. Treasury bills are zero coupon securities and pay
no interest. Issued at discount and redeemed at par

Characteristics
• High Liquidity Money Market Instrument
21
 • Absence of Risk of Default
• Ready availability on Tap
• Assured Yield
• Low transaction Cost
• Eligibility for Inclusion in SLR
• Negligible Capital Depreciation

Types of Treasury Bills

• Ordinary TBs: Issued to the public and other financial institutions for meeting theshort-
term financial requirements of the Central Government
• Ad-hoc TBs: Issued in favour of the RBI only. They are not sold through tender or
auction. They are purchased by the RBI and the RBI is authorised to issue currency notes
against them. They aren't marketable in India.
• 91-Day, 182-Dayand364-DayTreasuryBills
• 14-DayTreasury Bills: It is sold only to state governments, foreign central banks, and
other specified bodies in order to provide them with an alternate arrangement in place of
91 day tap TBs for investment of their temporary cash surpluses.

Investors and Sale of T-bills

• Banks, Primary Dealers, State Governments, Provident Funds, Financial Institutions,
Insurance Companies, NBFCs, FIIs (as per prescribed norms), NRIs & OCBs can invest
in T-Bills
• Treasury bills are available for a minimum amount of Rs.25,000 and in multiples of
Rs.25,000.
• T-bills are sold through auction

3. Commercial Paper
CP is an unsecured money market instrument issued in the form of a promissory note by a
corporation with high credit ratings to finance its short-term needs. CPS can be issued in a wide
range of denominations, can be either discounted or interest-bearing, and usually have a limited
or nonexistent secondary market.
Characteristics of CPs
• CPs can be issued on discount to face value basis or on a fixed interest basis.
22
 • CPs are unsecured, negotiable by endorsement and normally have a buy-back facility
• CPs as a source of short-term debt regarded as highly safe, simple, flexible, and quality
liquid instrument.

CPs in India
• It was introduced in India in 1990 with a view to enabling highly rated corporate
borrowers to diversify their sources of short-term borrowings and to provide an additional
instrument to investors.
• Subsequently, primary dealers and all-India financial institutions were also permitted to
issue CP to enable them to meet their short-term funding requirements for their
operations.
• Corporates, primary dealers (PDs) and the All-India Financial Institutions (FIs) are
eligible to issue CP.
• The tangible net worth of the company, as per the latest audited balance sheet, is not less
than Rs.4 crore.
• CP can be issued in denominations of Rs.5 lakh or multiples thereof.
• The fund based working capital of the company should not be less than 4 crore
• Every issue of CP, including renewal, should be treated as a fresh issue.
• There is no lock in period for CPs.
• CP can be issued for maturities between a minimum of 7 days and a maximum up to one
year from the date of issue (since October 2004).
• Individuals, banking companies, other corporate bodies (registered or incorporated in
India) and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional
Investors (FIIs) etc. can invest in CPs.
• The total amount of CP proposed to be issued should be raised within a period of two
weeks from the date on which the issuer opens the issue for subscription.
• Mandatory credit rating for issuance of Commercial Paper. The minimum credit rating
shall be P-2 of CRISIL and A2 for ICRA.
• Only a scheduled bank can act as an IPA for issuance of CP.
• CPs are actively traded in the OTC market. Such transactions, however, are to be
reported on the FIMMDA reporting platform within 15 minutes of the trade for
dissemination of trade information to market participation thereby ensuring market
transparency.
23
 • When the CP is held in physical form, the holder of the CP shall present the instrument
for payment to the issuer through the IPA.
• When the CP is held in demat form, the holder of the CP will have to get it redeemed
through the depository and receive payment from the IPA.

4. Certificate of Deposit (CD)

• CDs represent bank deposit accounts which are transferable from one party to another.
• Marketable nor negotiable short-term instruments in bearer from and are known as
Negotiable Certificate of Deposit (NCDs)
• Liquidity and marketability as its hallmark
• CDs are issued by banks for attracting large corporate deposits rather mobilising
individual savings
• The introduction of CDs in an economy has usually preceded the introduction of CPs

CDs in India
• In initial years (1980-1987) feasibility of CDs in India is subject to various constraints
like lack of secondary money market, administered interest rates, lack of proper
regulatory system
• Introduction of CDs in 1989 : recommendation of RBI working group on money market
(Vaghul working group, 1987)
• Broad objective is to further widen the range of money market instruments and to give
investors greater flexibility in the deployment of short term surplus funds.
• CDs can be issued by (i) scheduled commercial banks {excluding Regional Rural Banks
and Local Area Banks}; and select All-India Financial Institutions (FIs).
• Banks have the freedom to issue CDs depending on their funding requirements.
• Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be
accepted from a single subscriber should not be less than Rs.1 lakh, and in multiples of
Rs. 1 lakh thereafter.
• CDs can be issued to individuals, corporations, companies (including banks and PDs),
trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs.
• The maturity period of CDs issued by banks should not be less than 7 days and not more
than one year, from the date of issue.

24
 • The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from
the date of issue.
• CDs may be issued at a discount on face value.
• All CDs were subject to cash reserve ratio (CRR) and statutory liquidity ratio (SLR)
requirement, on the issue price of the CDs.
• Banks / FIs cannot grant loans against CDs and cannot buy-back their own CDs before
maturity.
• CDs are freely transferable by endorsement and delivery
• RBI Guidelines for Issue of CDs with respect to The maturity period, Minimum Size of
Issue and Denominations modified from time-to-time.
• Mutual funds are allowed to invest in CDs with cretin limit stipulated by Securities
Exchange Board of India.

5. Commercial Bills
• It is used for financing a transaction in goods that takes some time to complete. It shows
the liability to make the payment on a fixed date when goods are bought on credit.
• It is an asset which is "shiftable", and which carries a low degree of risk of loss
• Bill of exchange is known as Bankers' Acceptances in the US.
• There is no single fixed maturity period for bills in general.

Classification of Bills
• Demand bill: A bill in which no time for payment is specified
• Usance or time bill: It is payable at a specified later date
• Inland bill: Must (a) be drawn or made in India, and must be payable in India, or (b) be
drawn upon any person resident in India
• Foreign bill: Drawn outside India and may be payable in and by a party outside India, or
may be payable in India or drawn on a party resident in India, or (b) drawn in India and
made payable outside India

Discount Market
• Banks borrow funds temporarily at the discount window of the Central Bank;
• they are permitted to borrow or are given the privilege of doing so from the Central Bank
against certain types of eligible paper (collateral), such as the commercial bill or treasury
25
 bill, which the Central Bank stands ready to discount (to rediscount, strictly speaking) for
the purpose of financial accommodation to banks.

Discount and Finance House of India

• It should be the sole depository of the surplus liquid funds of the banking system as well
as the non-banking financial institutions.
• It should use surplus funds to even out the imbalances in liquidity in the banking system
subject to the RBI guidelines.
• It should create ready market for commercial bills, treasury bills, and
government/government-guaranteed securities by being ready to purchase from and sell
to the banking system such securities.
• DFHI was set up by the RBI with the objective of deepening and activating the money
market.
• It became operative with effect from 25 April 1988. It was a joint stock company in form
and is jointly owned by the RBI, public sector banks, and all-India financial institutions
which have contributed its paid-up capital of Rs 200 crore (the authorized share capital of
Rs 250 crore) in the proportion of 5:3:2.
• Further in the year 2004 DFHI has been merged with SBI Guilt Ltd, a subsidiary of SBI
and a new company has been formed which is known as SBI DFHI Ltd.
• Now it has been considered as a primary dealer and it has been created by RBI to support
the book building process in Primary Auctions of Government securities and provide
necessary depth and liquidity to the Secondary market in Government Securities.

LONG TERM SOURCES OF FINANCE

Why companies need long-term finance?
• When they are being set up for the first time
• At the time of expansion
• For diversification into other areas
• For modernizing its equipment and process technology
• For taking over of another unit and so on
When a firm wants to invest in long-term assets, it must find means to finance them. In most
cases, internal resources are not enough to support investment plans. So they have to seek
external funding.
26
Factors affecting the choice of source of funds
• Cost
• Financial strength and Stability of operations
• Form of organisation and legal status
• Purpose and Time period
• Risk profile
• Control
• Effect of credit worthiness
• Flexibility and ease

Sources of long term finance

The following are the sources of long term finance commonly employed by business firms.
1. Retained Earnings / Ploughing back of profits
2. Equity share capital
3. Preference share capital
4. Debentures Capital
5. Term loans

1. Retained Earnings / Ploughing back of profits

• Depreciation and retained earnings represents internal sources of finance.
• Companies usually retain 30% to 80% of profits after tax.
• Depreciation is used for replacing worn-out machinery.
• So retained earnings is the only internal source for financing growth.
• Ex: Microsoft
• Ex: Infosys is a debt-free company. It doesn't have any outstanding debt or fixed
deposits. The company presently generates sufficient cash internally to finance all its
operational, financing and investment requirements.

Company’s point of view: Merits:

• retained earnings are readily available internally
• eliminates issue costs and losses on account of under pricing – external equity
• no dilution of control
• useful for financing expansions
27
 • enhances reputation and increases capacity of business to absorb sudden business shocks
• no fixed obligation to pay interest or dividend
Company’s point of view: Demerits:
• amount of retained earnings may be limited and highly variable
• opportunity costs of retained earnings is quite high

Shareholders’ point of view: Merits:

• subject to lower rate of tax (capital appreciation) than dividend
• reinvestment of profits
Shareholders’ point of view: Demerits:
• conversion of capital appreciation into current income is inconvenient
• suboptimal investment policy hurts the shareholders

2. Equity Capital
• A share is the share in the capital of the company and includes stock except where a
distinction made between stock and share is expressed or implied.
• A share is one of the units into which the share capital of a company has been divided.
• A public company can issue two types of shares – equity and preference.
• Equity shares are shares which are not preference shares.
• They do not carry any preferential right.
• They will rank after preference shares for the purposes of dividend and repayment of
capital in the event of winding up (residual claim).
• The rate of dividend is not fixed – depends on the availability of divisible profits and
intention of directors.
• Equity shareholders control the company – entitled to vote at the general meeting of the
company.
• These shares cannot be redeemed until liquidation and the liability of the shareholders is
limited to capital contribution

Company’s point of view: Merits:

• no legal obligation for company regarding payment of dividend
• not repayable during lifetime of company – permanent capital
• do not carry any charge against assets
28
 • losses are not magnified during periods of adversity
• enhances credit worthiness of company – larger the equity base, higher is ability to raise
debt
Company’s point of view: Demerits:
• cost of equity is high – rate of return is high due to high risk
• equity dividends are not tax deductible payments – no tax shield
• cost of issuing equity is high – underwriting commission, brokerage, issue expenses are
high
• sale of equity stock may result in dilution of control

Shareholders’ point of view: Merits:

• Enjoy controlling power
• Liability is limited to extent of capital contribution
• Rewards of equity capital can be very high
Shareholders’ point of view: Demerits:
• Since equity shareholders are scattered – control exercised by them is weak.
• Cannot contest the dividend decision of Board of Directors
• Have residual claim – lowest priority
• Equity stock prices fluctuate widely – risky

3. Preference share capital

• Preference shares are those which carry following preferential right over other classes of
shares.
• Preferential right in respect of fixed dividend
• Preferential right as to repayment of capital – during winding up
• It is a hybrid form of financing.
• Preference dividend is payable out of distributable profits, not an obligatory payment and
not tax deductible payment.
• Dividend rate is usually fixed
• Do not enjoy the right to vote.
• In past three years there are many reputed companies such as Tata Capital, L&T Finance
Holding company, IL&FS, have issued preference shares under private placement. The

29
 dividend rate offered by them are very attractive for an investor, who are looking forward
to fixed tax free return.

Classes of Preference shares

1. On basis of cumulative dividend payable:
• i. Cumulative preference shares
• ii. Non Cumulative preference shares
2. On basis of Callability:
• i. Redeemable preference shares – called back by company
• ii. Irredeemable preference shares – not called back during its lifetime
3. On basis of Convertibility
• i. Convertible preference shares – convertible into equity shares
• ii. Non Convertible preference shares
4. On basis of Participation in surplus profits and assets – after paying equity shareholders.
• i. Participating preference shares
• ii. Non-participating preference shares

Company’s point of view: Merits:

• no legal obligation to pay dividend
• no redemption liability – except redeemable shares
• it is a part of net worth – enhances credit worthiness
• no dilution of control – no voting right
• no collateral is pledged.
Company’s point of view: Demerits:
• Compared to debt capital – very expensive
• Not a permanent source of finance
• Least preferred avenue of investment

Shareholders’ point of view: Merits:

• Earns stable dividend rate – less risky
• Tax exempt
Shareholders’ point of view: Demerits:
• can enforce their right to dividend
30
 • Preference dividend rate is rather modest
• Price fluctuation of preference shares greater than debentures.

4. Debentures Capital
• Debentures are marketable legal contract whereby the company promises to pay whoever
earns it, a specified rate of interest for a certain period of time.
• It is a document issued by a company as an evidence of debt due from the company with
or without a charge on company’s asset.
• Trustee- is responsible to ensure that company fulfills its contractual obligations to
debenture holders.
• Security- charge on immovable property
• Coupon rate- the company chooses it – may be fixed or floating.
• Maturity period- no restriction (earlier 7 years)
• Convertibility- into equity shares at option of debenture holders - Non convertible
debentures, Fully convertible debentures and Partially convertible debentures
• Ex: Kosamattam Finance, Muthoot Finance, Srei Equipment Finance, Dewan Housing
Finance Corp, JM Financial Credit Solutions and Shriram Transport Finance Company
together mopped up Rs 190 billion through retail issuance of non-convertible
debentures (NCDs) during 2018.

Company’s point of view: Merits:

• interest on debentures is tax deductible
• no dilution of control
• fixed monetary burden on company
Company’s point of view: Demerits:
• failure to pay interest can cause great deal of embarrassment
• enhances financial risk- increases cost of equity capital

Investor’s point of view: Merits:

• earn stable rate of return
• enjoy high order of priority in event of liquidation
• protected by various provisions of debenture trust deed
• generally have fixed maturity period
31
Investor’s point of view: Demerits:
• interest on debentures fully taxable
• Debenture prices are vulnerable to increase in interest rates.
• Do not carry right to vote

5. Term loans
• Term loans represent a source of debt finance which is generally repayable in more than
one year but less than 10 years. (Medium term-1 to 5 years)
• Security – assets financed with proceeds of loan – prime security and other assets –
collateral security
• Interest payment and principal repayment – definite obligation
• Restrictive conditions – are imposed on borrowers

Company’s point of view: Merits:

• cost is lower than equity or preference
• no dilution of control – no right to vote
Company’s point of view: Demerits:
• Interest and principal repayment – obligatory
• Restrictive conditions may reduce managerial freedom
• Entitles lenders to put their nominee on board
• Increases financial risk of the firm
• Convertibility claim

Lender’s point of view: Merits:

• earn fixed rate of interest and have definite maturity period
• secured lending
• restrictive conditions to protect interest
Lender’s point of view: Demerits:
• No right to vote
• Not represented by negotiable securities

32